You can’t manage costs effectively without taking into account the transaction costs. Many economists like to divide costs incurred by a business into two categories; transaction and production costs. Production costs include costs of producing as well as distributing a good or service. Everything else is categorized into the types of costs.
The managers can’t make right choices without analyzing transaction costs. We wanted to purchase a colored Doppler (ultrasound machine) for our charity hospital. However, the price of the device from well-known companies was out of our reach. On the other hand, we didn’t want to buy a product from some less reputed company. This led us to go for a refurbished colored Doppler.
There were dozens of sellers all around the province. We were touchy about the model, availability of spare parts and price of the product. Our searches cost us spending on telephone calls, letters, emails, etc. Similarly, we had to spend a lot of time which involved an opportunity cost. All these expenses were made to purchase a single product. What can be the volume of the cost in case of economies of scale?
They can be huge!
In fact, without analyzing these costs, we can’t find out the exact turnout of our deals. They become a detrimental factor in measuring the level of profits. The profits of a business decrease with increase in transaction costs. They also reduce the volume of our reserved capital which we can invest in specific profit yielding opportunities.
In a few words, the transaction costs are the costs which are paid other than money price for a product. These costs may also involve agreements regarding payments in installments, payment for future delivery, warranties and guarantees for quality and services, provision of more products in future on the same or some agreed price, etc.
These costs can be divided into three categories; costs on search and information, bargaining and policing and enforcement.
The costs made on finding a product in the market, finding the substitutes, finding the lowest market price, availability of spare parts, etc. are called search and information costs.
The costs made to reach an acceptable agreement by all parties to a contract are called bargaining costs. It may involve lengthy negotiations, travel, and opportunity costs, etc.
Policing and enforcement costs are very interesting and may continue to rise even after signing a contract. The money spent on writing an agreement, hiring services of a lawyer and enforcement of different clauses of the agreement included in this category. The legal system of a country decides the volume of this kind of costs in some transaction.
You can find some constructs of the theory of transaction costs. The primary factor is the governance structure. In a developing country, they may increase due to kickbacks, corruption and high costs to implement the contracts. In a developed country they reduce due to systematic approaches and robust accountability mechanism. When copyright violations are not penalized, they increase to the level of killing product. For example, you release a good song, but due to copyright violations, your poem is played without paying you a single dime. You may become very popular, but you will lose the benefit that could have come if copyright laws were enforced properly. To implement your rights, you will have to pay according to the governance structure of your country.
The next construct of the theory is outsourcing and the level of failure or success of outsourcing efforts. When Apple decided to launch its products from China, the main idea was to outsource labor from the cheapest options.
Another interesting factor of the theory comes from coordination and collaboration with other organizations. When your coordination is right, you will have to spend less. However, in case of a poor relationship, your coordination costs may increase.
The opportunity cost may also become an important factor in the analysis of the transaction costs. They may be in the shape of risks in holding money or investing to same to some other opportunity. We may also include operational cost and uncertainty as constructs of the theory.