Governance of Buyer-Supplier relationships in Supply Chains: A Theoretical Perspective

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1 Governance of Buyer-Supplier relationships in Supply Chains: A Theoretical Perspective S.Sapukotanage (ssapu@ou.ac.lk ) Open University of Sri Lanka B.N.F Warnakulasooriya S.T.W.S.Yapa Abstract Buyer supplier relationships in supply chains are becoming increasingly important as buyers realize that their success is often tied to the capabilities and performance of suppliers. However since the manufacturer and the supplier are separate entities with each having individual goals, it is not definite that the supplier will support the manufacturer s request and vice versa. As a result exchange partners are said to be more confident about co operative activities when they feel that they have an adequate level of control over the actions of their partners. Therefore, the need to manage a manufacturer s relationship with its suppliers has been discussed in literature over a long period of time. Thus the aim of this paper is to discuss how the supplier governance mechanisms have been identified in literature during the last decade. According to the literature, the manufacturing firms can draft legal contracts or create formal structures allowing suppliers financial resource (formal governance) or establishing strong ties that serve as part of the social control mechanism (relational governance) which governs partnership behaviours or maintains a combination of both. Many argue that formal contracts actually undermine trust and thereby encourage the opportunistic behavior which they are supposed to discourage. The benefits of relational ties are also questioned in the case of repeated partnerships. Reviewing the literature it could be concluded that it is important for organizations to understand the organizational context (power relationship and competition intensity) in which the relationship exists, the complexities introduced by 1 Electronic copy available at:

2 uncertainty and the circumstances in which they are applied in order to establish a win-win situation through the governance mechanisms. Key words: Supplier relationships, Governance, Opportunism, Trust JEL Classification: M31, M39 Introduction With the emergence of a relationship paradigm, organizations are directed towards the establishment, development and maintenance of successful relationships (Morgan and Hunt (1994), as cited in Thakkar et.al. (2008). Since few firms have the adequacy to internally control all the resources required for effective functioning firms are dependending on others for critical resources and are prone to the likelihood of unpredictable events favoring the institution of bilateral relationships (Carey and Lawson, 2011). Supply chains act as a facilitating mechanism for the exchange of resources. Therefore supply chain relationships often involve a higher degree of interdependency between companies (La Londe, 2002), as cited in Thakkar et. al. (2008). Supply Chain Management (SCM) is about integration of relational exchanges between suppliers, manufacturers, distributors, retailers and customers (Espallado and Lario, 2010). It amounts to managing relationships internally within an organization, with immediate suppliers, with first and second tier suppliers and customers along the supply chain and the entire supply chain. Managing relationships with immediate suppliers in a supply chain is one good example for such interdependency between companies. The buyer-supplier relationship includes the degree to which both parties (buyer and supplier) are engaged in an active long term working behavior which can improve the number of satisfied customers by reducing lead times, improving service levels and decreasing costs (La Londe, 2002), as cited in Thakkar et.al. (2008). The benefits intended by the supplier in a relationship with the buyer include reduced uncertainty, managed dependency, exchange efficiency, social satisfaction from the association and insulation from price competition. The buyer hopes to achieve improved supply continuity, a better match between the supplier s sales specification and reduced long term costs. Such a relationship in a supply chain can be simple if they involve the purchase of commodities or they can be complex if they involve specialty products obtained only from a limited number of suppliers or if they require specialized assets to produce. Electronic copy available at: 2

3 Although the relationship between the buyer and the supplier is supposed to produce positive outcomes to both parties as Kraljic (1983) points out. Supply and demand patterns can be upset virtually overnight and produce negative results. He himself raises the question as to how can a company guard against disastrous supply interruptions. Almost every manufacturer will have to answer this question. In the words of Bitran et.al. (2006) a mini maestro managing a portion of disintegrated supply network needs to operate with a different social contract. Here the portion of disintegrated supply network is the buyer-supplier relationship. The new social contract between the two parties allows and encourages individual players to reach their potential through repeated inter organizational exchanges embedded in social relationships (Espallardo et.al., 2010). Although the mutual and well balanced dependency between these two parties in exchange are expected to help to build enduring relationships, asymmetry in mutual dependency, decreasing the possibility of mistrust and reducing conflict within the network (Bitran et. al., 2006) because mutual dependency and power are closely related concepts. The buyer s dependency on the supplier is a source of power for the supplier and vice versa. A well known definition is that the relative power of an organization over another is the result of the net dependency of one on the other (Pfeffer and Salanick, 1978). Buchanan (1992), as cited in Carey and Lawson (2011) conceptualized power dependence imbalances in buyer-supplier relationships as the difference in value that buyers and sellers attach to the relationship. Buyer-supplier relationships that are characterized by asymmetric interdependency are more dysfunctional because the independent partner experiences high power and will attempt to exploit it (Anderson and Weitz, 1989), as cited in Canie and Gelderman (2005). The separation of ownership and control in the modern corporation also generates the potential for significant free rider problems between managers and shareholders (Thomsen and Nadvi, 2010). This highlights that inter-organizational alliances come with potential hazards (Rowley et. al., 2000). Hill (1999) and Dyer (1997), as cited in Poppo and Zenger (2002) state that in many industries managers engage in complex, collaborative market exchanges that involve rather high levels of asset specificity and that are characterized by other known hazards. According to them the participating firms are susceptible to the threats associated with opportunism. Therefore inter-organisational relationships involve an attempt to control uncertainty in the process of handling resources (Beckman et al., 2004; Burt and Doyle, 1994; Pfeffer and Salanick, 1978), as cited in Carey and Lawson (2011) because such Electronic copy available at: 3

4 relationships may lead to problems of incompatible goals and/or opportunism. Firms adapt to this uncertainty by having deployed particular governance mechanisms that mitigate the potential hazards. Governance structures describe how control and coordination is conducted across entities to embody different mechanisms for information sharing to reduce uncertainty (Grover and Khawaja, 2007). Poppo and Zenger (2002) have identified three broad areas in which governance features of inter-organizational relationships may be required. They are to match known exchange hazards associated with specialized asset investments, difficult performance measurement and uncertainty. Wathne and Heide (2004) argue that in the absence of appropriate governance efforts upstreams management of ongoing supplier relationship and may be associated with substantial renegotiation costs which may actually undermine the manufacturer s ability to respond to uncertainty in the downstream market. The implication is that without mitigating the uncertainty in the relationships with the suppliers, a firm is unable to meet the expectations of their customers. They argue that governance strategies must be adopted to reduce these risks of opportunism. At the same time since governance amounts to coordination with the exchange parties for the execution of the transaction without hazards each governance mechanism is a coordinating tool beyond controlling opportunism. Grover and Khawaja (2007) forward a similar argument saying that among the governance mechanisms there are a variety of coordination mechanisms that offer varying levels of coordination capability. There are explanations in literature emphasizing the use of governance as a mechanism for reducing risk of opportunism as well as a coordinating tool. However much of the prior research has focused on the transaction cost elements of the relationship, viewing governance as a cost minimizing tool which protects against known exchange hazards (Williamson, 1985), as cited in Yu et.al.(2006). Still there are also arguments raised by sociology scholars such as Granovetter (1985), as cited in Yu et. al. (2006) who believes that the role played by socially embedded relationships in economic exchange needs recognition. The above explanation stresses that the importance of managing a manufacturer s relationship with its suppliers to reduce the uncertainties involved in the transactions has been discussed in detail in supply chain management literature. Therefore in studying the buyersupplier relationships in supply chains, it is essential to review the literature related to the mechanisms suggested in literature to govern such relationships. This paper aims to review 4

5 the literature related to supplier governance mechanisms in supply chains published during the last decade. This study has been organized as follows: First it presents a literature review of the governance mechanisms of individual manufacturer organizations. The next step is the presentation of the methodology adopted for the literature review. It is followed by a discussion. Finally, conclusions are outlined. Literature Review Types of Governance Mechanisms The literature review revealed that there are broadly two categories of mechanisms that govern buyer-supplier relationship in supply chains. They are relational mechanisms and contractual mechanisms. Contractual governance relies on the use of formalized, legally binding agreements to govern the buyer-supplier relationship (Zhao et. al., 2008). They include the formal contracts which include the promises or obligations to perform particular actions in the future (Espallardo et.al., 2010). Contractual governance relies on the use of formalized, legally binding agreements to govern the buyer-supplier relationship (Zhao et. al., 2008). They include the formal contracts which include the promises or obligations to perform particular actions in the future (Espallardo et.al., 2010). Formal (Contractual) Governance Here the parties to the exchange and predict the potential hazards and define remedies for foreseeable contingencies (Poppo and Zenger, 2002). Contracts explicitly stipulate courses of action to be taken in the event of unforeseeable situations, and provide safeguards for minimizing losses arising from the inherent hazards of exchange faced by suppliers (Williamson, 1985), as cited in Zhao et.al. (2008). Authors however explain that contractual governance can signal distrust of the exchange partner. But Espallardo et.al (2010) explains that well specified contracts may still promote more cooperative, long term trusting exchange relationships by narrowing the domain and severity of risk by encouraging cooperation and trust as well as by having well crafted contracts that promote longevity in exchanges. According to the literature, Contractual governance enables monitoring of the supplier firm reducing opportunism because it enhances the ability to detect opportunism by reducing information asymmetry (Wathne and Heide, 2004).There are also motivational effects of contractual governance in terms of supervision on the controlled firm s performance. They 5

6 are monitoring, setting up explicit rules that reduce the target s perceived ambiguity, motivating the target to achieve the results (extrinsic motivation) or follow procedures (intrinsic motivation) (Espallado and Lario (2003), as cited in Espallardo et.al.(2010). When levels of uncertainty or asset specificity become too high, suppliers will require manufacturing firms to provide assurance (i.e., in the form of a legal contract), so as to mitigate the hazards related to unforeseeable scenarios (Williamson, 1985), as cited in Zhao et.al.(2008). These explicit set up of rules and commands of legal contracts positively influence performance uncertainty reduction by way of behavior control (Carey and Lawson 2011). However formal contracts are often ineffective in governing devices because they cannot fully cover all contingencies and may even undermine collaborative efforts (Rowley et.al, 2000). Relational Governance In relational governance, relational norms such as trust are viewed in literature as substitutes for complex, explicit contracts. Trust and its underlying normative behaviours are expected to operate as a self enforcing safeguard in relational governance. Trust is frequently considered to be the positive expectations one party has about another party s intentions. That is trust is one party s confidence in another s goodwill (Zaheer & Venkatraman, 1995), as cited in Yu et.al. (2006). There are two ways in which trust can be built up. One is the calculative trust. If one party is successful in meeting the agreed terms as promised, it demonstrates the ability to continue the exchange of relationship, or seems capable of generating some benefit for another partner in the future. Then the other partner may be more willing to continue to make exchanges and to stay in the relationship. Since the trust is calculated on the past performance it is calculative trust. Benevolent trust is where the exchange partners believe that partners will not take unexpected (non-cooperative) actions. Here the relational exchanges are governed by the faith one party has in the other. In the context of buyer-supplier relationships these norms indicate mutuality of interest and essentially prescribes the conduct surrounding the exchange (Heide and John, 1992), as cited in Zhao et.al. (2008). Therefore when compared to contractual governance for relationally governed exchanges the enforcement of obligations, promises and expectations occur through social processes that promote norms of flexibility, solidarity and information exchange (Espallardo et.al, 2010). 6

7 Proponents of relational governance heighten the probability that trust and cooperation will safeguard against hazards poorly protected by the formal contract (Espallardo et.al, 2010).This results from the increased levels of understanding in a relationship facilitating joint planning and problem solving (Claro et al., 2003, Yu et.al., 2006). Joint planning and decision making is enabled by knowledge sharing. Wathne and Heide (2004) explain that in relational governance, investments are made in knowledge sharing. It safeguards the buyer from the supplier s opportunism by means of the economic loss because trust functions as an ongoing social control mechanism and risk reduction device fostering the amount of knowledge exchanged. Unlike in formal contracts strong ties serve as a part of the social control mechanism which governs partnership behaviours in relational governance (Rowley et. al., 2000). Even when codes of conduct are drafted and third party monitoring is exercised, supplier compliance to CSR has proven an incomplete solution while mutual exchange relationships have been successful because in the development of strong ties inter firm partners learn about each other s organization, become more dependent on one another and develop relational trust. Relational governance mechanisms have proven to be beneficial economically as well since the existence of trust may reduce transaction costs and lessen the need to monitor or safeguard exchange hazards (Dyer & Singh, 1998), as cited in Carey and Lawson (2011). Similarly, Dyer and Singh (1998), as cited in Carey and Lawson, 2011) suggested that the marginal costs associated with formal safeguards are typically higher than those associated with informal safeguards, because formal contractual safeguards typically involve capital outlays for equity or other types of collateral (i.e. bonds). In other words, with their low transaction costs, relational governance mechanisms (such as trust) may act as highly effective substitutes for formal governance mechanisms (such as contracts) (Yu et. al., 2006). Governing a relationship in this way is said to encourage both parties to maintain the relationship through fostering mutually beneficial dependencies (Luo et al., 2008; Ryu et al., 2007), as cited in Carey and Lawson (2011). Carson et al. (2006), as cited in Carey and Lawson (2011) state that relational governance helps to prevent opportunism while offering superior flexibility and lower setup costs. However in the absence of a formal contract, when governance is based on relationships it continues for a considerable period of time and there is a risk to either party to the exchange while being ignorant of their responsibility to safeguard the interests. 7

8 Theories Embedded in Governance Mechanisms Literature also suggests that the roots of governance mechanisms can be identified in relation to a few theories. They are the transaction cost economics, social capital theory and resource dependence theory. The Transaction Cost Theory Transaction Cost Economics (TCE) provides a basis for understanding how managers craft governance arrangements ( Poppo and Zenger,2002, Espallado and Lario,2003). The basic assumptions of Transaction Cost Economics are that cooperative partners are having bounded by rationality and may sometimes display opportunistic behavior, and that the principal attributes of transactions are asset specificity, uncertainty, and frequency (Williamson, 1985), as cited in Zhao et. al. (2008). Zhao et. al., (2008) argue that because of the above exchange characteristics, as well as generalizable assumptions about human nature, manufacturing firms need to design particular governance mechanisms to protect suppliers specialized investments. Thus, governance mechanisms may help to achieve a win-win situation for both manufacturing firms and suppliers. TCE suggests that manufacturing firms must draft legal contracts or create formal structures for this purpose allowing suppliers financial recourse by mitigating the risks to suppliers related to manufacturers opportunistic behavior, as well as other unforeseeable eventualities. Their argument is that the exchange partners tend to be more confident about cooperative activities when they feel that they have an adequate level of control over the actions of their partners. Social Capital Theory Social Capital Theory (SCT) is considered useful for theorizing the nature of connection and cooperation between organizations (Adler and Kwon, 2002; Starkey and Tempest, 2004), as cited in Carey and Lawson, (2011). SCT supports the idea that people and relationships between organizations are instrumental to competitive advantage. Social capital refers to the stock of goodwill built up from past experience between the buyer and supplier (Tsai, 2000), as cited in Carey and Lawson (2011). Referring to McGrath and Sparks (2005) Carey and Lawson (2011) summarize the benefits of building social capital in supply chain relationships as: increased ability to create value for both parties; flexibility and speed of joint responses to market or customer, and optimization of costs and resources. The outcomes of the supply 8

9 chain relationships (the social capital) as highlighted by the SCT can be a safeguard against the potential hazards faced by the parties to the contract. For example the flexibility and the joint responses will enable the buyer and supplier to strategically handle an unforeseen hazard. Resource Dependency Theory The Resource Dependence Theory holds that Organizations are not autonomous. But rather are interdependent on other organizations since all the resources that it requires for continued operation are not in its possession (Pfeffer and Salanick,1978). Interdependence leads to a situation which is uncertain (Hillman et.al., 2011). Resource dependence theory (RDT) proposes the selection of governance structure as a strategic response to uncertainty and dependence because the governance structures can mitigate the possible risks of uncertainty. Analyzing from a different perspective it could be argued that according to RDT suppliers make use of governance mechanisms to secure the resources on which they are dependent. The supplier is then more committed to the buyer-supplier relationship so that he can use the resources and he is strong to take advantage of the relationship with the buyer (Carr et. al., 2008) Determinants of Suitability of Governance Mechanisms The network of relationships the organization has formed with its exchange parties can be dense or sparse. The network is said to be dense when there are many members in the network. In a sparse network there are only a few members. At the same time the relationships with members in those networks can be weak or strong. The relationships among members are strong when they have formed very close relationships. When the members of the network are not very closely related they are referred to as weak ties. The ultimate objective of entering into an exchange relationship is for both parties to the exchange and to gain from it. But the governance that is appropriate in each context will not be the same (Carey and Lawson, 2011). Transaction Cost Theory (TCT) argues that exchange conditions have varying levels of costs associated with establishing and maintaining a relationship. Firms that are able to properly match the governance structure with the exchange context perform better. These structures are implemented through coordination mechanisms. Based on TCT, the choice of the appropriate coordination mechanisms when 9

10 adopted and used will result in cost efficiency. Resource dependence theory (RDT) proposes the selection of governance structure as a strategic response to uncertainty and dependence. Therefore, literature on inter-firm governance recognizes that firms should employ coordination mechanisms that can effectively solve governance problems emerging from various contingencies such as the transactional environment and relational orientation between the transacting parties. Proponents of social contracting theory argue that exchange activity is embedded in a social context. Repeated interaction between firms or strong ties, create relational capital that influences exchange design choice. Thus, the nature of the relationship plays an important role in shaping the coordination mechanisms that are deployed in managing the relationship. Referring to Granovetter (1973), Rowley et.al., (2000) explain that if a firm has developed weak ties with the exchange partner the mutual trust cannot be developed. As a result it may be suitable for such partners to enter into a formal contract (Granovetter, 1973), as cited in Rowley et.al. (2000). At the same time strong ties promote trust and are governed by relational trust and norms of mutual gain and reciprocity. Repeated interaction between firms creates relational capital that influences the choice of exchange design. Thus, the nature of the relationship plays an important role in shaping the coordination mechanisms that are deployed in managing the relationship. Literature on inter-firm governance recognizes that firms should employ coordination mechanisms that can effectively solve governance problems emerging from various contingencies such as the transactional environment and relational orientation between the transacting parties. Coleman (1988), as cited in Rowley et. al.(2000) argue that a dense network promotes trust and cooperation among its members. Burt (1992), as cited in Rowley et.al.(2000) suggests that firms embedded in sparsely connected networks will enjoy efficiency and brokerage advantages based on the ability to arbitrage non redundant information exchanges. Information processing theory (IPT) proposes that uncertainty is the main source of coordination needs (Grover and Khawaja, 2007). Therefore uncertainty can be treated as a determining factor of governance that the exchange parties adopt. Since uncertainty poses the greatest risk of opportunism for each party in a buyer-supplier relationship, and they are thus likely to impact on the ability to develop social capital within the relationship, and it determines the type of governance appropriate in each context. Following Granovetter (1985), Rowley et. al., (2000) explain that the relational governance literature holds that the 10

11 development of social factors in the relationship will help to attenuate opportunistic behaviour in times of uncertainty. What is implied from this explanation is that cooperation becomes a self-enforcing outcome in times of uncertainty because, more coordinationintensive configuration is required in conditions of high uncertainty. Bensaou and Venkatraman (1995), as cited in Petersen et.al (2005) suggest that standard operating procedures suffice when uncertainty is low. A similar view is put forward by the Transaction Cost Theory (TCT). It proposes that hierarchical governance is appropriate under conditions of high levels of asset specificity, uncertainty, and transaction frequency. Cary and Lawson (2011) identify the different types of uncertainty that affect the relationship between governance structures and the development of social capital between buyers and suppliers. They propose that relational governance is robust in creating social capital under conditions of supply uncertainty, but subject to opportunism when customer product demand is uncertain. In conditions of high demand uncertainty, formal contractual mechanisms will be more effective. The effect of uncertainty on determining the nature of the governance mechanism is also dependent on the nature of the uncertainty. The types of uncertainty that can prevail in relation to buyer supplier relationships are demand uncertainty, supply uncertainty and technological uncertainty. When the level of uncertainty is high contractual governance can be hazardous, as it can discourage exchange in the absence of safeguards. Existing contracts may also suffer from higher governance costs due to incompleteness or the difficulties attached to conflict resolution (Hart, 1988; Srinivasan and Brush, 2006), as cited in Carey and Lawson (2011). High uncertainty may, for instance, also discourage a supplier from making specialized asset investments. Williamson (1985), as cited in Espallardo et. al. (2010) suggests that uncertainty will lead to an increase in the complexity of contracts, adding to the costs of exchange and monitoring of related investments. Building on this perspective, Luo (2002),as cited in Aitken and Harrison (2013) suggested that in periods of uncertainty, contracts will be made more specific in relation to the terminologies used and detail included. Relational governance mechanisms will motivate the self interest of both parties to adjust to and accommodate each other s priorities and behave reasonably in uncertain times. Whereas contract re-negotiations and re-specifications may be required in a period of uncertainty adaptations to the relational approach of governance are not as costly, or time consuming. 11

12 Methodology Proceedings of 12 th International Conference on Business Management This paper is based on a literature review. Therefore the methodology specifies how the literature review was conducted based on the five step classification process presented by Soni and Kodali (2011) for carrying out a literature review. They are to: i) Decide on a time horizon for the selection of papers ii) Select a journal iii) Select articles iv) Classify articles and v) Analyze classified articles. Decide on a Time Horizon for the Selection of Papers The first step was to decide on a time horizon for the selection of papers. During the period from 2001 onwards researchers have shown a growing interest in the field of supply chain management (Ashby, 2012). Therefore the assessment period for the study is year 2001onwards. The research papers published after year 2001 were subject to the review. Selection of a Database It was decided to use a number of databases in order to identify relevant articles across a selected set of journals. The databases selected were Jestor, Emerald, Taylor and Francis, Wiley Online, Sage and Science Direct since they are relatively more accessible at academic institutions and majority of journals publishing supply chain management (SCM) research are available in those databases. In each database the phrase supply chain management was searched in article title. The list of journals that contained supply chain management related articles were screened on their citation index. The Web of Sciences, ABDC journal list or the journal list of Scopus were used to screen the articles. Article Selection The articles to be included in the analysis were selected on the ability of the article content to establish a connection to the characteristics of governance mechanisms. Key terms used in the article selection were governance, relational governance in supply chains, formal governance in supply chains and governance of buyer- supplier relationships and supplier 12

13 management. The list of articles that were selected after this exercise are presented in Exhibit 1. Article Classification In this exercise the articles were broadly classified as those that discussed formal governance mechanisms, relational governance mechanisms and those that discussed governance of supply chains as a whole. Analysis of Classified Articles The final step in the literature review is the analysis of classified articles. When the direction of the articles was examined over time, both relational and formal governance mechanisms were given similar importance. The theories that explain justification for the implementation of governance mechanisms were also discussed in the literature reviewed. Exhibit 1: List of Selected Journals for the Literature Review Journal Title Number Journal of Manufacturing Technology Management 2 Journal of Management Information Systems 1 Harvard Business Review 1 Journal of MIT Sloan School of Management 1 Supply Chain Management: An International Journal 1 Strategic Management Journal 2 Industrial Marketing Management 1 Journal of Operations Management 2 International Journal of Operations & Production Management 2 The Journal of Marketing 1 Journal of Purchasing & Supply Management 1 Journal of Management 1 Journal of Business Ethics 1 Total 17 13

14 Discussion Proceedings of 12 th International Conference on Business Management When the literature related to governance mechanisms adopted in buyer-supplier relationships in supply chains was reviewed, it could be observed that human factors (i.e. bounded rationality and opportunism), environmental factors, and information asymmetry leads to uncertainty in the relationships. This creates a need for governance to safeguard against any potential hazards associated with uncertainty in the relationships between the two parties. Each exchange relationship includes the transaction cost of timing, money, human resource, risk needed when gathering information, negotiation and contract adapting. Since the suppliers and buyers attempt to sustain their relationship in order to enhance competitiveness and increase market shares the governance mechanisms are aimed at balancing the above costs by mitigating the risks of uncertainty. Parties in an exchange may sometimes described in advance the conditions of the exchange and establish a formal contract to safeguard against exchange hazards. There are other exchanges where the parties to the relationship operate on mutual trust. In the literature, Chuah et.al.(2010) have explained that buyer-supplier relationships have evolved from transaction processes based on arms-length agreements to collaborative processes based on trust and information sharing. Researchers argue that it is beneficial to have a formal contract as a safeguard against potential hazards when the exchange takes place under uncertainty. This is true. When the buyer and the seller jointly decide on the terms and conditions relating to their relationship, the buyer is in a position to monitor the seller s behavior. Seller also can have a clear understanding of how the contract is operated according to the terms and conditions. Then both parties can assure that they act as planned. However if uncertainty in the environment in which it the contract is operated necessitates a change in the manner in which the exchange takes place, then it is costly to redefine the terms and conditions of the contract. In such a context a relationship governed by mutual trust may be beneficial because the two parties can discuss with each other and adapt to the changed condition. That is the social capital created by mutual relationships. In the words of Carey and Lawson (2011) the benefits of building social capital in supply chain relationships are increased ability to create value for both parties; flexibility and speed of joint responses to market or customer, and optimization of costs and resources. The buyer-supplier relationships formed according to a formal contract enables to minimize any ambiguities created within a relationship. In a formal contract every detail is clearly laid down providing a motivation for the two parties to 14

15 somehow abide by the conditions to reach the outcomes of the contract. It is a mechanism well suited for a relationship that takes place in relation to a transaction which may create ambiguity. On the other hand in a buyer-supplier relationship governed by trust although the parties are well aware of the operation of the relationship, they may not be specific. This may create ambiguities. As a result the final purpose of the relationship may not be served. This can be an indirect cost. This justifies the arguments of the Transaction Cost Theory. Transaction Cost Theory suggests that manufacturing firms must draft legal contracts or create formal structures for allowing suppliers financial recourse by mitigating the risks to suppliers related to manufacturers opportunistic behavior, as well as other unforeseeable eventualities. Benefits of governance structures also change with the density of the relationship networks and the strength of the ties the parties to the contract are maintaining. Literature suggests that the dense networks provide opportunities for trust and cooperation. But in dense networks a firm is linked to many members. It creates doubts as to how an organization can develop a close relationship with many members when compared to a few members. Sometimes having relationships with many members can lead to redundant information and badly affect the trust between parties. But when the relationships are formed only with a few members it provides an opportunity for the firm to share information more carefully and enhance relationships. The governance mechanisms and the contexts in which they are appropriate in exchange relationships can be summarized in matrix form as shown in Exhibit 2. This can be used by firms to better leverage organizational context by using relationships with suppliers. Formal Governance Mutual Strength of ties Weak Strong High Low Uncertainty Dense Sparse Exhibit 2: Governance Mechanisms for buyer supplier relationships Density of relationships 15

16 This diagram highlights that formal contracts are suitable for governing buyer-supplier relationships when the uncertainty in the environment is high, strength of ties in the network is weak and density of relationships is dense. At the same time it explains that mutual trust based relationships are suitable in situations where the uncertainty is low, strength of the ties in the network is strong and the relationships are sparse. When the facts presented in literature are carefully looked at it seems that the researchers have discussed the governance mechanisms considering individual transactions. However the relationships between buyers and sellers will not limit to a single transaction. Rather the relationships with the same buyer and seller can extend to more transactions over a period of time. In such instances it is hard to believe that the formal contract will bring more benefits than the relational contract. Some authors argue that there is a risk that the importance assigned to the relationship be overlooked by the parties as a relational contract moves on. It is the opposite result that can be expected. That is, as a relationship between two parties develop they become more responsible to each other. Then the parties can be expected to guard against every possible risk. Therefore the literature may need to be questioned tested further in that respect. Conclusion This study was conducted with the aim of identifying how the governance mechanisms of buyer-supplier relationships have been discussed in literature during the last decade. The need for a detailed review of governance mechanisms arose as a result of the discussions developed in supply chain management literature regarding the importance of managing a manufacturer s relationship with its suppliers to reduce the uncertainties involved in the transactions. The literature review revealed that the parties to a contract can draft legal contracts or create formal structures allowing (formal governance) or establish strong ties that serve as part of the social control mechanism (relational governance) which governs partnership behaviours. Both the mechanisms of governing relationships have their advantages and disadvantages. Formal contracts are specific and clear cut. As a result they are suitable in conditions of high uncertainty as well as for transactions which may involve ambiguity. Relational governance is suitable when the transactions require changes in the process of execution and the understanding between the parties is needed for such changes to take place. There are also reasons to conclude that even a combination of both can be 16

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