Transaction cost. The least understood cost in business:

Mar 19, 2015 | Customers, Governance, Lean, Management, Small business

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Remove transaction costs.  Easy to say, hard to do.

The concept of transactions costs is generally attributed to British Nobel prize winning economist Ronald Coase, and the publication of his 1937 paper “The nature of the firm”

Transaction costs will always be present, they are the enablers of an organisation. The challenge is squeezing the maximum productivity out of the transaction costs you will inevitably incur.

Like all costs, transaction costs fall into three categories:

• • 1. Those that are necessary for the sale, and that add value to the customer, so they would be willing, if you asked them (and this is the big test) to pay for it. Things like delivery of physical products fall here, and we all know  there is no such thing as “cost free delivery”. ,
    2. Those that are necessary, but do not add value to the customer. Costs associated with compliance, your training and innovation programs, taxes and charges all fall here .
    3. Those costs incurred that do not add value in any way, just consume time and money, such as rework, picking up wrong deliveries, or correcting wrong invoices. You generally do not need an activity costing initiative to know that this third category is usually uncomfortably large, and should be eliminated.

The bloating of transaction costs has three basic causes:

• • 1.  Not getting “it right first time” requiring rework to correct the mistake. For small businesses, the costs of mistakes are relatively much harder to absorb than they are for a large enterprise.
    2. The penalty of small scale, expressed in the variable operational costs incurred, and the productivity per   dollar of overhead spent. The flip side is that small operations can be far more agile than large ones, as the distance between a decision being made and actually getting something done, is much shorter.
    3. Less than optimum processes, or the ways that businesses manage the things that need to be done to support and document a transaction.

If you chose to take a deeper look at these three causes, they are all rooted in the way people go about doing their jobs on a daily basis, and for small businesses, with less people, and far easier personal communication, this is where the leverage can be applied by continuous improvement.

It costs the same to raise and process an invoice of $1,000 as it does for an invoice of $100,000. Therefore the transaction cost % of the invoice value is far greater for the smaller invoice. This relationship is reflected throughout the supply and distribution chain, and even minor improvements can deliver substantial savings. Technology offers the opportunity to reduce the absolute cost of processing to almost nothing, making the transaction cost irrelevant either way, but once people are added to manage the exceptions that cannot be handled automatically, the costs soar.

The source of Woolworths superior performance over the last decade compared to Coles has been the impact of their reductions in transaction costs that have dropped straight to the profit line. Wal-Mart became the biggest retailer in the world by focusing on the reduction of transaction costs of all types, and passing the savings on to consumers as lower prices to attract the volume creating a virtuous circle. Less obviously, they passed many costs back to suppliers, then continued to insist on and successfully extract cost reductions from those same suppliers in spite of increasing their costs, simply because of the scale of their sales potential for suppliers.

It seems to me there are two parameters to transaction costs:

• • • The absolute amount of the costs in a whole process
    • The productivity of the costs in the process.

Most systems just look at the quantum, and set out to cut corners, work the current system harder, but by looking at the detail of the things that generate the costs, you can eliminate those that do not add value. However, moving a transaction cost on to another link in the supply chain does little to eliminate the cost, it just moves it. Retailers generally have been expert at this moving of transaction costs, while often creating them as a source of revenue. Practices such as making minor claims on a supplier, and holding up payment of a complete invoice until the claim is dealt with, then making the dealing with the claim a minefield for small suppliers abound. A source of the success of Aldi in Australia has been their focus on the reduction of transaction costs, but in return they get their “pounds worth” at the invoiced price point.

In dealing with supermarket retailers over many years, a number of transaction cost types have become evident:

• • • Cost of searching, storing, processing & managing information. Category management is a prime suspect here. Suppliers engage in a costly, data intensive exercise in the expectation (hope in most cases) that there will be returns from the collaboration that is hoped to occur, and from the opportunities good category management can unearth. While the costs of the data transactions themselves may have dropped precipitously over the last 20 years, the costs of the overheads to manage them have not.
  • • Cost of negotiation. In almost any negotiation where one party has the power, and is happy to use it, the outcome is virtually pre-ordained, it is just the quantum of the cost that is in question. Knowing, and sticking to your “Walk away” point is an absolute must.
  • • Cost of time. A vastly under measured cost in most businesses. We tend to have people on staff because there is a job to be done, and we pay them competitive rates to ensure we get the best people we can for  the job, but we tend not to measure the value delivered by the doing of the job, its cost is just a part of the fixed overhead. Every minute spent costs a business, but apart from VC operators who use “burn rate” as a key measure, we tend to ignore it.
  • • Cost of certification. The range of certifications that are supposedly “needed”  from HACCP to OH&S, to quality verification of components in a product to various religious and quality standards are legion. Each costs time, money, effort, and carry heavy opportunity costs. A bit of effort to isolate those that are really needed, and to manage those that are with automated or at least consistent processes can save a significant amount of time and money
  • • Cost of influence. People deal with people, not corporations, no matter how automated and impersonal our communications systems become. Getting to know people , building relationships and trust takes time and effort. It is time and effort well spent, to a point, and finding the point at which the costs outweigh the benefits is a management challenge most fail.
  • • Costs of cock-ups and rework. This is probably the biggest, most pervasive  source of transaction costs. From the wrong invoice to a truckload pf product turning up to be rejected, and turned around dumped or put into rework.  It is not just the cost of the product, but the added time, lost sales, loss of reputation, and needless consumption of capacity that really hurts. “Lean” processes target waste, and this one is the biggest waste that occurs, and is often made up of a lot of low hanging fruit if you go looking for it, and know where and how to look.

Small businesses are in a great position to reduce their transaction costs, simply by being good at everything they do, and being “close to the action” can make the wrinkles that can be ironed out that more obvious.

The original post that started the series is here, followed by the more detailed posts, 1, 2, 3, 4, 5.