THE LOCATION-CENTRIC SHIFT FROM MARKETPLACE TO MARKETSPACE: TRANSACTION COST-INSPIRED PROPOSITIONS OF VIRTUAL INTEGRATION VIA AN E-COMMERCE MODEL.
Commerce is witnessing a governance shift from traditional vertical integration toward "virtual integration" (Sheth and Sisodia 1999) coinciding with a location-centric shift from marketplace to a more virtual "marketspace" via the proliferation of new marketing models based on electronic commerce. What exactly is virtual integration? Many use the term indiscriminately. This research has a two-fold purpose: 1) to more precisely define and explain the concept of virtual integration; and 2) to propose that the tenants of Transaction Cost Economics (TCE) used to explain conventional vertical integration governance might also be used to explain virtual integration.
The manuscript is grounded in TCE theory because of the theory's robustness in explaining structure in terms of governance. After a brief review of the theory, we define and explain virtual integration and present it as an alternative to market or hierarchical governance (i.e., make-or-buy), and offer a case study of the Dell Computer Corporation as an example of a virtually integrated firm who has successfully applied a new model of commerce, e-commerce. Lastly, we offer propositions reflecting TCE theory in an effort to apply Transaction Cost analysis in explaining virtual integration.
TRANSACTION COST ECONOMICS AND GOVERNANCE
Governance decisions often prompt the examination of the following make-or-buy question: should marketing functions be performed within the firm by owned employees (i.e., integrated), or should the firm rely on external agents (i.e., nonintegrated) to perform the activity? In other words, to what extent should the firm vertically integrate the performance of marketing activities (Anderson and Weitz 1986)? This governance choice defines the boundaries of the firm (Ouchi 1979) by determining the economic organization of the firm's activities.
According to Alchian and Demsetz (1972), two important problems face a theory of economic organization. First, to explain the conditions that determine whether the gains from specialization and cooperative production can better be obtained within an organization like the firm, or across markets. The second problem facing a theory of organization is to explain the structure of the organization. One economic theory of vertical integration which addresses these issues which has received strong empirical support is Transaction Cost Economics (TCE).
TRANSACTION COST ECONOMICS
Transaction cost economics, first suggested by Coase in 1937 (Coase 1998) as `comparative economic organization' and developed principally by economist Oliver Williamson (1975, 1979, 1981, 1985) is part of the "New Institutional Economics," a term coined by Williamson (Coase 1998). A key conceptual move for New Institutional Economics is to push beyond the theory of the firm as a production function (i.e., `Old Institutional Economics') into a theory of the firm as a governance structure (Williamson 1998). Transaction Cost Economics theory has diffused from its original development in economics to assume a prominent place in a broad range of scholarly inquiry (Bensaou and Anderson 1997).
Transaction Cost Economics focuses on the conditions under which a firm's function is more efficiently performed within the vertically integrated firm (i.e., hierarchical governance mode) versus open market contracting (i.e., market governance mode) with independent entities (Anderson 1984). As proposed by Williamson (1975, 1985, 1989), TCE is built on a micro-analytic framework with strong behavioral reality (Klein 1989. Anderson 1985). Transaction cost theory may be viewed in a general sense as a paradigm whose primary focus is the design of efficient mechanisms for conducting transactions (Heide and Stump 1995). The basic insights of TCE--that transactions must be governed as well as designed and carried out, and that certain institutional arrangements effect this governance better than others--is now increasingly accepted (Shelanski and Klein 1995, 336).
Arrow (1969) described transaction costs as the cost of running the economic system, and as distinct from production costs. Williamson (1996) defines transaction costs as the "costs of contracting," and Cheung (1998) as "institution costs." Searching for information, bargaining, monitoring, and contract enforcement are instances of such costs (John and Weitz 1988). In TCE, attention is focused on economizing efforts that attend the organization of contracts--where a transaction occurs when a good or service is transferred across a technologically separable interface (Williamson 1996).
Transaction Costs Economics views governance in terms of designing particular mechanisms for supporting economic transactions (Heide 1994) and explicitly considers the efficiency implications of adopting alternative governance mechanisms (Heide and John 1988). The theory is robust in explaining when a firm should use an outside third party in performing a function (i.e., market governance), and when it should instead rely on vertical integration (i.e., firm or hierarchical governance)(Williamson 1985, 1996; Klein 1989). Vertical integration is defined as the combination of technologically distinct economic processes within the confines of a single firm (Porter 1980, 300). Consequently, vertical integration issues are make-or-buy decisions to the firm. By their make-or-buy decisions, firms decide their degree of vertical integration (Balakrishnan and Wernerfelt 1986). In describing the `make-or-buy' framework under TCE, Williamson (1989) writes:
Refutable implications are derived from the hypotheses that transactions, which differ in their attributes, are assigned to governance structures, which differ in their costs and competencies, in a discriminating--mainly cost-economizing way (Williamson 1989, 142).
This is known as the discriminating alignment hypothesis (Williamson 1998). Williamson (1985) has shown that market exchange suffers whenever increasing transaction costs are present. These costs arise from asset specific investments designed to carry out transactions, the uncertainty surrounding the transaction, and the frequency with which they occur. This creates a problem in relying on market governance, which is manifest in opportunistic behavior by agents. The TCE solution to this problem is the replacement of market governance with hierarchical coordination (Hennart and Anderson 1993), that is, vertical integration of that activity within the firm.
ASSUMPTIONS OF TCE
There is a set of three assumptions inherent in this structural governance analysis. First, transactions are assumed to occur under "bounded rationality." Bounded rationality refers to cognitive limitations that rule out the ability of transactors to anticipate every contingency in a transaction context (Joskow 1987) and objectively deduce the optimal response (Anderson 1984, 1985). A second assumption in TCE is that transactors are assumed to be imperfectly informed (Williamson 1975, 1985) and therefore to operate under some degree of uncertainty (Anderson 1984; Anderson and Schmittlein 1984). Finally, at least some of the transactors are assumed to act opportunistically (Williamson 1975, 1985; Joskow 1985), that is to cheat other parties whenever profitable (Anderson 1984, 1985).
Transaction cost theory suggests that parties may act opportunistically if given the chance. Opportunism poses a hazard (Stump and Heide 1996) to the firm to the extent that the exchange environment is supported by idiosyncratic investments dedicated to the exchange. The fundamental concern of TCE is to develop satisfactory safeguards to protect the firm from the hazards of this opportunism (Williamson 1985). The principal safeguard identified by TCE to protect the firm from hazards of opportunism is greater integration (Frazier and Shervani 1993) of the activity or function. Thus, according to TCE theory, vertical integration offers greater control of the exchange environment. In the present research, this greater control is evidenced by vertically integrating the sales function, instead of relying on agents. In instances where the line has made idiosyncratic investments, knowing the firm is vulnerable, a third-party provider may act opportunistically (e.g., cheat the line or selling strong trade lanes at the expense of the principal's trade lanes) whenever possible.
Transaction Cost Economics values the benefits of control only when the competitive marketplace breaks down (Anderson and Weitz 1986). The competitive marketplace breaks down when a firm dedicates assets in support of a particular set of transactions and is then subject to possibly being `held-up' (Williamson 1985) by opportunistic third-party providers. When these assets are specific to the set of transactions, the firm is subject to being `held-up' (Williamson 1985), facing the hazards of one party's opportunistic behavior in attempting to appropriate better terms with the investing party. This hazard manifests because the investments to support a set of transactions reduce the field of available alternatives from a large number (i.e., bargaining situation) to a small number (i.e., bidding situation). This is called the "fundamental transformation" (Williamson 1985).
Transaction Cost Economics examines how trading partners protect themselves from hazards of exchange relationships (Shelanski and Klein 1995). Williamson (1975, 1985, 1989) operationalized three tenets of TCE which yield clear causal relationships between transactional characteristics and institutional arrangements (e.g., market or firm governance). Those three transactional characteristics are: 1) the specificity of assets, 2) the uncertainty surrounding the transaction, and 3) the frequency of transactions. High levels of these tenets are hypothesized to lead to the decision to vertically integrate. Williamson (1989) introduces these key dimensions:
The principal dimensions on which transaction cost economics presently relies for purposes of describing transactions are (1) the frequency with which they occur, (2) the degree and type of uncertainty to which they are subject, and (3) the condition of asset specificity. Although all are important, many of the refutable implications of transaction cost economics turn critically on the last. (Williamson 1989, 142)
Transaction Cost Economics treats reliance on the market as a more efficient governance choice, a priori known as the "discriminant alignment hypothesis." Transaction Cost Economics posits that high levels of asset specificity, uncertainty, and frequency lead to market failure, which in turn creates greater transaction costs, and in turn leads the profit-maximizing firm to integrate that function rather than to continue relying on the open market (i.e., a nonintegrated sales force).
When markets exhibit high levels of these features, market failure is said to occur, with the result that cost-free exchange disappears and efficient conditions for the organization of activities are no longer present (Klein 1989). The costs arising under such conditions of market failure are called transaction costs, and include the costs incurred in searching for information, bargaining, monitoring, and contractual enforcement. Transaction costs will be greatest where competitive forces cannot be relied upon to ensure performance (Klein, Frazier, and Roth 1990). Without the presence of transaction costs, there is little or no incentive to substitute internal organization for market exchange (Masten, Meehan, and Snyder 1989). That is, if the market works efficiently, the profit-maximizing firm sees no benefit in internalizing that function. Conversely, in the presence of such costs, the theory prescribes the finn should consider vertical integration.
TCE regards the firm not as a production function, but as a governance structure (Williamson 1998, 37). Anderson and Weitz (1986) de scribe the TCE frame work for examining marketing and economic make-or-buy vertical integration decisions:
This framework begins with a bias toward the market mode. It assumes that control is undesirable in competitive markets, since dysfunctional outcomes may result. More faith is placed in the workings of the invisible hand than in the judgment of a `channel captain,' manufacturer, or other contractor. The ruthlessness of the market workings is thought to be highly beneficial in that competitive outcomes often prevent errors. Errors that are made are penalized, which pressures managers to learn and to correct their mistakes. Transaction cost analysis values the benefits of control only when the competitive marketplace breaks down, i.e., when bargaining over a small number is inevitable. Thus, the framework points toward a make decision in situations where specialization in performing a marketing activity occurs (Anderson and Weitz 1986, 18).
Next, the three general tenets of TCE are discussed. First, asset specificity describes the dedicated assets that are deployed in order to support a transaction or set of transactions (Williamson 1985). Then, uncertainty is defined and its two major forms (Joskow 1985, Williamson 1996) are discussed. Finally, the third tenet-frequency, surrounding the transaction(s) is defined. How these TCE elements are evidenced in the present research in maritime shipping is characterized in each respective discussion.
GENERAL TENETS OF TCE
This sub-part introduces and describes the three general tenets of TCE theory as set forth by Williamson (1975, 1979, 1985). Those are: 1) asset specificity, 2) uncertainty, and 3) transaction frequency.
A primary factor intensifying the problems associated with failing markets and resultant increased transaction costs is the need for a firm to make transaction-specific investments in a particular market, thus putting non-salvageable assets at risk in order to compete (Stem, El-Ansary, and Coughlan 1996). Williamson (1985) defines asset specificity as: "Durable investments that are undertaken in support of particular transactions, the opportunity cost of which is much lower in best alternative uses or by alternative users should the original transaction(s) be prematurely terminated" (Williamson 1985, 55). Williamson (1989) later added to this definition the "degree to which an asset can be redeployed to alternative uses and by alternative users without sacrifice of productive value" (Williamson 1989, 142). Asset specificity is thus a measure of asset redeployability (Williamson 1996). Transaction-specific investments involve dedicated physical or human assets which cannot be redeployed easily (Heide 1994), and are required to support exchange (Heide and John 1988).
Transaction-specific assets are tailored to a particular set of transactions, and thus are valuable only in a narrow range of alternative uses. The narrower the range the more specific the asset (Anderson 1985). Specific assets have the property of being difficult or costly to shift from one context (i.e., transaction) to others. Such assets are said to be `idiosyncratic' (Bensaou and Anderson 1997). Vertical integration becomes more likely as a firm invests in idiosyncratic assets (Williamson 1979, 1985).
Two forms of asset specificity suggested by Williamson (1975, 1979, 1985) are: 1) human asset specificity, and 2) physical asset specificity. Human asset specificity arises as a consequence of learning-by-doing, investing, and transferring of skills specific to a particular relationship (Joskow 1985). Special purpose assets are important because they eliminate competitive pressure (Anderson 1984, 1985, 1988), the major basis of the market superiority assumption (Williamson 1979). Transaction-specific assets make replacement expensive.
Similarly, physical asset specificity arises when investments are made in equipment and machinery (i.e., physical capital) that involve characteristics specific to the transactions or exchange environment and which have lower values in alternative uses (Joskow 1985). The second tenet of the TCE framework is uncertainty and is discussed next.
Uncertainty refers to changes in the environment that a transactor cannot control or foresee and it provides the dynamic element that makes a market unstable (Perrow 1986). Two types of uncertainty have been identified in TCE: 1) external (Williamson 1975, 1985), and 2) internal (Williamson 1981). Environmental uncertainty allows negative information asymmetries to develop and provides the potential for outside third parties to behave opportunistically (Klein, Frazier, and Roth 1990). Internalization is seen as a governance mechanism to allow the absorption of external uncertainty (Williamson 1985, 1991; Klein, Frazier, and Roth 1990). The likelihood of integration increases as the environment becomes more unpredictable (Anderson 1984, 1985).
Unlike environmental uncertainty, which is exogenously imposed, behavioral uncertainty arises within the context of the exchange or the firm itself (Williamson 1985; John and Weitz 1988). As the environment becomes more unpredictable and unstable, the higher is the uncertainty surrounding the transactions. Vertical integration is an appropriate response to increasing levels of uncertainty for the profit-maximizing firm.
Greater levels of uncertainty lead to increased transaction costs (e.g., trend monitoring, measuring performance). Regardless of type, high uncertainty, leading to high transaction costs, encourages greater control in order to reduce costs (Klein 1989). The avenue for such control comes in the form of vertical integration. Vertically integrating to exert control over employees may be useful to reduce the opportunism that arises in an uncertain environment (Anderson and Weitz 1986).
The third TCE tenet, transaction frequency, is discussed next.
The more often that spot market transactions are performed, the greater are the costs entailed in the administration and monitoring of those transactions (Klein 1989) and the greater the likelihood a firm will internalize the function (Williamson 1985). As such transactions occur more frequently, vertical integration becomes more desirable since potential losses, from not integrating, outweigh the overhead costs of integration (Anderson and Schmittlein 1984). More frequent spot transactions are argued to lead to vertical integration (Williamson 1985).
Vertical control issues are productively studied as cases of market failure (Klein 1989). Transaction Cost Economics is a robust theory (Williamson 1998), with strong corroborative empirical support in explaining vertical integration of marketing activities when competitive markets fail (Anderson 1996).
THE E-COMMERCE MODEL OF VIRTUAL INTEGRATION -- WHAT IS IT?
Virtual Integration uses technology and information to blur the traditional boundaries in the value chain between suppliers, manufacturers, and customers (Magretta, 1998). In coordinating a series of partnerships to deliver low cost, fast solutions to generate high value to the customer and shareholders, virtual integration avoids investing in low-return manufacturing assets and instead concentrates resources on satisfying customers. Thus, the firm's primary skill and major investment is in directly interacting with individual customers.
Virtual Integration begins by using rapid communication to build direct relationships between the customer, manufacturer, and supplier. The firm must define what it does best and focus on it, partnering with others for capital and labor-intensive service (Dell, 1998). Partners must be sought who are the best in their field and who hold to the same quality and performance standards that are used within one's own firm (Dell, 1998). Doyle (1998) describes the three basic principles of virtual integration: 1) Taking control of distribution, by eliminating the dealer and selling direct. This enables the firm to create potential competitive advantage by tailoring solutions to individual customers. It further enables brand recognition and prevents the offering from becoming a commodity. 2) Eliminate stock and build to order. This allows for minimal investment and risk in working capital, transforming thin operating margins into high returns. Large inventory levels cause unnecessary storage and distribution costs as well as capital tied up in inventory. 3) Maintain flexibility that will allow for switching of partners when the technology changes. Suppliers are treated as part of the firm, linked to the customer ordering cycle to create a fast delivery system. As the technology changes, a supplier may lose its advantage over others and its product may become outdated or not priced competitively.
By following the above principles, firms attempting to move to virtual integration hope to accomplish the following (Principles of Virtual Integration, 2000): A) conduct direct business-to-business transactions, B) Focus on the firm's core competencies, C) Collaborate with other supply chain members to spur velocity through the chain, and D) Use technologies to cross boundaries.
Suppliers and customers must be treated as partners and collaborators jointly looking for ways to improve efficiency across the value chain. Since the suppliers are integrated within the business, they must perform to the same quality standards and metrics as the focal firm. Virtual firms establish direct relationships "that close the gap between customer, manufacturer and supplier," according to Michael Dell (Magretta, 1998, p.75). Direct relationships with customers create valuable information, allowing the firm to coordinate its entire product design back through manufacturing to product design (ManufacturingNews.com, 2000). There are many benefits to having a tightly coordinated supply-chain management--one of which is measuring inventory in hours or even minutes, instead of days. Moving from just-in-time delivery to real-time, additional benefits of virtual integration include the following: A) easier to form and expand systems, B) requirements of less capitalization, C) maximization of local control and autonomy, D) decision making layers and corporate bureaucracy minimized, and E) more agility in identifying and responding to local market growth opportunities
The days are gone in which the firm must closely guard its information assets. Rather, these assets must be used as a foundation for open, information-based partnerships that speed the flow of data, improve efficiency and add customer value while providing benefits to the partners (Dell, 1998). Success of these partnerships hinge on the following five factors (Virtual Integration: Critical Success Factors, 1999): 1) Sharing of a long-term vision and well-articulated ground rules among members, 2) Accepted forward-looking network leadership, 3) Ability to generate concrete short-term results, 4) Realistic performance expectations and clear measures of success, and 5) Interpersonal trust.
SHIFTING TOWARD BUSINESS-TO-BUSINESS (B2B) E-COMMERCE
The purchase of industrial parts is a major cost to manufacturers around the globe. Manufacturers spend no less than 35 cents for every dollar in sales, $5 trillion a year worldwide, towards purchasing industrial parts (Tully, 2000). Traditionally, these parts are purchased through contracts made between the manufacturer and supplier. Before a contract expires, the manufacturer sends out a request for quotations (RFQ). A traditional RFQ doesn't spell out a lot of the important terms, such as delivery schedule, amount of inventory the supplier will hold, whether the supplier will provide people to restock bins, and so forth. Therefore, it is hard to surmise the best deal. Furthermore, bids are usually sealed and are valid once. This leads to a lot of game-theoretic maneuvering within the industry. Suppliers have little idea what prices their competitors are offering, so they take a blind educated guess at how low they must bid. Therefore, with all the unknowns in the RFQ process, most manufacturers remain with their current supplier, given that they agree to keep their prices more or less flat.
The online auction, one form of e-commerce B2B, turns the traditional secretive RFQ into an open bidding war (Tully, 2000). The suppliers in the online auction must not only deliver the same part, but do it on the same schedule, with the same payment terms, and inventory arrangements. Therefore, since each package is essentially the same, the only thing that remains is to find the lowest price. Linked over the Internet, these auctions allow each bidder to see other bidders' competitive bids in real-time. In Transaction Cost terms, then, we are witnessing a return to large numbers bargaining process (Williamson 1975) from a small numbers bidding process (Stapleton 1999).
B2B marketplaces are of two types: vertical and horizontal. Vertical hubs serve a particular industry with a particular line of products. Most sites are of this type and serve all the suppliers and buyers whose interaction eventually produces an automobile, for example. Horizontal hubs serve wide-ranging industries with wide-planning products (i.e. Amazon.com for businesses). Vertical hubs that allow thousands of suppliers and buyers of an industry to interact over the Internet are replacing the traditional methods of finding, buying, and transporting manufacturing materials and other goods (Banham, 2000). Integrating sourcing, purchasing, and billing, B2B hubs reduce the cost of acquiring materials and other business goods, which in turn helps firms improve capacity use, increase inventory turns, and improve cash flow. Since there are a lot of firms from which to select the best product at the best price, Internet database technology can be used to provide seamless supply chain integration.
Drawbacks to the B2B bartering system have included the lack of an electronic logistical component. Therefore, many hubs are building logistical platforms to provide pricing, fulfillment, and tracking services using shipping specialists (Banham, 2000). The missing link has been a logistics solution telling how much it will cost to move a product from one point to another before the business transaction takes place. Previously, buyers and sellers had been able to make transactions online, but they had to go offline to move their merchandise. Thus, B2B participants found that they needed to create physical distribution and consumer service facilities for orders placed over the Internet. Firms have recently formed alliances with logistic finns to ensure their transactions occur more smoothly and offer true one-stop shopping. Examples of these alliances include (Banham, 2000): 1) PaperExchange.com, a B2B marketplace serving the pulp and paper industry that added C.H. Robinson Worldwide as the transportation and logistics provider for its site. Soon, the hub's users will receive real-time transactional quotes from Robinson for the cost of moving merchandise from supplier to buyer. 2) PlasticsNet.com, an e-commerce marketplace for the plastics industry that formed a similar alliance with Schneider Logistics. With the alliance in effect, PlasticsNet.com shoppers will be able to instantaneously acquire transportation rates based on desired transit times and shipment characteristics.
The B2B marketplace offers a greater choice of merchandise from more suppliers and greater price competition. They essentially are the electronic version of the centuries-old trading bazaars. Instead of contacting several suppliers to determine what they have, at what price and when it is ready to ship, a customer can go to one website for all that information.
Consumer markets are small compared to business markets. It is estimated that one-forth of all U.S. business-to-business purchasing will be done online by 2003 Graphic Arts Monthly, 2000). Forrester Research Inc, in Cambridge, Massachusetts, expects that $2.7 trillion of business-to-business Internet trade will occur by 2004 (King, 2000). A majority of this trade will take place on vertical industry exchanges--online trading communities where multiple buyers and sellers come together to buy, sell, and conduct other activities. Not all exchanges operate in the same way. Some link buyers with sellers, while some operate with a middleman at the center of the process and others offer auction capabilities.
The following segments have been reported by Goldman Sachs as the future market leading industries in B2B (Nucifora, 2000): A) Chemical: $349 billion by 2004, B) Computer hardware and software: $221 billion, C) Industrial equipment: $140 billion, D) Energy/utilities: $133 billion, E) Agriculture: $124 billion, F) Government: $94 billion, G) Paper: $93 billion, H) Aerospace/defense electronics: $77 billion, I) Information services: $53 billion, and J) Motor vehicles and parts: $47 billion.
E-business provides transaction speed, access to global markets, and mass customization (Littman, 2000). Feedback from research, recent acquisitions, joint ventures, partnerships, and alliances indicate that most noncommittal B2B functions will eventually be outsourced (e.g., human resources, sales, purchasing, consulting). B2B allows the user to see the parts and products online, reach new customers, and provide better customer service. Through the use of the Internet, transaction costs can be dramatically reduced. The Internet allows for fewer data-entry errors, creating time-savings and lower labor costs. Internal resources are reassigned and certain tasks are outsourced. Electronic procurement can cut purchase order costs to a third of that of conventional purchase orders (Martin, 1999).
Solectron Corp., a contract manufacturer, is a part of the new breed of U.S. supercontractors that is revolutionizing manufacturing (Engardio, 1998). The firm has dozens of factories and supply networks around the world. It is becoming more common for them to manage their customers' entire product lines, and offer services ranging from inventory management to delivery and after-sales service. The flexibility in their operations has allowed the firm to produce returns on assets in the range of 20% (Engardio, 1998).
Arrangements with firms such as Solectron represent a type of extended enterprise, a set of partnerships between product developers and specialists in components, distribution, retailing, and manufacturing. This partnership allows the organization to act like a single, closely-knit firm. Its strategies slash unnecessary time and costs from the supply chain. As a result, customers have achieved cost efficiencies of 15% to 25% (Engardio, 1998). By spinning off manufacturing and other noncore functions, large industrial firms can focus new investment where it is best needed; research and marketing. Additionally, since this strategy reduces the need for capital and in-house operations expertise, startups face lower barriers to entering the market.
REDUCTION OF TRANSACTION COSTS
Reducing transaction costs to the manufacturer, the retailer, and any other supply chain member is what integration does best. Most importantly, it reduces transaction costs to the consumer. Traditionally, most manufacturers have tried to reduce transaction costs in two ways (Schultz, 1994). The first way has been through economies of scale or experience curves to lower the cost of the product. The second way has been to reduce transaction costs by reducing the cost of distribution. However, most firms today can only experience short-term gains in lowering transaction costs through these methods.
Inflation has always been a primary concern when considering pricing strategies. However, some economists predict that the Internet's boosting of global growth will negate the impact of inflation (Economist, 2000). The Internet makes it easier for buyers and sellers to compare prices. It potentially cuts out middlemen between the firm and the customers. It reduces transaction costs, and it reduces barriers to entry. Since the Internet reduces costs, it also reduces the optimal size of firms. Small firms may be able to compete as effectively as large firms by buying from outside suppliers more cheaply.
The Internet cuts costs, increases competition, and improves the functioning of the price mechanism. Thus, it moves the economy closer to the textbook model of perfect competition, which assumes abundant information, zero transaction costs, and no barriers to entry (Economist, 2000). In theory, then, the Internet makes markets more efficient.
B2B e-commerce cuts firms' costs in three ways (Economist, 2000): First, it reduces procurement costs, making it easier to find the cheapest supplier and cuts the cost of processing transactions. Second, it allows better supply-chain management. Third, it makes possible tighter inventory control so firms can reduce their stocks or even eliminate them. The longer the supply chain, the bigger the potential gains from B2B e-commerce, since it allows firms to eliminate the many layers of middlemen that hamper economic efficiency.
It is estimated that doing business with suppliers online could reduce the cost of making a car by as much as 14%. In the world's five largest economies, its has been calculated that B2B e-commerce could reduce average prices across the economy by almost 4% (Economist, 2000). A Goldman Sachs study estimates that B2B e-commerce will cause a permanent increase in the level of output by an average of 5% in these same five economies, with over half of this increase coming within ten years. This implies an increase in GDP growth of 0.25% a year (Economist, 2000). Now that we have defined virtual integration and some of its underpinnings, we will now examine some of the conceptual shifts involved in the movement from vertical integration to virtual integration.
CONCEPTUAL SHIFT FROM VERTICAL INTEGRATION TO VIRTUAL INTEGRATION
Today, we are witnessing a metamorphosis in the weighting of firms' asset bases from physical assets to more human assets. The major contributor to this phenomenon is the advancement of technology and the fact that more firms are entering the "service" sector that encompass the Internet and Business-to-Business concepts. No longer is it the proverbial "what you have," but rather "what you know."
In today's growing virtual commerce society, sustainable competitive advantage is measured in terms of who has the latest technology and information. It is about who `can be innovative in meeting the needs of the consumer, not who has the most money or physical assets. However, its not just about having the technology, but rather the strategic thinking to encapsulate the advantages of that technology with the core competencies of the firm and its relationship with the consumer. The market is evolving at a faster pace and firms are no longer able to create a competitive advantage around a single solution. Instead, survival is based around identifying and capitalizing on emerging markets opportunities; managing intellectual capital; and the ability to implement strategies redesign business operations (World Reporter, October 1999).
In addition, firms must realize that in today's technological world, there is no longer a sense of proprietary knowledge versus common knowledge. Not only is information widely accessible from the public sector, but the technological information used by firms is very homogeneous across industries, making it susceptible to duplication by the competition. When trying to capture competitive advantage, firms need to concentrate not on the technology or its application, but rather on sustaining the relationship with each individual customer. As the marketplace evolves, each business is becoming unique in its operations, requiring a specialized application system. No longer is it possible to meet the customer's need with a standardized product. Firms might use the same core technologies to develop systems, but the overall product has to be thought of in a dynamic and synergistic frame of mind, constantly evolving with its environment to satisfy the changes (World Reporter, October 1999).
Traditionally, business concepts focused on the product and its marketplace. However, in today's more highly competitive technological environment, we are seeing an underlying shift in the way firms behave. Before, success involved leveraging physical assets, but many strategists are seeing the importance of consumer and supply chain information and how they can leverage it to attain long term financial success (Srivatava et al. 1998). These intangible assets are difficult to measure, but are the keys to the success of the firm.
In their article, Srivatava, Shervani, and Fahey discuss the concepts of intangible assets and segregates them into two types: relational and intellectual. Relational assets are the outcomes from a firm's relationship with key factors in its supply and distribution channels, such as retailers, distributors, end customers, and any alliances. Intellectual assets are the firm's knowledge of its environment, including market conditions, competitors, customers, and channel members (Srivatava et al. 1998). The authors delved into the correlation between the two assets and were able to create some basic conclusions: 1) Knowledge is the ultimate source of opportunity; it guides creativity and innovation. Relationships are widely viewed as essential to opportunity creation. 2) The intangible nature of market based assets renders relational and intellectual assets extremely difficult to imitate. The corporate culture and knowledge embedded in each person cannot be emulated by the competition and, therefore, provides longer sustainable advantage than physical assets. 3) Possessing information about changing attitudes and tastes of the consumer enables firms to supplement the value generation of its physical assets by enabling the firm to more efficiently and quickly adapt processes to meet those changes. 4) Relational assets augment the value of the firm by making it a part of an informational network, creating a business ecosystem where everyone relies on each other. 5) Relational and intellectual assets can enhance shareholder value by increasing cash flows through increased responsiveness to the market
In this fundamental shift to market space, firms will no longer be able to survive as "islands" in the business world. As we have witnessed over the past five years, many firms are establishing strategic alliances or creating mega-mergers to exploit economies of scale and access key competencies. However, in that same frame of mind, firms must not be too hasty to share or outsource its products, because what little you save today may hurt your competitive ability in the future due to the loss of core knowledge (World Reporter, October 1999).
The final concept that finns need to keep in mind is that they cannot take a narrow perspective in the growing world of market space business solutions. Too often, firms focus on a particular product or service instead of how it might fit into the overall firm strategy. In addition, many traditional "bricks and mortar" firms make the mistake of trying to adapt their present marketing and logistics strategies to fit the technological business world. Instead, what is needed is a fundamental shift in the way of thinking, and the realization that the two business worlds are completely different. To enter this emerging market, one needs to reengineer their way of thinking, forgetting all the traditional concepts of business and starting from the ground up. Each decision had to be looked at individually to see if it fits within the strategic confines and direction of the firm.
SUPPLY CHAIN MANAGEMENT (SCM)
As we shift towards marketspace, the most vital issue that firms will have to become proficient at is Supply Chain Management (SCM). The key to success is the information you derive from the various levels with your supply chain and how you employ it. In reference to SCM and the auto industry, Chia Nam Liang, a Deloitte Consulting manager says, "good and effective supply chain management is crucial to competing effectively" (World Reporter, August 1999). Neil Graham expands further, "the most crucial thing is maximizing communications in each `community' within the supply chain cycle ... don't focus on logistics per se, but look instead at how well you can work with suppliers" (World Reporter, August 1999). Supply Chain Management is not firm or even industry specific, but rather a concept that businesses will need to concern themselves with if they are to survive. As Liang notes, "Competition will in future no longer be a case of firm versus firm. It will be a case of who has the better supply chain management. And quality per se will no longer be singularly important. The real competition will lie in the speed, and who can provide the lowest cost of purchase" (World Reporter, August 1999).
There are many models within supply chain management, but the most recognized is the direct business model (i.e. Dell Computers' model). Just-in-time systems utilize inventory management techniques to allow for minimum storage and the delivery of components only at the time when they are needed. To facilitate communication, many manufacturers encourage suppliers to locate centrally to their locations of production. However, this is not always possible and some items must still be brought in from an external source. This is where the direct model or Dell Model comes in.
DIRECT BUSINESS MODEL (DELL MODEL)
The direct model is one in which the firm sells directly to the customer and builds products to order. It employs concepts that eliminate intermediary costs, inventory storage and carrying costs, and allows for semi-instantaneous process engineering to meet customers' needs.
In a 1998 article, Michael Dell, founder of Dell Computers, discussed Dell and how it utilized the direct business model to achieve its success in such a relatively short time. In addition, he discussed the principles and philosophies behind the direct model, its pioneering impact on the shift towards virtual integration and its future implications on how firms conduct their operations. Virtual integration is using technology and information to blur the traditional boundaries in the value chain among suppliers, manufacturers, and end users. It employs the tight coordination of traditional vertical integration with the focus and specialization of virtual organizations (Magretta, 1998).
As a start up firm during the mid-1980's, Dell Computers did not have the assets or resources to create all components within its supply chain. But as Michael Dell states, "why should we want to?" He concluded that the firm was better off leveraging the investments and knowledge that others had and focusing more on the actual delivery systems for the products. As Dell analogized:
"If there you've got a race with twenty players that are all vying to produce the fastest graphics chip in the world, do you want to be the twenty-first horse, or do you want to evaluate the field of twenty and pick the best one?" (Magretta, 1998, p. 74).
Dell Computers realized this contradiction in strategy and offered another solution. Firms that made nothing but computer chips did not have really high returns, so Dell thought that it could be more profitable to put the firm's capital into activities where it could add value for the customer and not be just another step in the whole process. "That allow[ed] us to focus on where we add value and to build a much larger firm much more quickly. Most important, the direct model has allowed us to leverage our relationships with both suppliers and customers to such an extent that I believe it's fair to think of our firms as being virtually integrated. I don't think we could have created a $12 billion business in thirteen years if we had tried to be vertically integrated," explained Dell (Magretta, 1998, p. 74).
But what makes the direct model so different and why is it so successful? As Michael Dell explains, there are fewer things to manage. There are not all the physical assets and personnel to deal with and, therefore, less of a chance of things going wrong. It is a lot easier to use someone else's capacity than to develop a system of your own. As Dell elaborates:
"There are, for example, 10,000 service technicians in the field that service our products, but only a small number of them work for us. They're contracted with other firms ... but ask the customer `who was that person that just fixed your computer?' The vast majority think that the person works for us, which is just great. That's part of virtual integration" (Magretta, 1998, p. 75).
However, there are many that argue that the direct model is nothing more that just outsourcing, a concept that has been in existence for years. Michael Dell thinks otherwise. He sees what Dell Computers does as being more about the coordination of activities to create value. Dell Computers creates quality standards and support linkages with its suppliers to better evaluate how the process system is working and responding to the customer. They look not at what is presently being demanded, but what demand will be over the next five or ten years. By coordinating with its suppliers--to the point where the supplier's engineers work with Dell's design teams--Dell Computers achieves a cohesive unit in which the supplier virtually becomes a partner and part of the firm. However, unlike traditional firms, in virtual integration, finding a partner doesn't necessarily mean sticking with them forever. Michael Dell points out that in today's technologically oriented business society, demand and change are forever becoming more volatile. Some of the more stable sectors will facilitate long-term relationships, while others will be more short term and fractional. Dell analogizes virtual integration as "stitching together a business with partners that are treated as if they're inside the firm ... you're sharing information in a real-time fashion" (Magretta, 1998, p. 75)
One might think that if the advantages of virtual integration are so enormous, why aren't more firms doing it? Michael Dell poses that the biggest challenge to establishing relationships in a virtually integrated setting is changing the organization's focus tom how much inventory there is, to how fast it is moving (Magretta, 1998). As he explains, assets, especially inventory and receivables have inherent risks about them, which grow over time. This is even more prevalent in the technology sector where the product life cycle is measured in months, not years. If you have a high inventory, you become more susceptible to market share loss with the advent of better technology because you have to first clear the old inventory before you can introduce the new product. In addition, with product costs forever decreasing through emerging technologies and efficiencies, a firm with high inventories is at risk for higher cost-of-goods sold (COGS) and the possibility of obsolete inventory. As Dell further explains, the key to being perpetually successful at virtual integration is constantly working with suppliers to reduce inventory and increase turnover and velocity (Magretta, 1998). Where this really pays off is the fact that Dell Computers actually has a negative cash-conversion cycle. The firm actually gets paid before it has to pay its suppliers, thus giving them an inherent cost advantage. This is similar in scope to Wal-Mart's negative cash-conversion achieved through cross-docking of inventory. As with Dell's competitors, the traditional way involved having to pay intermediaries (resellers) before getting paid by the consumer, thus reducing cash flow and profits (Magretta, 1998). Dell Computers works with its suppliers to make daily pick-ups, informing them of what its daily demand will be. As a result, the firm does not have to warehouse products. For the suppliers, this may seem counter-intuitive, especially for those who traditionally profited through bulk distribution. However, Dell Computers sees it as win-win situation. By not warehousing inventory, the firm saves on costs; by doing daily pick-ups in coordination with the supplier, the supplier benefits by Dell Computers using the product faster and purchasing more (Magretta, 1998). Thus, higher turns allow both firms to pursue profit maximization without reliance on traditional squeezing methods.
Once product procurement has been finalized, the next vital step is the process of assembly and distribution. Without a coordinated distribution and monitoring system, virtual integration does not work. Dell Computers utilize real-time communication strategy up and down its supply chain to make the distribution of components and the final product more efficient. Typically, Dell Computers produces about 10,000 units per day, but because it custom-builds its computers, it must employ a real-time strategy in inventory management with its suppliers to make sure there are not too many or too few of the necessary components. By maintaining a few days or even hours of inventory and by being in contact with members along the supply chain, Dell Computers is able to quickly adapt to any changes in demand.
It is very typical that many firms in the industry have a 90-day lag between point of demand and point of supply, creating many inefficiencies in the process. To relieve these efficiencies, many organizations simply stuff the supply chain with old inventory to get rid of it and meet their short-term goals. However, Dell Computers' model is better because it substitutes information for inventory, only shipping and producing when there is actual demand from the end customer. In addition, if certain items are temporarily out of stock, the direct model allows Dell to direct the customer to comparable products, thus not affecting the inventory flow. Granted, not all industries will be able to employ the virtual integration model at its face value due to inevitable variabilities such as product size, manufacturing time, and overall production process. However, many can implement the core process of the model and customize it to their respective firms. The implications of using the direct model have not only benefited Dell, but its suppliers as well. By minimizing the distance between itself and its customers, the firm has minimized the variability and discrepancy of information regarding demand, which it transfers onto its suppliers.
Many are familiar with Dell from a traditional consumer standpoint, but that was not always the case (See Figure 1). Michael Dell admits that when the firm started out, it did not pursue the consumer segment because it did not have the resources to introduce such a vast segment to the age of computers. Instead, the firm took a passive approach, allowing the large competitors to teach society about computers, while it sat back and observed. What it noticed was the fact that as consumers learned, they demanded better and more powerful machines, but instead of going to the competition that they had originally bought from they began coming to Dell.
Because Dell sold directly, it could see exactly what consumers wanted and as the industry's average selling price was going down, the firm's was going up. As a result, Dell decided to dedicate a specific part of it efforts to the consumer segment. Customers also benefit from this type of segmentation because it puts them closer to the source of the product. This closeness provides Dell with vital information about forecast and demand and allows the development of accurate strategies, thus reducing overall costs and creating savings which are eventually passed on to the consumer through lower prices.
Michael Dell points to this one principle as the major reason why competitors have been unable to emulate his firm's success.
"It's not just that we sell direct, it's our ability to forecast demand--it is both the design of the product and the way the information from the customer flows all the way through manufacturing to our suppliers. If you don't have that tight linkage--the kind of coordination of information that used to be possible only in vertically integrated firms-then trying to manage to 11 days of inventory would be insane. We simply couldn't do it without customers who work with us as partners" (Magretta, 1998, p. 79).
In commenting on the virtual integration process, Michael Dell sums it up as being able to let one meet customers' needs faster and more efficiently than any other model. You can be successful through vertical integration, as long as the environment is stable--and we all know that to rarely be true. As Dell stated, "to lead in that kind of environment, you have to be on the lookout for shifts in value, and if the customer changes. One of the biggest changes we face today is finding managers who can sense and respond to rapid shifts, people who can process new information very quickly and make decisions in real time" (Magretta, 1998, p. 83). Virtual integration allows you to be both efficient and responsive to change in a real-time sense.
TRANSACTION COST-INSPIRED PROPOSITIONS
In analyzing the previously described tenants of TCE and its explanation of vertical integration, the following propositions are made regarding the application of those tenants in explaining virtual integration as evidenced by the direct model.
Transaction-specific investments involve dedicated physical or human assets which cannot be redeployed easily (Heide 1992, 1994), and are required to support exchange (Heide and John 1988). Specific assets have the property of being difficult or costly to shift from one context (i.e., transaction) to others. Such assets are said to be `idiosyncratic' (Bensaou and Anderson 1997). Vertical integration becomes more likely as a firm invests in idiosyncratic assets (Williamson 1979, 1985). However, as exemplified by the surging technology industry, as we move from a marketplace environment to a marketspace environment and attain virtual integration, we see less asset specificity, particularly with physical assets.
Physical asset specificity arises when investments are made in equipment and machinery (i.e., physical capital) that involve characteristics specific to the transactions or exchange environment and which have lower values in alternative uses (Joskow, 1985). Prima facie, this aspect of Transaction Cost theory does not seem to be able to explain virtual integration in the same manner as it explains vertical integration. On the contrary, the principles appear to be the opposite. It seems that as customization and specificity of physical assets increases, the greater the likelihood that a firm will outsource or virtually integrate with market specialists. The reason appears to be that assets are becoming more general, with their application being the specific or customized asset. As this customization increases, it is not feasible or cost effective for firms to manage it; thus they outsource to external specialists and virtually integrate. If physical assets are specific to a firm-supplier relationship, the firm should elect to virtually integrate. This is because a market specialist is better able to produce its output more efficiently and cost effectively and is able to adapt to changes better and quicker. This saves the parent firm a great deal of investment capital and risk. If technologies or tastes change, the firm does not have a great deal of its own capital invested.
However, it appears that the theory of TCE and general assets as it relates to vertical integration also applies to the issue of general assets and virtual integration, especially in the technology industry. As with vertical integration, the more general the asset the stronger the reason to outsource to specialists for cost and quality reasons. The same applies to the technology industry, as there are a growing number of suppliers of homogeneous products. As a result, firms are better off outsourcing to these suppliers due to the volatility of the market and the fact that the growing number of suppliers spurs competition and innovation. With general assets, a firm is not tied to a particular supplier out of necessity. It can pick amongst suppliers to constantly have the best product without having to invest the capital itself. The firm is tied to suppliers by choice. Since the firm has general physical assets it is able to switch between suppliers if it so chooses. Thus, as asset specificity increases, virtual integration may be an alternative to vertical integration.
Proposition 1: As the specificity of physical assets increases, the higher the likelihood the firm will virtually integrate as an alternative to market governance.
Human asset specificity arises as a consequence of learning-by-doing, investing, and transferring of skills specific to a particular relationship (Joskow, 1985). Special purpose assets are important because they eliminate competitive pressure (Anderson 1984, 1985, 1988), the major basis of the market superiority assumption (Williamson, 1979). However, today, most firms know or have access to the same basic information. Thus, radical thinking and innovation is occurring faster and more frequently, with greater advances in technology. Today, the main asset for firms is the ability to communicate and transfer information. This is something that is not relationship-specific and thus, does not become antiquated or used up, but rather only the mode by which it is done. As markets change, knowledge and experience are adaptable; thus, human asset capital is not specific to a situation, but only changes in the way it is applied.
Competitive advantage is about knowing more than your competition. Because technologies and their applications change so rapidly, it is difficult for firms to integrate technology within to the point of constant innovation. As a result, most firms choose to virtually integrate and leave innovation and human asset specificity to specialists. In addition, as technology changes, firms must consider the learning curve costs associated with integrating within versus virtually integrating. If knowledge is specific it may be cost effective to virtually integrate with a specialist, especially if the volatility of the industry is high. Consequently, the TCE tenet of human asset specificity with vertical integration does not seem to apply in the same context when explaining knowledge and human asset specificity within virtual integration. Due to the ease of knowledge transfer in industries, firms are not tied to a particular supplier. If technologies change and a particular knowledge becomes obsolete, it is not difficult to shift that knowledge to a different area. Thus, similar to proposition 1, TCE likely explains virtual integration in relation to human capital, though for very different reasons. Then,
Proposition 2: As the specificity of human assets increases, the higher the likelihood the firm will virtually integrate as an alternative to market governance.
Uncertainty refers to changes in the environment that a transactor cannot control or foresee and it provides the dynamic element that makes a market unstable (Perrow, 1986).
Behavioral uncertainty, or internal uncertainty arises within the context of the exchange or the firm itself (Williamson 1985; John and Weitz 1988). As the environment becomes more unpredictable and unstable, the higher is the uncertainty surrounding the transactions. Vertical integration is an appropriate response to increasing levels of uncertainty for the profit-maximizing firm. Transaction cost reasoning argues that as internal uncertainty increases the higher is the likelihood the firm will vertically integrate, thus taking on the overhead expense of owning a function rather than relying on the market. As far as the tenet of internal uncertainty is concerned, virtual integration appears a simple variation of market governance. Thus,
Proposition 3: As internal uncertainty increases, the higher the likelihood the firm will virtually integrate as an alternative to market governance.
Environmental uncertainty allows negative information asymmetries to develop and provides the potential for outside third parties to behave opportunistically (Klein, Frazier, and Roth 1990). Internalization is seen as a governance mechanism to allow the absorption of external uncertainty (Williamson 1985, 1991; Klein, Frazier, and Roth 1990). The likelihood of integration increases as the environment becomes more unpredictable (Anderson 1984, 1985).
With virtual integration, this theory of TCE seems to imply the opposite. As with the other tenants of TCE, it appears that as industry and environmental uncertainty increases and changes occur more frequently, the lower the efficiency and greater the risk to a firm that internalizes; thus the greater the reason to outsource and virtually integrate. The issue in regards to uncertainty in the external environment is whether or not the market is static or dynamic. If the market is dynamic and a firm is risk averse, it would want to virtually integrate. This is because it will have less of its own capital invested in the relationships, and will be less susceptible to changes in the marketplace.
Another issue is how often change occurs in the market. If change occurs often, a firm may want to virtually integrate to protect itself from the unpredictability of the market. High uncertainty, leading to high transaction costs, encourages greater control in order to reduce costs (Klein, 1989). Thus, similar to Proposition 3, it appears the firm sees virtual integration as a form of market governance. Then,
Proposition 4: As internal uncertainty increases, the higher the likelihood the firm will virtually integrate as an alternative to market governance.
Frequency of Transactions
The more often that spot market transactions are performed, the greater are the costs entailed in the administration and monitoring of those transactions (Klein, 1989) and the greater the likelihood a firm will internalize the function (Williamson, 1985). As such transactions occur more frequently, vertical integration becomes more desirable since potential losses from not integrating outweigh the overhead costs of integration (Anderson and Schmittlein, 1984). More frequent spot transactions are argued to lead to vertical integration (Williamson, 1985).
However, as with uncertainty, this tenet of TCE implies the opposite when explaining virtual integration. It appears that the more frequent transactions occur, the more likely a firm is to virtually integrate. As transactions occur more frequently, the less the risk involved for the firm with regards to such issues as obsolescence of inventory and changes in demand and supply. As the industry becomes more volatile and technologies advance quicker, there is the risk of greater inventory carrying costs, storage, and waste due to obsolete inventory. As frequency increases, a firm is better able to manage the segments within the supply chain and allow for more efficiency through better knowledge of changes in tastes and demand. In addition, as the demand for greater customization has increased, firms have seen the necessitated increase in frequency to remain competitive and endure these changes.
Proposition 5: As transaction frequency increases, the higher the likelihood the firm will virtually integrate as an alternative to market governance.
This manuscript has reviewed transaction cost economics and its efficacy in explaining governance decisions. Importantly, all of the propositions (asset specificity, uncertainty and transaction frequency) imply that virtual integration, as in the Dell direct model of electronic-commerce, is a third alternative to make-or-buy, somewhere between market governance and hierarchical governance. This manuscript argues that Transaction Cost theory may, in part, explain virtual integration. Importantly, however, we argue that virtual integration is not simply market governance, but an alternative to market governance, where transactions are not simply spot transactions but are long-term in orientation and are more easily divested than owned assets such as in hierarchical governance as the market changes.
Commerce is witnessing a governance shift from traditional vertical integration toward "virtual integration" (Sheth and Sisodia 1999) coinciding with a location-centric shift from marketplace to a more virtual "marketspace". What exactly is virtual integration'? Many use the term indiscriminately. This research had a two-fold purpose: 1) to more precisely define and explain the concept of virtual integration, and 2) to propose that the tenants of Transaction Cost Economics (TCE) used to explain conventional vertical integration governance might also be used to explain virtual integration. The manuscript was grounded in TCE theory because of the theory's robustness in explaining structure in terms of governance. After a thorough review of the theory, we discussed several empirical tests of the theory. We then defined and explained virtual integration and presented it as an alternative to market or hierarchical governance (i.e., make-or-buy), and offered a case study of the Dell Computer Corporation as an example of a virtually integrated firm. Lastly, we offered propositions reflecting TCE theory in an effort to apply Transaction Cost analysis in explaining virtual integration. It is hoped that future researchers will apply TCE in an effort to better validate our suggestions and better explain and understand virtual integration.
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Drew Stapleton, Peter Gentles and Kyle Shubert are affiliated with the University of Wisconsin, La Crosse.
Jon Ross is affiliated with the Trane Company, San Francisco.