Virtual/Network Organizations


Virtual Organizations

A firm that contracts out almost all functions. The only function retained by the organization is the name and the coordination among the parties. A virtual organization might not have even have a permanent office.

Especially common in the fashion industry where you can have clothing labels that are just that. Say the label is "John Taylor". The label has a clear identity in the public eye, but when you try to track down the John Taylor company, you find there are no John Taylor designers, no John Taylor manufacturers. It's just 3 people in an office subcontracting out all functions.

It is a network of firms held together by the product of the day. An open-ended system of ideas and activities and firms.

Network Organizations

A network organization is a collection of autonomous firms or units that behave as a single larger entity, using social mechanisms for coordination and control. The entities that make up a network organization are usually legally independent entities (separate firms) but not always. Some of the entities may be wholly owned subsidiaries. They can even be divisions within the company, but treated as separate companies that sell to outside customers.

For the purpose of discussion, it is convenient to distinguish three types of network organizations: internal, stable, and dynamic.

Internal Network

Large company that sees its units as separate profit centers. It may encourage the units to sell its products outside the company as well (e.g., GM and its spark plug division). One reason for doing this is the belief that if units have to operate with prices set by the market, they have incentive to improve performance and reduce prices.

In these organizations, corporate headquarters acts like broker. A bit like role of government in business in Japan.

Stable Network

The stable network consists of a central organization that outsources much of its operations to other companies. For example, at BMW, they outsource about 65% of the total production cost of a car.

The central organization often has longterm relationships with suppliers, who have access to the company's computer system and may be present at private planning sessions. The central organization may also have several joint ventures, alliances, long term contracts, etc. going with different companies.

Dynamic Network

The dynamic networks outsource even more heavily. Basically, an integrator firm identifies and assembles assets owned by other companies. Typically, the integrator is a downstream player whose core competence is understanding the market. For example, Nike is the center of a dynamic network. Their only functions are R&D and Marketing.

Dynamic networks are common in the fashion, toys, publishing, motion pictures, and biotech industries.

Market Networks

There may exist a fourth type of network organization, which we might call the "market network". These organizations don't have a lead player that coordinates the others. Instead, a collection of organizations trading in the market fall into a stable pattern of relationships that gradually becomes solidified. Initially, members of the network may not be aware that they have fallen into this pattern. We can think of these organizations as natural "subassemblies” of the economy.


Comparative Advantage of Network Organizations

The first question to ask is, What are the alternatives to network organizations? There are two basic alternatives: vertically integrated firms, and the open market. How do firms decide what functions to perform in-house, and which to purchase on the market? Why aren't all functions purchased on the market?

Transaction Cost Analysis

Think about a firm that makes a product based on a certain kind of computer memory chip. They buy the chips on a recurring basis from a few different suppliers. Demand for these chips varies widely from time to time so availability and prices are never givens. Also, there are wide variations in quality because the silicon wafer technology has not yet solved some basic production problems. Every batch of chips purchased has to be scrutinized carefully, and bad chips have to be sent back and replaced. The variations in availability and price force the company to overbuy and then maintain warehouses full of supplies so that their assembly lines do not have to be shut on and off with variations in the chip market. By maintaining a lot of inventory, they can buffer their core technological processes, doling out the chips in a measured, reliable stream. The trouble is, maintaining a lot of inventory is expensive, especially when the chips change over time and old chips are made obsolete.

The problem is even worse when the company needs specialized chips from their suppliers, custom products that they have designed themselves. Or, the other way around, each chip company does things differently, and the manufacturer has to adapt their designs to specific chips (the way operating systems are built for specific families of processors).

Under these conditions (frequent transactions, uncertainty of supply, and customization) organizations will elect to bring the process in-house. That is, they will vertically integrate. The reason is that contracting with outsiders under these conditions is costly. There are costs in maintaining inventories, costs in monitoring the exchanges for malfeasance, costs in searching for suppliers, costs in specifying legal contracts, etc. Furthermore, because they are working with this custom product, there are no other sources of supply that are ready-made. So they could be charged a premium price.

In contrast, for functions that do not require frequent exchanges, that do not suffer from uncertainty of supply, and which do not require customization, organizations will contract with outside firms, because it will be cheap enough to do that. The costs of making and monitoring the transactions themselves will not be prohibitive, which allows the organization to take advantage of hiring specialists to do the job. These specialist firms can deliver a higher quality product, and can often do it more cheaply because of the volume they do. According to economic theory, in a perfect competitive market, it is always better to hire out a function unless the transaction costs make that too expensive.

What Conditions Favor Network Organizations

Network organizations are a blend of market and firm. They are halfway between vertical integration and market disaggregation. The conditions that favor network organizations are:

Frequent transactions. Infrequent exchanges are best negotiated on the market.

Demand Uncertainty. Not to be confused with supply uncertainty. Demand uncertainty refers to the inability to predict how well an organization's products will sell. For example, the film industry suffers from the inability to predict which films will make it and which won't.

Customization. Also known as asset specificity, exchanges that involve individually customized products or services.

Task Complexity. How complicated is the product being created.

Structural Embeddedness. The extent to which firms (and their members) are related to each other via a host of ties, so that information about each other is always flowing. This helps to coordinate and control the firms.

As you can see, most of these conditions are the same as those favoring firms rather than markets. Network organizations are more like firms than markets. But they occur in situations where demand uncertainty makes vertically integrated firms a bad idea. When technology and markets are changing fast enough, it doesn't make sense for a company to invest in a whole division because when things change they are stuck this whole infrastructure that is now obsolete. So they decouple -- taking the highly volatile sections out. Yet, because of all the other conditions, they need to maintain control, so they don't just hire it out on the market.

A network organization is like an ordinary firm which does not have a system of direct supervision, nor standardized rules and procedures that apply throughout the firm. Consequently, they have to coordinate and control the units in some other way. Some of the ways they do this are:

Joint payoffs. Networks are organized around specific products or projects. Payments for work are arranged based on the final product, so that if the product doesn't make it, nobody gets any money. This provides incentives for everyone to do their best.

Restricted access. By definition, network organizations do not hire just anybody on the market. Instead, they restrict their exchanges to just a few longterm partners. This makes the organizations more dependent on each other, so that their is more cost in defaulting. In addition, but increasing the probability of future exchanges, this creates the conditions for avoiding a bad deal now so as to get future rewards. (If I take advantage of you on this deal, I'll make out like a bandit, but I'll never get work from you again, so I forgo all that future money.)

Reputation. In the film industry, everyone talks to everybody. If someone is difficult to work with, or doesn't pull their weight, everybody hears about it and it affects their ability to get future jobs.

Macroculture. The existence of a common industrial culture greases the wheels for coordination. Everybody speaks the same language, has similar expectations and understandings of the task, so more can be implicit rather than explicit.

Copyright 1996 Stephen P. Borgatti Revised: February 05, 2001 Go to Home page