3 The Role of Strategy in Transaction Cost Economics

At this point, it would be reasonable to ask the question why a book on strategic management accounting should start with a simple model of what the difference is between an organisation and a market. The reason is that I will use the insights from transaction costs to explain the benefits of a strategy for a organisation and how management accounting plays a role in reaping the benefits of a strategy. The fundamental insight of transaction cost economics is that organisations exist because they are more efficient at coordinating certain asset-specific investments than independent organisations transacting in markets. The argument in this chapter is that an organisation’s strategy can be defined by which investments they coordinate and that different management accounting tools help to coordinate these investments. To make that proposition more concrete I will use the examples of the Apple and the Android ecosystem in the smartphone industry.

Strategy and Transaction Costs

The categorisation of organisation strategies is a source of a lot of debate. A company’s strategy explicates how organisations exploit opportunities in the market place that lie within their capabilities (Horngren et al., 2012) or their strategies specify the direction a company tends to take over the long term to achieve its mission and meet its objectives. Most management accounting textbooks focus on the distinction between cost leaders and differentiators (p.5 in Horngren et al., 2012; p.14-15 in Langfield-Smith et al, 2008). Cost leaders provide products and services at prices that competitors cannot match. Examples of cost leaders are Amazon, JetStar, and Red Rooster. Typically, cost management will be an important tool for companies with a cost leadership strategy. Other organisations try to differentiate their products and services from competitors. Apple is a prime example of a company that has been able to differentiate its iPhones and MacBooks to the extent that some customers almost see them as a different product category, separate from other smartphones and laptops. A subtler example is Subway that has successfully built an image of being a healthy fast-food alternative.

Although this distinction is useful and can be further refined ^[1], I look slightly differently at an organisation’s strategy. The established view of strategy in management accounting textbooks assumes that the strategy is decided upon at the top of the company and top management tries to implement that strategy with the help of management accounting tools such as budgets, cost accounting systems, incentive systems, and other performance measurement systems. While this assumption might be realistic in organisations that are tightly controlled by a powerful CEO such as Steve Jobs (Apple), Jeff Bezos (Amazon, Blue Origin), or Elon Musk (Tesla, Solar City, SpaceX), it does not have to be true.

The approach in this textbook is different in that it does not assume that the strategy of the organisation is a deliberate choice of top management. For the purpose of this text, the strategy of the organisation is determined by the investment decisions that give the organisation a difficult to imitate competitive advantage. The assumption is that organisations that have no sustainable competitive advantage will be copied, or taken over by competitors, and disappear from the market place as they are being replaced by more efficient copy-cats.

One way how organisations can create a difficult to imitate competitive advantage is by coordinating a lot of asset-specific investments. Remember that these are investments that are only valuable within the organisation and if they are combined with other asset-specific investments. One example is a vertically integrated organisation like Apple. Apple tightly controls the hardware design, the engineering of the computer chip, the operating system, the marketing and the retail experience for their iPhone smartphones.

Markets

In order for a organisation’s strategy to provide a competitive advantage, it is not enough that no other single organisation can copy the strategy. The organisation also wants to avoid that a collection of organisations together outperform the organisation’s strategy. This is especially important for vertically integrated organisations like Apple. For the production of the iPhone, Apple tightly controls the hardware design, the engineering of the computer chip, the operating system, the marketing and the retail experience. For the typical Android smartphone many more companies are involved such as Google, Samsung, Telstra, JB Hifi and they all have direct control over some of these activities.

The Android market approach has a number of attractive features. As each organisation is a for-profit entity, they all have a strong incentive to be efficient. An inefficient organisation will either be quickly put aside by their customers because their prices are too high or they will incur losses and run out of funding. The incentives in the market are in general much stronger than those for individual departments in an integrated organisation as we have seen in the previous chapter.

The second feature of markets is that the price of the different products and services is a coordination mechanism between the individual companies. When customers are buying more Samsung phones, the retailers, such as JB Hifi, are willing to pay a higher price for Samsung phones and carriers, such as Telstra, are willing to subsidize the purchase of a Samsung phone with a phone plan. This is a signal to Samsung that their phones are popular and they should produce more of the phones that are in high demand. Although, Samsung is not in direct contact with the consumers, they still receive feedback on the popularity of their products ^[2]. What holds for the final product, also goes for all the intermediate components that make up the phone. Every supplier in the whole production process will get price signals that determine whether they should make more or less of a product or product category. This is the famous invisible hand of Adam Smith at work.

Incentives and Information in Organisations

Integrated organisations will need to replace the incentive and price signal of markets internally. This is one of the major functions of the strategic management accounting tools that we are going to discuss in the second section of the book. The goal of budgets, balanced scorecards, cost accounting, and bonus systems is some combination of gathering information from inside and outside the organisation, disseminating that information through the organisation, and motivating the different departments in the firm to work in the best interest of the organisation.

As an example, organisations can set up a transfer pricing system which is the most direct reflection of a market mechanism. A transfer price is a price paid by one department of the company to another for a product or service. For instance in a proto-typical manufacturing company, the production department assembles the product and the sales department sells to the final customer. The transfer price is a revenue for the production department and a cost for the sales department which allows the headquarters to assess each department’s contribution to the organisation’s profit (See further in this textbook for more on transfer pricing and chapter 22 in Horngren et al. (2012) or chapter 12 in Langfield-Smith et al. (2008)). Alternatively, organisations can allocate a budget to each department and assess whether the department used the budget efficiently. The allocation of budgets can also be used as a way to coordinate both departments. If headquarters want to increase the number of products manufactured, they can allocate a larger budget to the production department (see further in this textbook for more on budgets, or chapter 6 in Horngren et al. (2012) and chapter 9 in Langfield-Smith et al. (2008)). As a last example, organisations also collect non-financial measures to evaluate and motivate employees instead of relying on market incentives and financial measures only. Financial measures and non-financial measures are used together in a balanced scorecard and they help organisations to keep track of the overall performance of the organisation and to coordinate the different departments. The balanced scorecard allows the organisation to break up the overall strategy into departmental strategies that are measured in separate, departmental balanced scorecards so that each department knows how they can contribute to the overall goal of the organisation (see further in this textbook for more on the balanced scorecard, or chapter 13 in Horngren et al. (2012), and chapter 14 in Langfield-Smith et al. (2008)).

Integrated Organisations and Transaction Costs

Because performance measures and evaluation systems are rarely perfect, they often contain less information than the price in a perfectly functioning market and the incentives in organisations are often less strong than in a competitive market. Organisations can not as easily fire employees as they can change their suppliers. When markets seem to be better at summarising information and providing incentives, the question remains why vertically integrated organisations exist. In other words, why has the market of software and hardware manufacturers not driven Apple out of the smartphone market?

The advantage of an integrated organisation is that it can combine and coordinate all the functions at once and create synergies. Apple for instance has created its own system on a chip (SoC) which optimises energy use and performance for its software on its hardware. To get the best of this combination Apple needs to invest and coordinate the investments in the design of the chip, the software, and the hardware at the same time. The coordination of all these benefits is a delicate balancing act but if the benefits of this integration outweigh the costs of abandoning the market’s price mechanism, an integrated organisation has a sustainable, difficult to copy strategy. For our purpose the key insight is that the success of the integration will depend crucially on using the right management accounting systems to assign the necessary budget to all projects, hold divisions accountable for their contribution to the overall strategy, and communicate the overarching strategy to the different divisions ^[3].

In the smartphone industry, other players such as Google, Microsoft, and Samsung, have with varying success moved towards more vertical integration. In general, all organisations are combining and coordinating multiple investments. That is, all organisations are integrated to a certain extent. I have used the comparison between Apple and the Android ecosystem as another simplified story to illustrate the value of integrating multiple functions and coordinating them well. The simplified story shows that while management accounting tools might not be as effective as the market price in an efficient market, this does not necessarily diminish the value of these tools if they allow firms to combine and coordinate multiple functions and create synergies. This cost-benefit analysis between the transaction costs of setting up management accounting tools and the benefits of synergies is how we should evaluate the value of strategic management accounting tools ^[4]. As a result, not all organisations are necessarily trying to get more vertically integrated. Some organisations choose a strategy that tries to remove transaction costs. The success of companies such as Uber and Amazon shows that some organisations do not shy away from creating markets, and using a pricing system as the core of their strategy. Uber, for instance, manages demand and supply for driving services through a dynamic pricing system.

These transaction costs of management accounting tools can take numerous forms: from the cost of hiring consultants to help design the system, over the cost of IT systems to manage and collect the data, to the reaction of employees to being monitored or have their salary depend on imperfect measures. It is equally important to know what transaction costs are not. They are not the costs of goods, services, and human resources that are necessary for the production process of the organisation ^[5]. I believe that one of the key differences of my approach to strategic management accounting compared to traditional textbook approach is the focus on transaction costs. I fundamentally start from the premise that all management accounting tools have transaction costs associated with them. Thus, they will only be useful to an organisation if the benefit of having the management accounting tool are larger than the transaction costs of developing and implementing it.

References

Horngren, C. T., Datar, S. M., & Rajan, M. V. (2012). Cost Accounting: A Managerial Emphasis (14th ed.). Pearson Prentice Hall.

Langfield-Smith, K., Thorne, H., and Hilton, R. W. (2008). Management accounting: Information for creating and managing value. McGraw-Hill Higher Education.