Coase was most famous for his theory of why firms exist. Core to his theory is the concept of a transaction cost. Coase argued that there are transaction costs associated with operating in an open market – for example the need to negotiate and bargain when interacting. Coase argued that firms exist when the advantage of avoiding these transaction costs exceeds any costs associated with running the firm.
Let’s park Coase for a moment and ask a question - why do organizations outsource functions such as IT? There are many reasons which have arisen in the history of outsourcing. The outsourcing companies have economies of scale, are specialists in IT with more mature processes and advanced capabilities than other organizations. Lots of similar claims are regularly made about how efficient and effective the outsourcing companies are at running IT.
But I think there is another reason that firms outsource. It is simply that by outsourcing a firm makes its cost of IT clear and transparent. Cost transparency is extremely useful in large businesses as it supports to effective operations and efficient resource allocation. Of course, cost transparency is possible with internal functions, but somehow it seems much easier to achieve when dealing with an external supplier than when dealing with an internal function. Internal functions’ use of resources often seems murky and unclear. Precisely who is using what percentage of that functions resources and costs is often a long way from being transparent. Finance functions spend huge amount of time working out what costs to allocate to whom, often using very broad estimates and unproven assumptions.
What’s interesting in the outsourcing situation is that in going from an insourced IT department to an outsourced one, an organization exposes itself to all those transaction costs which it had avoided by internalising the function. However, for many organizations the advantages of cost transparency may be great enough to accept the transaction costs associated with outsourcing.
This is of course only true if an organization actually understands the transaction costs associated with outsourcing. In my experience this is often not true. In other words, we get cost transparency over one set of costs – for example those of running an outsourced IT department, but instead loose site of a whole lot of other costs – the transaction costs associated with managing such a relationship.