Transaction Cost Economics in Construction Industry

TCE asserts that transactions have distinct characteristics that explain how firm’s boundaries are drawn and when determine whether “market or hierarchy” will have the lower transaction costs in various circumstances. Asset specificity, uncertainty and frequency are the three variables of TCE that are used to characterise transactions.

Williamson (1979) suggested four main forms of asset specificity, namely site specificity, physical asset specificity, dedicated assets and human asset specificity. Asset specificity refers to the degree to which the investments for a transaction are specific to that particular transaction. In other words it refers to the extent to which the resources required are available from a large number of sources which can be bought from competitive market; or only a few sources and the market is oligopolistic. In the later case, the investment would be less valuable in some second best use if the transaction fail.

Such situations are rare in construction, and are probably limited to the more demanding civil engineering projects (Reve and Levitt, 1984) and high performance specifications in areas such as building services. For instance, most large infrastructure contractor would invest in batching plant/ on-site concrete mixer, which allow specialty concrete mixtures to be developed and implemented on respective construction sites, instead of buy from ready mix concrete manufacturing company.

The reasons being (1) concrete has limited timespan of approximately 90 minutes between mixing and going-off; (2) most batching plants are mobile and relocating them is relatively inexpensive; (3) the contractor can easily locate a potential buyer in the market should he decided to dispose it.

There is uncertainty in life. Harold S. Geneen quotes “Uncertainty will always be part of the taking charge process”; John Allen Paulos quotes “Uncertainty is the only certainty there is….”. The issue in transaction uncertainty is that how hard is it to foresee the eventualities that might occur during the course or even at the beginning of the transaction.

Over the last two decades, construction industry has been profoundly affected by economic and industrial change as a result of recession, changing market and increasing competition arising from greater regional and global integration.

These changes exposed construction industry players to a great uncertainty in terms of construction projects available and awarded as the pie to be shared are limited. In addition, erratic weather and geological conditions (natural uncertainty) and temporary project-based construction team (organisational uncertainty) levelled up the potential unforeseen circumstances. Not to mention that each project has its own architecture design, structure, mechanical and electrical specification and building material requirement (task uncertainty) that will generate learning curve problems.

While asset specificity and uncertainty has been discussed exhaustively, frequency has received far less treatment in literature (Macher and Richman, 2008). Nevertheless frequency of transaction involved, ranging from occasional to recurrent. Williamson (1985) notes that higher level of transaction frequency provides an incentive for internal organisation as “the cost of specialised governance structure will be easier to recover for large transaction of recurring kind” and vice versa.

For instance, a construction firm might not want to employ architect even though all buildings require architecture design. If the construction firm did employ architect, it would then need to compete with ‘more competent’ architecture consulting firm in the market to seek opportunities to sell the service when the architect is not designing for the firm’s project.

Above-mentioned key characteristics of transactions are made in a behavioural context of bounded rationality and opportunism. Bounded rationality refers the fact that people have limited cognitive processing power whereas opportunism refers to the possibility that people will act in a self-interest way “with guile” as Williamson puts it.

Construction industry’s workload is highly diversified. It involves numerous parties, various processes, different phases and stages of work, and many inputs from both the trades and specialists. Such workload and labour can be divided into two phases (Bajari and Tadelis, 2001). First, the design phase for the appearance, layout and function of buildings which involve consultants of various disciplines. Second, the actual construction process that directly produce the end product.

Let’s discuss the second phase first. Upon approval of architecture and engineering plans by respective authorities, actual construction works begin. Construction firm would then need to decide whether to carry out the work on its own or engage market construction players. In view of the uniqueness and the need of wide range of technologies characteristic of construction industry, Costantino (1996) assert that economies of scale (i.e. faster construction time, reduce construction cost, reduce liability exposure and greater flexibility) can only be met by using a variety of resources that are generally not entirely available within a firm.

In construction material and equipment context, market governance transaction prevail on the basis that the availability of many possible sources for construction firm to compare and choose from an array of suppliers on the basis of the best quality and price combination. The existence of many suppliers presumably ensures lower production costs vis-à-vis those that are incurred in a hierarchy-governed transaction, where choice of construction firm is restricted to one predetermined internal source thus precluding the benefits from market competition (Costantino and Pietroforte, 2002).

As construction firm moving up the experience curve, it establishes a trust relationship and with respective suppliers and thus create a network forms of transaction governance. At this level, transaction frequency is high but asset specificity and uncertainty are low. Thus creates bilateral governance or what Eccles (1981) called quasifirm. Construction firm has a list of stable, trustworthy network of suppliers and with this it can reduce transaction costs in relation to market governance in fulfilling respective suppliers’ credit search requirements.

The situation also applies in construction firm’s subcontracting decisions made that resulted in a large presence of building subcontractors in the industry which are typically very small but collectively undertake most of the works. Subcontracting partial or majority of the actual construction increase construction firm’s flexibility and minimises the capital committed to the project. On a project basis, this relationship takes the form of classical contracting, but as parties cooperates over the years, the same relationship takes the form of relational contracting (Costantino et al, 2002).

Nevertheless, Chiang’s studies (2007) have asserted that subcontractors are ‘bullied’ and ‘treated with little respect’ by certain construction firms due to low bargaining power and asymmetric relationship between them. There is a grain of truth in the assertion. For instance in Malaysia, most public sector projects are awarded to “bumi” (which means native) status construction firm only in order to boost bumi’s participation in construction industry.

This policy has allowed ‘bumi’ construction firms to oligopolise and generates opportunism in public sector projects, where it takes the advantage of its ‘Bumi’ status by exerting its bargaining power to distort behaviour of other industry players. Upon acceptance of projects, the bumi construction firm will subcontract the project to a non-bumi construction firm at a fixed price, say 95% of total contract sum awarded. With this arrangement, substantial risks and responsibilities are transferred to subcontractors.

Fixed price contracts in this situation will required subcontractors to perform excessive pre-contract search for information about material prices and costs and leads to the tendency of poor performance as subcontractors would try to cut corners to reduce production costs.

Moreover, subcontractors are the weaker counterpart during post-contract renegotiation for additional contract sum due to building material drastic price fluctuation. Bumi construction firm can once again request for fixed percentage from the additional contract sum successfully approved by respective authorities, leaving subcontractors vulnerable. However, subcontractors are still willing to cooperate due to prospect of repeated business in the future. Many of them had become too reliant on bumi construction firm and vulnerable to the latter’s bargaining power, eventually bringing upon themselves their own decline or even demise (Lonsdale and Cox, 1998).

The transaction characteristics will be totally different in the first phase of construction where it involves consultants. At the beginning of the project life, the owner hires architects and engineers as technical consultant in planning, designing and supervising. However, the major construction contract is signed with principal construction firm. As the transactions, say development of a 5 acres residential estate, are infrequent, it is not worth investing in transaction-specific governance structure. Nevertheless the issues on construction dispute on price fluctuation, inappropriate project management and unfavourable weather conditions has increasing delay construction projects and resulted in cost overrun.

Thus trilateral governance, which relies upon third party arbitration, emerges to resolve these issues. As most owners would have little knowledge in construction industry, it is difficult for them to evaluate and measures construction firm’s performance. As such, professional service contracts are prepared in a way that takes on hierarchical effect between owner, consultant and construction firm. Winch (2000) argues that the market transaction governance with hierarchical effect can be achieved by (1) specifying authority systems to facilitate change; (2) providing standard operating and conflict resolution procedures; and (3) using administered pricing system to handle uncertainties.

For instance, construction firm are entitle to claim additional cost in relation to material price fluctuation should the consultant certify on its claim. It is hence consultant responsibilities to ensure material price fluctuation claimed agrees to national statistic, vouch material quantity against suppliers’ invoices and confirm material ordered match agreed-upon specification. The consultant would have to certify on construction firms’ claim before owner remit the amount claimed to construction firm.

Basically, the owner and consultant relationship is moral relationship whereby the owner trust in consultants’ expertise and believe that consultant will act in owner’s interest. Nevertheless, the asymmetry of knowledge allows consultant to serve their own goals rather than the construction firm. When consultants have a few projects all require urgent attentions, the consultant may prioritise one project at the expense of another project and give rise to transaction cost, known as agency cost. Many a time, consultants will merely carry out their duties instead of practicing professional code of ethics in real life.

In appointing consultant, i.e. architect, the owner delegates the responsibility and ownership of architectural planning and process to the architect and it is architect’s responsibility to coordinate the elements to his design so as to achieve owner’s objective. Going back to the 5 acres development of residential estate, an integrity architect does not merely design the residential units according to engineering and environmental information available but also try to maximise return to owner, e.g. to align 105 units instead of 90 units within the land area, which means greater revenue will be generated.

Nevertheless, there is not much the owner can do to prevent agency cost but to rests the trust on the assumption that there is effective social control of the profession by the state and the professional guild, and that the professionals adhere to professional norms and standards acquired through training, socialization and licensing (Reve and Levitt, 1984). To certain extent, the reputation of consultants can be enforcement mechanism. Short term gains from opportunism can result in long term loss from damaged of reputation and trust in the industry community.

Construction industry players are not mutually exclusive. Involvement of players and characteristics of transaction determine the vertical boundaries of the industry in deciding transaction governance. Construction firms that choose wrong governance structure for transactions will incurred higher costs for respective construction projects. Management has to learn from mistakes and from other players in the industry as construction firm’s vertical boundaries vary considerably based on the distribution of project management activities.

Besides, minimising transaction cost and production cost in construction industry does not necessarily deliver a project of appropriate quality and this does not maximise the construction firm’s benefits. Only proper management and alignment of project governance structure against firm’s objectives will eventually allowed construction firm to attain cost leadership and consequently the capacity to offer competitive tenders/ development to capture even more market share. (1,962 words)

Reference:

Bajari, P. and Tadelis, S. (2001) “Incentives Versus Transaction Costs: A Theory of Procurement Contracts.” RAND Journal of Economics, Autumn 2001, 32(3), pp. 287-307.

Chiang, Y.H. (2009) “Subcontracting and its ramifications: A surcy of the building industry in Hong Kong” International Journal of Project Management pp80-88

Costantino, N. (1996) “La Gestione Del Progetto In Edilizia: Problematice Organizzative e Di Mercato, L’industria” Vol 2 pp 361-390

Costantino, N. and Pietroforte, R. (2002) “Subcontracting practices in USA Homebuilding – An Empirical Verification of Eccles’s Findings 20 years Later”, European Journal of Purchasing & Supply Management, Vol 8, pp15-23

Eccles, R.G (1981) “The Quasifirm in the Construction Industry” Journal of Economic Behaviour and Organisation, Vol. 2 pp335-357

Jensen, M.C. and Meckling, W.H. (1976) “Theory of Firm – Managerial Behaviour, Agency Costs and Ownership Structure” Journal of Financial Economics Vol 3 Issue 4. pp305-360 Lonsdale, C. and Cox, A., (1998) “Outsourcing: A Business Guide to Risk Management Tools and Techniques”. Earlsgate Press, London.

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