50 years since Franklin Roosevelt gifted a DC-3 Dakota airplane to King Abdul-Aziz, allowing the country a leap into modernity, national carrier Saudi Airlines’ fleet has grown to 139, making it the region’s leading Aviation Company.
But as the Gulf’s spending power grew via habitual oil booms, so did the transport-expansion capacity of neighbouring countries. Competition in the region has become brutal, with billions of investment pouring into modernization and fleet expansion by countries such as Qatar and the Emirates. Add to that the entry of low-cost carriers such as National Air Services and SAMA Airlines which looks into a whole new field.
Saudi Airlines decided to take on the challenge on multiple levels. Firstly, a global marketing campaign drew attention to Saudi hospitality and strength as a service provider. By investing in an upgrade of its business class services and placing an order for 22 Airbus A320 wide-body jumbo jets, the airline aims to maintain its leading position of the last years (official website, 2010).
In addition, a privatization process is expected to further extend its competitive edge, with its catering and technical services units already spoken for and other segments to follow in 2009. “Saudi Arabian Airlines is reputed in providing world-class services with a distinctive Saudi character and warm Arabian hospitality,” explains Yousef Atiah, Vice President for Customer Service. “All our improvements, enhancements, and innovations are based on this principle” (Foreign Affairs, 2008).
“Saudi Arabian Airlines signed five landmark agreements Sunday to privatize its core aviation unit, establish a new company for ground services at all Saudi airports, finance its new fleet of aircraft and manage the IPO of its catering company” (arab news, 2010). Such news is filling the air nowadays whilst Saudi Airlines carryon forward their ambitious goals of fully privatisation by the end of 2015.
Saudi Airlines began the process of privatisation in 2006, where it dividing itself into Strategic Business Units (SBU); the catering unit was the first to be privatized. In August 2007, Saudi Arabia’s Council of Ministers approved the conversion of strategic units into companies. It is planned that ground services, technical services, air cargo and the Prince Sultan Aviation Academy, as well as the catering unit, will become subsidiaries of a holding company.
Apart from the privatisation goals stated formerly, some supporting divisions were kept in the shade and not mentioned in the line-up. Departments such as Information Technology, medical centre, and training department were not clearly addressed in the strategy plan mentioned before. Never the less, decisions have been made actually to outsource some of them, mainly the medical and the training centres, as independent profit institutes. Regarding Information Technology, it was not clear whether to keep it in-house as a core competence or outsource it to the market [[1]].
To elaborate more on this issue, the Information Technology Dept. will be taken as a case-study where it will be measured and analyzed using two strategic perspectives, mainly transaction cost (TCE) and resource based view (RBV).
Information Technology department, having a huge number of employees (around 500), is responsible for providing a verity of e-solutions and e-support to various segments of the company; and their main responsibilities are:
1. Host and maintain the company’s reservation system: that handles reservations, ticketing, and scheduling transactions where the system is hosted in-house on a mainframe system administrated 24/7 by a dedicated well trained team. In addition to a support team who are responsible of make required amendment to the system.
2. Hosting other department systems: such as financial, marketing, human resource, and payroll systems with dedicated teams to each of them for support and development. These were recently replaced by SAP Enterprise Resource Planning (ERP) solution.
3. e-Business centre: which provide a verity of -services to employees such as medical appointment reservation, airline staff booking, payroll information, statistical and market information for executives and training materials.
4. Network administration: where networks between different sectors of the company in addition to sales offices around the world are monitored and maintained via the network dept.
5. Communication services: including corporate e-mail and other messaging systems are provided for staff and crew members.
6. Hardware and Software maintenance: for all PCs, printers, terminals, and other related parts.
Transaction cost economy (TCE), following Williamson (1975), is concerned with all the costs of search, metering and monitoring associated with the transfer of resources and products across markets and within organizations.
TCE is basically built on the idea that efficient firms are the ones who minimize the sum of production costs and transaction cost (Lockett, Thompson 2001: 728). The production costs are all inputs to the production process that includes physical inputs such as raw materials, machineries, and workforce, workers & administration. The transaction cost, on the other hand, represents the indirect costs needed to carryout that process. It is the cost due to using the market in issues such as searching for buyers and sellers, negotiating deals with them, preparing contracts, monitoring deliveries, and the payment mechanism.
Another application of TCE is in the ‘make or buy’ decision making, which involve deciding whether to produce the required component in-house or source it from market. TCE propose that “in the absence of production cost difference the solution hinges on the relative cost of using the market or internalizing the transaction. Where the costs of using the market are high, the make – or vertical integration – option will generally be preferred. Where the costs of using the market are low it will usually be cheaper to use the buy option” (Lockett, Thompson 2001: 728).
The transaction cost was first introduced by Ronald Coase in 1937 to try to explain existence of firm. Coase looked at firms as a way of eliminating transaction cost since firms are though to be productive unites (vertically integrated) prepared to produce and sell goods in order to avoid the spot market related costs such as searching, negotiation, and monitoring delivery in each re-contracting. In the absence of the firm model, these costs occur on daily basis where workers are hired. As a result, daily hiring cost, uncertainty of both hiring or availability of enough labour are some of the threats; in addition in loosing the chance of learning and training due to daily basis recruitment.
Although the Coasian firm tried to explain the transaction cost idea by addressing the physical costs involved, it actually lacked the behavioral perspective of the subject. Oliver Williamson (1975; 1985) further developed that theory by involving these behavioral factors to the model.
Williamson explains the difference of his view by stating that “there is some discomfit with the apparent disjunction between neoclassical and transaction cost modes of economic analysis where the former emphasizes production costs and views the firm as a production function, while the latter focuses on transaction costs and regards the firm as a governance structure” (Williamson, 1985).
His two major contributions were posing internal organization and markets as alternative ways of coordinating transaction; and exploring the determinants of the transaction cost.
Consequently, many behavior determinants have been defined in addition to the Coasian physical ones; and these are:
1. Bounded Rationality
2. Opportunism
3. Information asymmetry
4. Uncertainty
5. Small numbers bargaining
6. Frequency of transaction
According to Williamson, it is the mixture of two or more of these that actually raise the transactional cost. So in the absence of symmetric information, for example, as in the case of selling a car, a dealer how knows better could behave opportunistically with the buyer who lacks information about the car and as a result the transaction cost could be severely high.
Another key factor (according to Klein and Teece) is the asset specificity. An asset specified to a particular task generally generates higher returns in that use than any other general purpose one. A good example could be Oil pipelines, used specifically to transfer oil from Oil wells/fields to refineries or seaports. With the existence of asset specificity, there is always a risk of arguments and disagreement between contracting parties, which in turn might result in a total hold-up. Such situation, if occurred, would certainly increases the transaction cost involved.
Therefore, vertical integration – make – is preferred to market sourcing – buy – when Transaction cost is high and frequency is high and visa versa. Some exception to this role happens in cases involving innovation, culture differences, or country/industry specific factors.
TCE proved to be widely applicable to most economic and contractual relationships; including vertical and horizontal integration, corporate finance, marketing, Human Resources, organisation of work, commercial contracting, transfer pricing, franchise, and even regulations (Selanski H.A. and Klein, P.G. 1995).
In addition, if a superior transactional system can not be imitated, it would be a critical source of sustainable competitive advantage, as the case of Toyota with their sub-contractors.
It is not surprising, then, that Rumlet, Schendel and Teece (1994: 27) stated that “of all the new subfields of economics, the transaction cost branch of organizational economics has the greatest affinity with strategic management” and continuo on observing that TCE “is the ground where economic thinking, strategy, and organizational theory meet” (Rumlet et al.1994: 27).
By applying TCE methodology, it could be decided whether to outsource the IT dept. or keep it in-house (vertically integrated). By looking at the transaction cost associated with outsourcing the facility, it is not recommended to go for market for many reasons:
1. Outsourcing the entire department can not be done for multiple suppliers due to the uniqueness of the systems which can not be duplicated. On the other hand, sourcing to only one supplier carries, also, the hazard of reliability and quality of services provided. Supplier’s environment robustness is a mandatory, since any malfunction could paralyze the entire business.
2. Another issue is regarding opportunism behaviour. Since the supplier knows how crucial these systems are to the work-flow of the company, he would have a strong bargaining power when renewing the contract.
3. The indirect cost associated within such as searching cost and time, negotiating deals, metering payments, monitoring deliverables are very high and time consuming. And in case opportunism behaviour occurs, it would be very costly to change to another one.
4. Although not considered as a core of the business, IT is important for the deliverable of almost all services in the business and relying such important component on just one source could cause a hold up by the supplier. So, a back-up should be available (which is not the case here!).
5. If the contract involves preparing a location (asset specificity) for the supplier to work it would result in more transaction cost, especially in the case of cancelling the contract (sunk costs).
Although TCE has an advantage of being built on a simple and straightforward rule -cost minimisation, and guides decision making by posing internal organization and market as mentioned previously, nevertheless there are many issues that have been raised against the benefits of using TCE.
TCE tends to be technologically deterministic, where innovation might cause the prediction to be invalid (Lockett and Thomson: 110). It is, also, subjective in costs estimates, as managers might define transaction costs differently. TCE is hard to measure, and testing tend to be in an indirect form in that they merely explore relationship between contractual outcomes and assumed determinants of transaction costs and not the costs themselves. In addition, it does not give a value for trust in contracting and always assume opportunism.
Other critics concern the actual philosophy of TCE theory and whether it is good enough to be used in business strategies at all. One such issue is that TCE tends to put too much emphasis on opportunism and too little on trust (Ghoshal and Moran 1996). It, also, focuses only on cost side of a transaction and ignores the benefits of a transaction, which frequently cater to the social side of humans (Zajac and Olsen 1993). In addition, it could not explain the firm heterogeneity (Conner 1991).
Initiated in the mid-1980s by Wernerfelt (1984), Rumlet (1984) and Barney (1986), Resource Based View (RBV) perspective tries to explain the link between the internal features of firm and its overall performance (Barney, 1991). In this strategic theory, the firm is viewed as a collection of tangible and intangible resources that enable that firm to compete with other firms. It focuses on the relationships between a firm’s resources and their competitive advantage. Resources can be categorised into:
• Physical resources (machinery, building)
• Human resources (knowledge, experience, workers’ insight)
• Organizational resources (culture, structure, informal process)
• Finance resource (debt, equity)
The RBV is based on two main hypotheses: resource diversity and resource immobility (Barney, 1991; Mata et al., 1995). According to Mata et al. (1995), these assumptions are defined as:
1. Resource diversity: (also called resource heterogeneity) relates to whether a firm owns a resource or ability that is also owned by many other competing firms, then that resource cannot provide a competitive advantage. A good example might be a firm is trying to decide whether to implement a new production technology. This new technology might provide a competitive advantage to the firm if no other competitors have the same functionality. If they do have similar functionality, then this new technology doesn’t pass the ‘resource diversity’ test and hence doesn’t provide a competitive advantage.
2. Resource immobility: this refers to a resource that is difficult to gain by competitors due to the cost of developing, acquiring or using that resource which is too high. Consider, as an example, a firm trying to decide whether they should buy an ‘off-the-shelf’ supply-chain monitoring system or have one built specifically for them. If they buy an already built solution, they will have no competitive advantage over others in the market because their competition can implement the same system. If they pay for a customized one that provides specific abilities that only they can implement, then they could have a competitive advantage over their competitors.
Sustainability in a sustainable competitive advantage is independent with regards to the time. A competitive advantage is considered sustainable when all efforts by competitors to make the competitive advantage redundant have failed. When the imitation attempts ends without distracting the firm’s competitive advantage, then the firm’s strategy can be called sustainable. This is divergent to other views such as Porter’s which stated that competitive advantage is sustained when it provides above average returns in the long run.
Industrial Organisation Economics (IO), promoted by Porter (1980), views the company’s competitive advantage as derived from the company knowing where to position itself in the market. Prime determinant in IO view is that performance is based on external environment and industry structure. Therefore, profit source is market positions and that the positions are protected by barriers to entry into the market.
Resource based view is different. It looks inside the company which it considers as a bundle of resources and looks at which resources that allows a firm to obtain a sustainable competitive advantage. Therefore, a company’s competitive advantage is not based on market or industry structures but rather, what it derives from its own internal resources.
It could be clearly seen that RBV doesn’t challenge IO; in fact they both go in-hand. IO, on one hand, looks at the opportunities and threats of a SWOT analysis, while RBV looks at the Strengths and Weaknesses of that SWOT.
Barney (1991) defines the criteria on which a resource could be considered as a source of competitive advantage and highlights the importance of intangible elements that can be found in organisations. RBV does not propose that every resource can be a source of competitive advantage. Rather it must possess a number of characteristics to be considered as such.
Consider Barney’s (1991) report about the RBV. He (1991:102; emphasis in original) explains that
“A firm is said to have a competitive advantage when it is implementing a value creating strategy not simultaneously being implemented by any current or potential competitors. A firm is said to have a sustained competitive advantage when it is implementing a value creating strategy not simultaneously being implemented by any current or potential competitors and when these other firms are unable to duplicate the benefits of this strategy”.
Thus, a resource is considered as a source of sustainable competitive advantage if it is:
1. Valuable: which refers to the ability of a firm attribute to exploit specific opportunities and counter threats in the environment.
2. Rare: the resource must be rare among the firm’s present as well as potential competitors. As long as the number of firms possessing this resource is less than the number of firms needed to generate perfect competition, the resource is adequately rare to potentially create competitive advantage.
3. Imperfectly imitable: the resource may be imperfectly imitable due to any one of these three factors. If it is dependent on unique historical setting or its relation to competitive advantage is causally ambiguous or the resource is socially complex.
4. Imperfectly substitutable: indicates that there are no strategically equivalent substitutes that are valuable but are either imitable or not rare.
Resources with these characteristics are called VRIN resources. A VRIN resource can be a source of sustainable competitive advantage. Knowing which the competitive advantage sources are is very important for the company as it allows decision makers to decide how rare it is and to protect it from imitation.
Isolating mechanisms are the main ways of protecting the company’s resources from imitation and conserve profit flow. One of these mechanisms is known as the causal ambiguity. Causal ambiguity limits imitation and mobility because competitors do not know what the causes of a rival firm’s efficiency are. This can become a source of competitive advantage particularly if firms themselves ignore the link between their resources and their advantage which causes others to do the same.
In order to compete with others, firms need to effectively manage their resources and to do so it must protect their current resources, continuously improve them and build new ones. Resources have to be durable, difficult to identify and understand, imperfectly transferable, hard to replicate and clearly owned and controlled by the company.
From RBV point-of-view, strategic choices are limited by the firms’ resources. Therefore if strategies are not based on its VRIN, then only short-term returns are expected at best, which is also not sustainable. The best way for maintaining long term benefits is for firms to envisage strategies that are built on their resources.
Advocates of RBV argue that diversifications have prominent implications for corporate strategies if based on firms’ specific resources. Diversification is recommended to utilize resources that can have uses in markets that are not currently exploited by the firm.
Seen as a way of matching a firm’s resources with market opportunities, RBV recommends that firms should adopt strategies that their resources can support.
Unlike TCE which acts pessimistically, RBV looks for the source of power inside the firm & tries to find the core competences within. By search the competences involving the IT Dept., it is recommended to go for market sourcing for many reasons:
1. IT is not a core competence of the business. Although it has a great deal of importance, still it can not be considered as competences since such solution are already available in off-the-shelf versions. So, they are not rare nor they are imitable.
2. Outsourcing would, also, be good since these services will be handled by professional firms, whose core competence is to deal with such work.
3. Eliminating such issues, helps the company focus on and develop their actual competences, and even search for new ones.
4. Unlike TCE, RBV does not over estimate hold-up, if trust exists between both parties it would be save to outsource to them.
Despite the many benefits that RBV gives to strategic decision making, still there are some major drawbacks for this perspective.
The over-focus on current resource is one main problem, because it tends to narrow down the view to existing resources, which can become obsolete after a while, and discarding any dynamic capability which might eventually result in losing the opportunity of discovering new potential competences (i.e. core rigidity).
RBV tends to exclude market power, because firms have no bargaining power in product markets. Thus, competitive advantage can not be based on market power in the sense of raising price above cost via restricting supply.
It is weak in the sense of competitive activities because they are limited to protecting costly-to-imitate resources. As a result, price discrimination, product differentiation and technological competition are hard to imbed within RBV (Makowski and Ostroy 2001).
Transaction costs are ignored in RBV perspective. So, it is not possible to mount corporate strategy issues such as the choice of distribution channels and relations to suppliers in terms of comparative contracting (Chi 1994).
In addition, the process of creating, capturing, and protecting value is barely seen in RBV. Thus, value creation due to product innovation or differentiation (Machove 1995), improving contractual arrangement and internal organization (Williamson 1994; Foss and Foss 2002) and others can not be encapsulated within.
In conclusion, taking either TCE or RBV as a strategic approach for decision making is a mistake by itself. Both view have there pros and cons. In addition, TCE tends to look at the external factors that might affect business strategy, while RBV search in the internal aspects that could create a competitive advantage. Both are actually complementing each other; where TCE focuses on Opportunities and Threats, RBV deals with Strengths and Weaknesses. As a result, they jointly complete the SWOT paradigm.
For Saudi Airlines’ IT to take a better decision, it should look into both approaches. And rather than taking a lump-sum decision on fully outsourcing or fully keeping in-house, it is better to divide the whole structure into small chunks some of which are critical and must be kept at house and some are more trivial and could be outsourced safely.
By doing so, Saudis’ IT Dept could better optimize their resources and focus on core business in hand and be ready for the new era (privatization era).
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