Inter-organizational relationships and contracts

Changes in the economic environment have speeded the companies’ process in focusing their activities in core competencies, outsourcing several others, and therefore reducing diversification levels. In this context, the vertical integration (realization of distinctive technological phases under the same decision command) frees space for inter-organizational contracts as an alternative coordination structure (relationships). It is the era of specialization, innovation and solution driven behavior.

The called “hybrid forms” gain space in the universe of networks and relationships. Since hybrid forms are mostly done by contracts, we see the emergence of smooth collaborative networks based on relationships.

Inter-organizational relationships can be formalized (based on written contracts) or informal (oral agreements). Depending on the institutional environment, both have the same value. Some societies value oral agreements and participants have reputation, and a formal document is not needed to make transactions happen and to guarantee behavior. Other countries need formal documents, and in some countries with weak institutional environments, even these written documents don’t have value.

Companies are getting more involved in transactions and with plenty availability of suppliers and distributors, relationships grows to smooth cooperation making possible to reduce the transaction costs, with well designed contracts.

Contracts are elaborated in a mutant environment and in the presence of bounded rationality. Bounded rationality is defined as the non-capacity to foresee ex-ante, in other words, before the beginning of the transaction all future contingencies. Incomplete contracts enhance several opportunism problems and bring undesirable transaction costs that could be reduced if the process of building a contract, of thinking more about the transaction or the relationship could be done with more time and details.

Contracts are mechanisms that help to regulate flows. These are the traditional flows between companies, or from a seller to a buyer. When a transaction is completed, we will have the flow of products, services and communications from the seller to the buyer, and then, the flows of money, information about the product and new requests, going from the buyer to the seller. Any contract should define well the responsible actors to perform the flows. Here are the main topics considered in each flow:

Product and services flow: product characteristics, inventory management, product transportation, product modification and after-sale service, customizing a product for the specific needs, providing technical service, product maintenance and repair, procedure and handling of returned products, promote product availability, packaging, specific packaging requirements, evaluating new products, after-sales follow up, industrial consumer services, preserving quality, and others. Communication flow: (from company to final customers) sales promotion to final consumers, information about product features, advertising, providing sales force, frequent visits/face-to-face contacts, packaging information, loyalty programs, web site participation, traceability information and others, nowadays mostly involving new and digital media formats.

Information flow (from customer to company): sharing knowledge of local market, consumer behavior, scanning data (access to computer data), complaints via web site/service line, order frequency, order formats consideration; arrange information about consumption and others.

Payments and financial flows: paying for the products, conducting credit checks on final consumers, billing customers, caring for specific customer orders, arrange for credit provisions, price guarantees, financing and others.

As a final comment, these inter-organizational arrangements also have a learning curve. It means that repeated transactions between companies’ increases trust, making it possible to reduce costs via adoption of more “just in time” practices, reducing stocks, eliminating redundancies and collaborating more, since there is a increase in trust as “time goes by”.

One of the problems to be avoided in long term relationships between companies is accommodation and its consequences, as lack of innovation, cost reduction and others. So even in stable relationships, some competition is important to keep innovation and reduce accommodation.

In the network economy, the process of building more complete contracts is very useful. This article brought some contributions to help the process of building or reviewing contracts in the era of relationships. It is a mechanism for building nice governance strategies and structures.

The author is professor of strategic planning and food chains at the School of Economics and Business, University of Sao Paulo (Brazil) and international speaker. Has 25 books published in 7 countries. (You can email him to favaneves@gmail.com)