The kinds of interactions and transactions that a firm conducts with its customers, suppliers, employees, etc. is a key factor to consider for organizational design.
Transaction costs are the costs associated with making the economic transactions needed to participate in a market. Every interaction in a firm is an economic interaction between processes (groups of activities), and these activities consume resources and incur costs. Where the interactions work well, transaction costs will be lower; where they do not work well, transaction costs will be higher.
For process interactions to work well, the output of an upstream process must be fit for purpose of the downstream process – i.e., usable first time, every time. This means that upstream processes, as suppliers, must know they needs of their downstream customers intimately and design their process to supply against them so that all requirements are met.
The design of an organization and its processes can help firms to reduce transaction costs. Where internal process connections are unstable and the outputs from an upstream process not usable first time by downstream processes, transaction costs will be high due to the failures. Improving, or redesigning, the upstream process and its connection to the downstream process can reduce these costs.
Even where process failures are low, transaction costs can still be driven by poor coordination between processes. Processes need to work together – it is not just enough to supply high quality output, the output must be available when it is needed, in the quantity needed. Addressing coordination issues between processes is a key aspect of reducing transaction costs.