Outsourcing to Create Digital Capital

In a month when thousands of jobs have been saved (for now) at Rover and thousands lost at Ford, it's tempting to ask why companies employ people at all. Why not run the company with contractors that you employ only when you need them?

The reasons were articulated as far back as 1937 in a paper on the nature of the firm by economist Ronald Coase. He argued that the companies couldn't rely solely on contractors due to the prohibitive transaction cost of hiring the people with the right skills, at the right time, for the right price.

In effect, companies found the best compromise between the staff-only and contractor-only models by employing the minimum number needed to carry out a task. One more employee than the minimum needed would make the company wasteful. One less than the minimum would elevate the overall transaction cost.

The key to Coase's work, for which he won a Nobel Prize, was its interpretation of the strategies companies adopted for vertical integration. It explained why Ford owned rubber plantations that supplied the raw materials for its tires, and a fleet of vessels to transport its raw materials up and down the Great Lakes. In both instances, Ford was reducing costs by integrating processes upstream of the mass-production of its cars.

By doing so Ford epitomised the Industrial Age. And by doing exactly the opposite, Cisco epitomises the New Economy. Cisco owns only two of its 40 factories, the rest of which are run by manufacturing partners who participate in Cisco's supply chain. Less than a quarter of all orders actually touch Cisco; most are fulfilled directly by the partners. Cisco owns the designs, and the software that controls its products. The rest is in the hands of its manufacturing partners and resellers. Yet it is the third most valuable company in the world today.

This does not render Coase's work incorrect. It's just that the transaction costs have changed, because of electronic and digital possibilities, which have changed the way companies organise themselves. The old monolithic model applied when transaction costs were high. As fluid collections of businesses come together using the Internet and other digital media, transaction costs fall, making it more efficient for companies to outsource activities. A recent book by Don Tapscott, David Ticoll and Alex Lowy called Digital Capital explores how businesses might react to this new environment.

The thesis of Digital Capital is simple: competitiveness in the Internet era depends on business model innovation. In industry after industry, new Net-enabled business models are killing off old models of wealth creation. The new models are as different from the old as Ford's mass production was from the methods of the village blacksmith.

The b-Web
Digital Capital establishes the idea of a business web, or b-web, a network of suppliers, distributors, commerce service providers and customers, conducting business on the Net and in other electronic forms to produce value for each other. b-webs can be differentiated by the economic control and the degree of value integration that takes place. Some business models are dominated by a single entity that controls content, pricing and the nature of transactions. Others are self-organising. Some take the output of other companies and integrate them into a single coherent product. Others don't change anyone's products, but offer them in a convenient market.

Agora and Aggregation
The authors identify five different types of b-web. Agora, named after the ancient Greek market, handles complex transactions between buyers and sellers, providing a mechanism for discovering the market-clearing price. The new electronic exchanges, such as eBay or AutoExchange from GM/Ford, with their auctions, online negotiations and dynamic pricing, illustrate this model. The second type is called Aggregation, which organises the distribution and delivery of goods to customers. Tesco and Amazon.com provide excellent examples of a business model that offers selection and convenience to the customer, without changing the core product, whether books or cornflakes, in any way.

Value Chain and Alliance
In the Value Chain b-web a single company like Dell or BMW organises the output of many different manufacturers to create a high-value item such as a computer or a car. The result is closely associated with the company that controls the chain, and customers seek the difference that the value integrator brings. The Alliance b-web is described by the authors as "a bit of magic" where the goal is to create high value integration without the hierarchical control exercised by a BMW or a Dell. Allies collaborate, usually online, to create, for example, Linux: a freely available operating system that competes against that most extreme of value integration icons, Microsoft.

Distributive Networks
The final b-web is the Distributive Network. Companies using this model are providing the economic and social glue by supporting the economic system. Examples are utilities, telecoms companies and banks.

The key to Digital Capital is not the b-webs themselves, but the fundamental characteristics they share. Companies of the future will not simply follow one model, but will combine different features from each to create distinct enterprises that are finely tuned to the needs of the customer.

For companies setting up today, Digital Capital represents an excellent overview of the opportunities available. Businesses created in the Industrial Age must reassemble their processes into "an artful rendering that draws judiciously on the many shades" of Digital Capital.

The game is still the same: making the best use of the resources available, while reducing the associated transaction costs. I don't think Ronald Coase would be at all displeased.

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