Transactional Costs Economics Analysis for Iran Khodro Company Case Study

Transactional costs economics analysis for Iran Khodro Company Case Study.

This article aims to identify the key characteristics of TCE and analyse the vertical boundaries of a firm by describing the critical role played by coordination in a vertical chain. The firms and the examples are real and come from author's personal business experiences. The firm which was selected to be analysed is IRAN KHODRO Company ( IKCO) [Bb 1] the largest car manufacturer in the Middle East with over 1,000,000 cars production per year.

Industrial revolution in 18th century changed the face of the world by two main factors, Variety of products and mass production. Consequently firms were obliged to lower the costs and make more qualified products to be able to survive and develop in a high competitive campaign. This high competition in price and quality made the firms to be specialised in their main activities to minimise the costs, keep the quality acceptable to attain reasonable share of the market and finally maximise the profit (known as neoclassical profit maximising theory). Therefore they could be good in only one ring of the product vertical supply chain. But product supply chain consists of different activities starting from raw materials (or even idea and design) up to retailers and delivery to the customers and after sale service. Here a very important task of the firm management arises: what will be the vertical boundaries of the firm? What must be made in-house and what must be bought from market? Some firms cover only a small part of the chain, while some others cover several parts and so called vertically integrated firms.

"The make or buy" dilemma in our case study company for a specific part, resulted to the born of two new companies, Noor Ista Plastic (NIPCO)[Bb 2] in 1989 and COMPART company [Bb 3] in 1993 for supplying an specific car part according to the contracts between IKCO, NIPCO and COMPART. I was commercial manager of NIPCO from the construction stage of the company up to the production and sales of the products.

Here the product obviously is a car. But for manufacturing this car, thousands of parts and services shall be supplied so that the customer can get the car. Here the above mentioned dilemma arises: from where these parts shall be supplied? Made in-house or to be bought from market? As the management decides to make the parts more than in-house, he expands the vertical boundaries of the firm indeed. Now IKCO management shall analyse the costs for make or buy dilemma. A very important point is that the costs of BUY from market is not simply the prices offered from the supplier. Coase, Williamson and others developed the framework of TCE (Transaction Costs Economics) which states there are costs other than offered price when doing transactions with the market.

TCE was introduced and used by Oliver E.Williamson. However the root idea goes back to John R.Commons (1931). then Ronald Coase used it to develop a theoretical framework in firms behaviour analysis in his paper "The nature of the firm" (1937) and "The Problem of Social Cost "(1960) [Ref 1].

Transaction main costs arise from: supplier sourcing process, market date gathering, bidding, contract negotiation and contract enforcing procedure, monitoring and inspection of contract progress and legal costs that comes from supplier breach of contract. As it is seen clearly the execution of the work relies on the contract between firm and the market. In other words the contract is the base and main point of the procedure.in the same time there are some factors that causes contracts to be incomplete in reality. First of all, negotiators for contracts are naturally bounded in their rationality because of lack of the information or in some cases huge amount of information which causes complexity. Secondly, both parties have an opportunistic mind and behaviour which makes the contract monitoring and inspection costs to be high, and finally information is asymmetric for both parties and so one party can abuse the shortage of information of the other part. It becomes more complicated and costly when there is asset specificity in the transaction as well.

Regarding our real example, IKCO needed an important part for his cars named front panel, which is a platform for all the front parts of the Peugeot 405 car. The part was manufactured by using composites technology, specific moulds and special presses. IKCO needed 200,000 pcs per year at that time (1990) with a growing demand for the future. At that time the parts were in the pack sent by a French supplier. The price for each part was 80 USD when imported from abroad (pure buy).IKCO was suffering of high price because of monopoly game (only one European supplier had the moulds), currency rate changing (USD evaluating comparing to Iranian Rial every year) and European supplier delays and not having any control on the supplier. The question was to make in-house or buy from market? The investment for setting up such a production line was about 6,000,000 USD.