Do You Have an Efficient Organization? IE INSIGTHS- Article by researcher: Mikko Ketokivi
01 dic 2021

Seeking efficiency in organizations has become synonymous with unpopular cost-cutting policies, but these measures are actually the antithesis of sustainable efficiency, writes Professor Mikko Ketokivi.


If there are two alternative ways of doing something, why not choose the one that generates less waste?


Simple enough. Now try to apply it in a complex organization facing an uncertain future. Problems start at the fact that waste comes in many forms, some of which may be difficult to pinpoint. Delayed flights, expired Covid vaccines, and a high scrap rate in production are salient forms of waste, but how about the notion that communication, attention, and cognition can be wasted as well? Yes, sometimes the very act of having to think about something can be a form of waste.


Economist Frank Knight famously equated avoidance of waste with efficiency.


I am painfully aware of how dangerous that word is. When organizations seek efficiency, they downsize, they squeeze every penny out of their suppliers by aggressively renegotiating contracts, they make employees work more hours without additional pay, the list goes on. This is efficiency, right?



Allow me to me propose that these examples represent efficiency the same way undercooked poultry represents nutrition: hazardous. I prefer to label ruthless cost-cutting as myopic efficiency. This is not only distinct from but downright antithetic to sustainable efficiency, which is about eliminating the excess, not the essential; nurturing cooperation, not jeopardizing it; mutual value creation, not unmitigated self-interest.


I am trying to think of examples of bullying providing a long-term solution to an efficiency problem but cannot come up with one. Can you?


Efficiency comes in many guises. In my collaboration with organization economist and strategy scholar Joe Mahoney of the University of Illinois, we have cast a wide net to unearth and analyze different manifestations of efficiency in different organizational contexts (available in a forthcoming book published by Oxford University Press.) The following table provides seven different examples of organizational efficiency and its drivers.


Allow me to elaborate on two examples, one familiar and the other perhaps a little surprising: vertical integration and the legislature.


About twenty years ago, I sat in an industry seminar with a number of purchasing managers, one of whom lamented the complexity of a problematic supplier relationship that kept him up at night. The contract with the parts supplier contained several hundred pages of legal and technical specifications that were beyond the ability of any one individual to comprehend in their entirety. I asked the manager whether the daily costs of enforcing the contract were considered jointly with the productivity benefits associated with outsourcing the parts instead of making them in-house, which is what the firm had done in the past.


The manager appeared puzzled at my question, but really he should not have been. Transaction costs are just as real and as relevant as production costs. The drafting and the daily enforcement of a complex contract constitute a real cost that should be directly attributed to the transaction instead of being considered overhead. Also, not being able to sleep at night… what a waste!



This anecdote introduces my first example: vertical integration. Which components should the final assembler produce in-house and which should be purchased from external suppliers? Should a firm have its own legal department to handle intellectual property issues or should it contract an external law firm? More generally, how should the organization approach the canonical “make-or-buy decision”?



It is unsurprising that many outsourcing decisions do not lead to the kinds of cost savings that were first envisioned.



How should the insomniac manager apply efficiency thinking in the make-or-buy decision of the component? The obvious part of the analysis is to compare the internal production costs to the price at which the external supplier would sell the part. This analysis should be comparatively straightforward. I have the creeping suspicion this was the criterion on which the outsourcing decision was originally made: The direct internal production cost was higher than the price the external vendor offered.



The more elusive part is the cost of contracting. If the parts are standardized and alternate suppliers are available, then purchasing the parts would amount to little more than “ordering them from a catalog.” For example, it should not come as a surprise that car manufacturers do not make tires. Tire sizes are standardized and specialized tire companies such as Bridgestone and Continental produce tires for all automakers. Due to massive economies of scale and economies of specialization, they are far more efficient in developing and producing tires than individual automakers could hope to be. Since contracting costs are negligible, the logic suggests it is more efficient to buy tires from specialized manufacturers instead of making them in-house.



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