| Abstract |
Outsourcing grew rapidly during the 1990s and has now become an accepted dimension of corporate strategy. While outsourcing continues to grow in importance, the nature and focus of outsourcing is evolving. Historically, most outsourcing took place in manufacturing industries, but it is now spreading rapidly within service industries. Whether in manufacturing or services, outsourcing is becoming increasingly cross- national and global. The growth of international outsourcing has accentuated controversy surrounding trade liberalization efforts in developed economies, especially in the United States.
THE BENEFITS FROM OUTSOURCING
There is emerging evidence that investors usually expect outsourcing to create value for shareholders (Hayes et al., 2000). The broad purpose of outsourcing is to: (1) lower the purchase price of some input by taking advantage of external suppliers’ lower costs, or (2) improve the quality of one or more inputs by purchasing some superior resource or capability from an external supplier. In either case, the supplier’s advantage will be one that is not easily imitable. If the firm could easily imitate the cost or capability advantage of potential outside suppliers, it could easily bring the production of the activity “in-house”. Both direct cost savings and the acquisition of superior capabilities can be thought of, and described, in cost-saving terms – superior capabilities could only be produced at the same quality within the firm at a higher unit cost. However, it is usual in the business strategy literature to analyze each specific activity on the value chain in terms of the firm’s ability to lower cost or to improve quality (or, more broadly, to in some way to differentiate their production process). We follow that distinction in the following discussion of the potential benefits of outsourcing.
Cost-Reducing Rationales for Outsourcing
The costs that must be compared are the costs of internal production of the activity to the cost if the activity is outsourced. Production costs are directly generated by the opportunity costs of the resources—land, labor and capital—actually used to produce the good. Of course, it is impossible to design firms to take advantage of economies of scale for all inputs – even the largest global pharmaceutical firms do not manufacture their own computers. Many inputs are inevitably outsourced. In practice, inputs that can be bought in highly competitive “spot” markets – “off-the-shelf” purchases -- raise few outsourcing issues. Therefore, outsourcing is really only a further step on the continuum from purchasing and procurement.
There are a number of cost-related reasons for considering outsourcing. The most basic reason for outsourcing is that in-house production of the activity entails production at too low levels to be efficient; that is, to achieve minimum efficient scale (McFetridge and Smith, 1988; Lyons, 1995). Many goods and services for which the organization has low unit demand exhibit significant cost “lumpiness”,
holding quality constant (Loh and Venkatraman, 1992; McFarlan and Nolan, 1995). An independent specialized producer selling to multiple (outsourcing) buyers can achieve minimum efficient scale. Economies of scale do not apply only to the core operations (production) of a firm: the most significant economies of scale may relate to secondary value chain activities such as administrative and information systems, knowledge and learning, access to capital markets and marketing (Muris et al., 1992; Veugelers and Cassiman, 1999). For example, a major rationale for the significant degree of outsourcing of information systems is the inability of firms to achieve minimum efficient scale in either installing, updating or managing these systems (McLellan, 1993).
Similarly, and closely related to economies of scale, economies of scope are becoming a rationale for outsourcing. With the advent of flexible manufacturing (Greenwood, 1988), the potential to achieve economies of scope has increased dramatically (Pine, 1993). Firms that produce a range of products that can utilize the same production equipment have a significant cost advantage that they can pass on to customers (Besanko et al., 2001; Morrison, 2003). Smaller firms, therefore, in a single line of business will often not be able to achieve the same marginal production costs. Also closely related to an economy of scale rationale is the potential to change large fixed capital costs into variable costs (Quelin and Duhamel, 2003). For example, semiconductor plants (“foundries”) that approach minimum efficient scale cost approximately a billion dollars. Capital-constrained smaller firms cannot access such capital. Even when they can, committing those funds might crowd out more critical investments.
Recent theories of the “boundary choices” of firms emphasize that the optimal scale and scope of a firm depend on the degree to which new undertakings are specific to the firm’s existing asset base (Poppo and Zenger, 1998). That is, the relatedness of the undertakings ultimately conditions the net benefits of locating the relevant undertakings within or outside the firm. Relatedness can extend beyond technological similarities to include shared management knowledge and even a common language. Nevertheless, a relatively large and indivisible scale of required investment combined with rationing of financial capital may limit the ability of firms to exploit relatedness across activities.
Other economic cost-based rationales for outsourcing include superior external supplier economies of learning or experience (Hayes and Wheelwright, 1984), superior ability to introduce new technologically superior product generations quickly, and at low cost, and superior capacity utilization (Morrison, 2003). When work force demands are unevenly distributed over time, it may be cheaper for firms to outsource the work involved rather than lay-off and rehire workers (Abraham and Taylor, 1996).
There are also organizational factors relating to cost that suggest a rationale for considering outsourcing. Most importantly, in many organizations, especially large multi-unit organizations, there is a tendency for internal production units to act as if they are monopolists (Alles et al., 1998). Monopoly-like behaviour blunts efficiency incentives by reducing comparative performance benchmarks for internal customers and by making it less likely that a good is efficiently priced in the internal firm market, thereby obscuring the efficiency of the internal supply unit. Inefficient internal prices can arise for two reasons. First, the internal production unit may be an efficient low-cost producer, but prices internally as a monopolist – production unit managers are usually responsible for this problem (Reichelstein, 1995; Vining, 2003). Second, the production unit may not have sufficient incentives to achieve the minimum production costs that are technically feasible. As a result, they allow production costs to “drift” upwards – either managers or employees or both may be responsible for this syndrome (Leibenstein, 1976; Button and Weyman-Jones, 1994). Competition, that is the absence of monopoly, is normally the crucial driver in forcing down production costs to their lowest level. Profit-maximizing firms in a competitive market will be forced to price at the lowest possible marginal cost, thus eliminating inefficient practices. Monopolistic internal production units may not be subject to this same level of competition. (Although firms can simulate such competition by forcing different internal units to bid against each other for production rights.) This rationale for outsourcing might be a more important reason for outsourcing than minimum efficient scale issues, especially for larger, bureaucratized firms.
An additional organizational-cost reason for outsourcing is that internal production of an input may generate significant organizational negative externalities (or more accurately “internalities”, as they are internal to the organization) that can be reduced or eliminated by outsourcing. (Conversely, as discussed below, outsourcing can also generate negative externalities for the outsourcing firm.) Internal production of an input, for example, may require a distinct corporate culture that is dysfunctional for the rest of the organization (Camerer and Vepsalainen, 1988). Similarly, firms can experience diseconomies of scope in management of multiple firm activities or diseconomies of scale in producing a single activity (Graves and Langowitz, 1993; Zenger, 1994).
Finally, cost savings can result from altering obligations that a firm faces under government laws and regulations or under agreements with labour unions. As an example, firms may be obliged to pay health care benefits to workers classified as “full-time”, whereas part-time workers are not entitled to the same level of benefits. Outsourcing specific activities may enable firms to “re-hire” the same or similar workers from external suppliers as part-time or temporary employees. To be sure, if labour markets are reasonably competitive and not segmented, such cost savings may prove to be only temporary. Market forces will force supplying contractors to pay higher wages to their employees to compensate them for the absence of health care benefits. These suppliers, in turn, will pass the higher wage costs on to those firms hiring the workers on a temporary basis.3
There is evidence from a variety of sources that outsourcing can lower production costs. Clearly, the anticipation of various kinds of cost saving is a major driver of outsourcing (Lacity and Hirshheim, 1993; McFarlan and Nolan, 1995; Kakabadse and Kakabadsee, 2002; Quelin and Duhamel, 2003) however, as noted by Leiblin et al., (2002) and other commentators, there is relatively little hard empirical evidence that comes from contexts where firms outsource to other firms. The limited evidence in part reflects the difficulty in measuring production and other cost savings (Bryce and Useem, 1998). Nevertheless, Ang (1998) found that a large sample of banks that outsource primarily considered production cost savings in their decisions, and there is some evidence to suggest that this finding is generalizable (Walker and Weber, 1987; Lyons, 1995; Benson and Ieronimo, 1996; Saunders et al., 1997). Much of the best empirical evidence comes from outsourcing by government to private suppliers.
Empirical studies tend to find in this outsourcing context that production cost savings are approximately in the 20% range, especially if competitive bidding is used (Vining and Globerman, 1999; Hodge, 2000).
As we discuss below, a crucial point is that even those empirical studies that have examined the relative production costs of internal provision versus outsourcing have not included the costs of governing the outsourcing relationship, specifically, bargaining and opportunism costs, which a priori might be expected to be higher with outsourcing. Indeed, some governance mechanisms for outsourcing can be expected to raise production costs -- for example if cost-plus contracts are used (McAfee and McMillan, 1988; Ulset, 1996).
Differentiation (Quality) Rationales for Outsourcing
Firm-specific resources and capabilities are becoming increasingly recognized as the drivers of competitive success (Wernerfelt, 1984; Barney, 1986). Capabilities that are difficult to imitate, or, at the extreme, cannot be imitated, are therefore the key to sustainable competitive advantage (Barney, 1991). The capability may be inimitable for a wide range of reasons. Barney (1999) points out that the firm could attempt to acquire the capabilities through internal development or by acquiring a firm that already has the capability; however, it may be very costly or impossible to do either. Four reasons why it may be costly to develop a capability internally are: (1) unique historical conditions that no longer exist; (2) path dependency; (3) social complexity, and (4) “causal ambiguity” resulting from the difficulty of knowing what is the source of the capability (Barney, 1999: 140-1). Five reasons why it may be costly to acquire a firm that has the capability are: (1) legal constraints; (2) acquisition itself might negate the capability; (3) acquisition may be costly to reverse if the capability turns out not to be valuable; (4) there may be undesirable characteristics that offset the valuable capability, and (5) integrating the capability into the acquiring firm may be difficult both because of causal ambiguity and implementation problems (Barney, 1999: 142-3).
Whatever the reasons for inimitability, a firm producing a given product or service that requires a capability has to decide whether to compete with a firm that has a given capability or to attempt to purchase the higher quality input from them. If the capability is critical to the success of their product (that is, a “core competency”) the firm may have no choice but to attempt to acquire the capability internally, although some commentators disagree even with this assessment (Baden-Fuller et al., 2000) But, if it is not developed internally, the firm may be able to acquire the capability through outsourcing. Historically, for example, many firms have outsourced specialized legal services and advertising. The evidence suggests that this rationale for outsourcing is increasing (Quinn and Hilmer, 1994; Farrell et al., 1998; Kakabadse and Kakabadse, 2003). Specifically, Quelin and Duhamel (2003: 649) argue that “cost reductions, while important, are but one objective expected from outsourcing. Other objectives include improved flexibility, quality and control”.
Again, as with cost-reducing rationales for outsourcing, the systematic empirical evidence of the value of outsourcing for improving quality is still quite limited. Gilley and Rasheed (2000) and Gilley et al. (2004) have recently found evidence that outsourcing various aspects of human resources management can innovation although they did not find direct evidence of financial performance improvements. Leiblein et al., (2002) present evidence that there are benefits from outsourcing, but they are contingent on the specific attributes of the contractual relationship, both in terms of the nature of the activity to be outsourced and the governance response by the firm.
We turn to a consideration of governance costs that may potentially offset the cost-lowering or differentiating-enhancing benefits of outsourcing.
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CONCLUSIONS
There is increasing interest in outsourcing among firms in a wide range of industries. Moreover, there is evidence that outsourcing is becoming increasingly more international, so that the benefits and costs of outsourcing are becoming an increasingly important social issue, especially in the United States and Western European countries when it involves outsourcing activities to less developed countries. Although not dealt with here, as a result outsourcing governance is increasingly likely to include managing the political and stakeholder environment. In this paper, we suggest that many of the potential costs associated with outsourcing can be mitigated by contracting and related strategies on the part of the outsourcing firm. We propose a simple framework that relates some alternative strategies for standard problem situations surrounding outsourcing. This framework does not deal with all strategic outsourcing issues. The outsourcing firm also has to develop information strategies so that it can continue to learn – about changing costs and other relevant factors (Cross, 1995).
A strategic approach towards outsourcing must explicitly acknowledge the game-theoretic context in which the activity takes place and attempt to condition the environment in order to minimize the governance costs associated with outsourcing. It also must recognize that in specific circumstances the governance costs will be so high that a firm should not outsource. This approach is distinct from a strategy that emphasizes adaptation or renegotiation in response to conflict with an outsourcing partner (Melese, 2000). In this regard, management experts have argued that managers seriously underestimate the costs associated with transitioning to a new vendor (Barthelemy, 2001).
The difficulties and costs associated with implementing a comprehensive strategic approach to outsourcing should not be underestimated. However, it is important to emphasize that there are likely to be economies of scale and scope in the outsourcing activity itself. Hence, substantial efficiencies may be realized by establishing a group or department specifically devoted to integrating company-wide experiences with outsourcing and using the resources in that unit to establish project teams with expertise in specific outsourcing activities (Barthelmy, 2001).
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