Reasons for the Strengthening of the Overall Corporate Governance System - Term Paper Example

Introduction Organizations often find themselves into difficult situations in terms of whether to produce in- house or outsource some of the processes, products etc. Such decisions are often based on lack of internal resources; need to refocus on core competencies or simply to reduce costs. Whatever the reasons, the decisions are often marred with uncertainty as well as other issues such as adverse selection, asymmetric information as well as agency problems. The factors are not just limited to the uncertainty as Akerlof (1984) described that the labor markets can also be explained through an interaction of quality and uncertainty therefore what is critical while understanding the dynamics behind choosing to make or outsource decision is an objective assessment of different factors impacting such decision making. Some of the factors which can define the decision making process of whether to buy or outsource also depend upon the agency relationship. Bergmann and Friedl (2008) are of the view that since managers have the private information regarding the projects therefore they intend to exert "unobservable levels of different kinds of effort in order to increase the feasibility of successfully completing the project in terms of meeting product specifications." (Bergmann and Friedl). This paper will attempt to present a comprehensive analysis of the above factors and their impact on the decision making process of whether to buy or outsource. Further, this work will also attempt to present what remedies may be available to address such problems in terms of agency cost. Make versus buy decisions To make or buy is one of the fundamental dilemmas faced by the modern organizations as increasing competition and globalization is forcing organizations to re-evaluate their strategies as well as processes and technologies to better position themselves onto the competitive landscape. As discussed above that the decision to make or buy depends largely upon whether the organization is willing to refocus its strengths on exploiting its core competencies and outsource some of the activities which do not probably fall under the domain of their specialty therefore instead of developing weaknesses into strengths, organizations often consider to focus on their strengths. Secondly, lack of internal resources such as manpower, technology, economies of scales etc may force organizations to decide on buying rather than producing in house. Thirdly, cost reduction is another critical element which contributes in deciding whether to buy or make because due to lack expertise, lack of resources, organizations may find it expensive to produce in house and rather focus on outsourcing. However, despite all these factors, there are some other critical elements which contribute to that decision making process. As discussed above that uncertainty is one of the key elements which differentiate the labor markets therefore both internal as well as external factors heavily influence the decision making process of make or buy. Internal organizational factors such as agency relationships as well as adverse selection involve the management of the firms however; uncertainty and asymmetric information may be internal as well as external in nature. Agency Relationship Diversification is one of the reasons why managers often decide to make investments so that the risk could be easily distributed across the different products as well as markets. It is also because of this reason that the managers often have to decide whether to initiate that diversification process by producing that product or procuring that machinery in-house or outsource them. However, Denis et al (1997) are of the view that there is a negative relationship between the diversification and the managerial equity ownership. (Denis, Denis and Sarin) This fact also points towards the tendency of the managers to perform in ways which create a sort of value reducing diversification for firms. Therefore taking an analogy from this fact, it can easily be inferred that while making decisions regarding whether to buy or outsource, managers often tend to react in their own benefit rather than to the overall benefit of all the stakeholders. It has also been argued that the nonpayment of profits as dividends to external stakeholders is often done by the insiders i.e. managers in a bid to either achieve personal benefits or divert them into projects which are often unprofitable and do not deliver value to the shareholders. (Porta, Silanes and Shleifer). Therefore the decisions like make or buy also fall prey of the agency relationships between the external as well as internal stakeholders of an organization because of if cash within the organizations i.e. in the shape of profits can not be disgorged in the shape of dividiends than some of it can end up being invested into bad projects. There is also a further argument which suggest the diversion of the agency relationships from the basic assumptions of M&M model therefore the fact that by not linking the firm's investment decision making process with its dividend policy often lead to improper investment decisions. Asyemtric Information It is critical to note that agent's access to private information regarding the future profitability of any proposed project, no matter whetehr it is an in house or out sourced project, the principals often become unable to monitor and evaluate the performance of their agents there information assymetery seem to prevail between them. When deciding on make versus buy decisions, managers, due to their agency relationship, often attempt to act in somewhat irrational way and they are not considered as rational in their expectations. (Demertzis and Hallett). However, managers also often themselves at the odd ends because of the lack of symetric information to make rational decisions. The proposition that the internal agents may act in a way which significantly deviate from the rational behavior may also be justified by taking into account the way information is provided to them. An asyemetry of information can signficantly may dampen the capability of managers to decide in more rational way. It is also because of this reason that most of the outsourcing decisions backfire because of the communication gaps and information asymetries between the firms and their agents working on their behalf. One improvement in this process which has often been suggested is to strengthen the contract writing process so that if managers decide to enter into an outsourcing arrangements than the softer side of the transaction can be secured with minimum risk profile and highest reward possible. It is also critical to understand that assymetric information can also lead to wrong and often inaccurate estimation of the different projections based upon which different estimates such as Net Present Value are made. Therefore, asymetric information not only contributes in making wrong estimates but also force managers to make irrational decisions which may not often result into value creation for all the stakeholders of the firm. For example, if a car manufacturer in Brazil is willing to implement robotic technology to assemble cars within the country may ponder on whether the same technology can be built up within Brazil or should it be imported Such decision can lead to inaccurate and adverse selection if organization decide to import that technology from a country which has the higher opportunity cost as compared to Brazil to produce such technology. Asymetric information therefore also often lead to the dilema of adverse selection which managers often face while making such decisions. The next section will discuss how the adverse selection plays its part in make or buy decisions. Adverse Selection The traditional economic view of project management suggest that managers will often act in a way which helps them to maximize the profitiability of their firms. This view is based on the rational expectations as managers are required to act in the benefit of their shareholders however this is not often the case as managers may not always act in rational way. The agency relationships and costs may therefore also cause adverse selection of the projects which may only benefit managers rather than shareholders. Therefore the problem of adverse selection shall be viewed within the perspective of agency theory. Since managers have the access to private information and an incentive to act in their own self interest therefore such tendency give rise to the problem of adverse selection as managers may start to act in their own benefit at the cost of their principals. Therefore , while making decisions regarding whetehr to buy or outsource, managers may act in a way that seems irrational from the view point of their principals. (Harrison and Harrell). Thus this tendency to view their own behavior as rational, managers often select projects which reflect adversely on the overall performance of the firm and can result into adverse selection. Remedies In order to correct such anomalies and avoid such problems, it is critical that the overall corporate governance system shall be strengthened. (Qian)By further improving the corporate governance and improvement the regulatory framework, supervisors can often force managers to make prudent as well as rational decisions. By improving the role of shareholders through formation of more effective boards of directors can significantly dilute the impacts of such problems. Works Cited 1. Bergmann, Rouven and Gunther Friedl. "Controlling innovative projects with moral hazard and asymmetric information." Research Policy 37.9 (2008): 1504-1514. 2. Demertzis, Maria and Andrew Hughes Hallett. "Asymmetric information and rational expectations: When is it right to be "wrong"" Journal of International Money and (2008): 1-13. 3. Denis, David J., Diane K. Denis and Atulya Sarin. "Agency Problems, Equity Ownership, and Corporate Diversification." The Journal of Finance 52.1 (1997): 135-160. 4. Harrison, Paul D. and Adrian Harrell. "Impact of "Adverse Selection" on Managers' Project Evaluation Decisions." The Academy of Management Journal, 36.3 (1993): 635-643. 5. Porta, Rafael La, et al. "Agency Problems and Dividend Policies around the World." The Journal of Finance 55.1 (2000): 1-33. 6. Qian, Yingyi. "Enterprise Reform in China: Agency Problems and Political Control." Economics of Transition 4.2 (1996): 427-447. Read More