How a Firm's Capabilities Affect Boundary Decisions

Determining which business activities to bring inside a firm and which to outsource is a critical strategic decision. Firms that bring in the wrong business activities risk losing strategic focus; those that fail to bring the right business activities within their boundaries risk losing their competitive advantage.

A well-developed approach for determining a firm's boundary, called transactions cost economics, specifies the conditions for managing a particular economic exchange within an organizational boundary and the conditions for choosing outsourcing. A popular version of transactions cost economics requires managers to consider a single characteristic of an economic exchange -- its level of transaction-specific investment.

Three concepts aid in understanding transactions cost economics as applied to firm boundary decisions: governance (the mechanism through which a firm manages an economic exchange), opportunism (taking unfair advantage of other parties to an exchange), and transaction-specific investment (any investment that is significantly more valuable in one particular exchange than in any alternative exchange). Firms can use governance mechanisms to mitigate the threat of opportunism.

Traditional transactions cost economics does not focus on the capabilities of a firm or its potential partners, even though economic exchanges involve (1) cooperating with firms that possess critical capabilities, (2) developing capabilities independently, or (3) acquiring another firm that already possesses needed capabilities.

The author describes the conditions under which a firm's decisions on managing its business activities should be affected by its capabilities and those of its partners. When these conditions hold -- conditions particularly common in rapidly evolving high-technology industries -- firms should make boundary decisions that differ significantly from what would be suggested by traditional transactions cost analysis.