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English: Outsourcing

While global statistics are difficult to come by on the scale of outsourcing, a Frost & Sullivan 2005 consulting report stated that the global market for outsourcing by Global Fortune 500 companies was valued at US $648 billion in 2004, a figure expected to increase to US $920 billion by 2007.[1] The “true” global market for all outsourcing at the current point in time is very likely to be much higher owing to growth, to definitional issues that would seem to omit much of what passes for outsourcing, and to the omission of firms lesser in scale. No review of outsourcing could ignore the definitional problem. A commonly held definition states that outsourcing is concerned with performing activities outside the firm that were previously and normally conducted within the firm.[2] The problem with this definition is that no clear distinction exists with the make-versus-buy decision. The make-versus-buy decision is very similar to functional spin-off and vertical integration. The make-versus-buy decision examines the choice of governance with market transactions at one end of the spectrum, hierarchies (or vertical integration) at the other end,[3] and with hybrid, alliance-type exchange as an intermediate form. Functional spin-off is a marketing term that may be defined as the subcontracting of a marketing function by a channel intermediary to another intermediary.[4] Spinning-off a function and shifting it a third party is essentially equivalent to the “buy” option of the make-versus-buy decision. One further problem with the common definition of outsourcing concerns the notion that innovations in communications, information and production technologies, products and component parts, transportation systems, and material handling equipment shift underlying cost structures, thereby increasing (or decreasing) the appeal of various make-versus-buy alternatives. Furthermore, these innovations foster new behaviors, practices, and, more important, new functions and processes that the firm must assess and decide whether to perform in-house (i.e., to integrate vertically) or to outsource (either to a market or through a hybrid form of exchange). A clear example is the infusion of electronics into automobliles -- at some point in time, manufacturers had to decide who would design, manufacture, integrate, and distribute the new and previously undreampt of innovation. In the search for efficiency and effectiveness, firms are in a constant state of flux as they experiment with alternatives that selectively increase or decrease the boundaries of the firm. Research on outsourcing, vertical integration, and the boundaries of the firm:

  • Has been conducted in a variety of settings including manufacturing,[5] healthcare,[6] agriculture,[7] transportation carriers,[8] and chain restaurants;[9]
  • Has been applied to various functions including accounting,[10] information technology,[11] supply chain management,[12][13] product assembly,[14] sourcing versus production of component parts,[15] and marketing;[16]
  • Is dependent on a variety of approaches including game theory,[17] statistical analysis of primary and secondary data,[18] experimental design,[19] case analysis,[20] and economic modeling;[21] and
  • Has largely adopted one of two theoretical perspectives: Transaction costs economics (TCE);[22][3] and, more recently, the resource-based view (RBV) of the firm.[23][24]


Transaction Cost Economics (TCE)

TCE is primarily concerned with explaining and predicting where various functions (e.g., product design, warehousing) will be conducted on the market (buy) – hierarchy (make) continuum.[3] The theory is reliant on two behavioral assumptions and three transaction traits.

  • Behavioral assumptions:
    • Bounded rationality refers of the inability of decision makers to fashion fully reasoned decisions due to limited information processing capability. Information asymmetry between a buyer and seller may create additional rationality problems.
    • Opportunism refers to adapting one’s behavior to take advantage of a specific set of circumstances. The term “guile” is often used in relation to opportunism. This refers to crafty or artful deception. For instance, an incomplete contract between a buyer and a seller may lead the seller to behave in a fashion that leads to a goal (e.g., higher profit), but is detrimental to the spirit of the exchange relationship.
  • Transaction trait variables:
    • Uncertainty refers to an inability to anticipate future states of the world. In general, uncertainty exists in the level of demand, in various processes related to production, supply chain management, and marketing, and in products themselves due to both changing consumer preferences and to innovations resulting from new product development.
    • Frequency is straightforward and refers to repetitive volume.
    • Asset specificity refers to the extent to which items used in a transaction are dedicated solely to that transaction (or repetitive transactions with the same customer or supplier). For example, a manufacturer of cheese will require refrigerated containers for shipping purposes. These containers, however, may be used to ship other dairy products as well as fresh produce and packaged meat. Specificity of the “refrigerated container” asset would thus be low as the assets may be applied to different products and buyer-seller pairs. In contrast, the assets used to unload coal at an electric utility may be dedicated to the repeated transactions between the utility and a specific vendor. In this case, the assets have little value outside of the transaction and asset specificity is therefore high. Asset specificity comes in three forms: (1) physical (as in machinery); (2) human (as in a specialized selling knowledge that cannot be applied to other products and hence customers); and (3) site specificity (related to a geographical advantage).

The variables and assumptions about behavior form a complex web of concepts that explain and predict the make-versus-buy decision and relations between companies. For example, when product uncertainty is high (i.e., product churning), supplier contracts quickly lose validity due to changing component part specifications. The cost of rewriting contracts to reflect changing requirements may be excessive and detrimental to the “buy” option.[2] Outsourcing the production of component parts may lead to opportunism and the “hold-up” problem if production machinery asset specificity is high. The general tenet of TCE is that low asset specificity, uncertainty, and frequency associate with a greater likelihood of the transaction being governed by market exchange (the “buy” option) as opposed to hierarchical exchange (the “make” option, or vertical integration). Williamson[3] indicated that asset specificity should dominate uncertainty and frequency as the primary factor predicting vertical integration. Research has borne this sentiment out. Asset specificity associates with:

  • Internal product production;[25][26][27][28]
  • A vertically integrated export channel;[29][30]
  • Integration into private trucking and private warehousing;[31][32]
  • Internal integration of computer services;[33]
  • Vertical integration through the use of an in-house sales force;[16][34]
  • And a vertically integrated channel of distribution.[35]
  • Asset specificity has been found to interact with environmental uncertainty in predicting vertical integration[29]

A number of other research studies have been undertaken that examine other elements of the TCE framework. Asset specificity is correlated positively with sales force opportunism,[18] contract complexity[36] and length,[37] time horizon alliance length,[38] and supplier continuity expectation.[39] Vertical integration is more likely when the fraction of total cost represented by a specific input[40] and product complexity[6] are high.

Resource-based View (RBV)

The RBV aspires to explain and competitive advantage through analysis firm resources. Wernerfelt defined a resource as “anything which could be thought of a strength or weakness of a given firm.”[23] Barney built upon this, stating that a resource “includes all assets, capabilities, organizational processes, firm attributes, information knowledge, etc., controlled by a firm that enable the firm to conceive of and implement strategies that improve its efficiency and effectiveness.”[24] Specifically:

  • A competitive advantage is derived when a firm implements a value enhancing strategy not implemented by competitors;
  • A sustained competitive advantage is derived when a value enhancing strategy is not implemented by competitors and when competitors are unable to copy the strategy’s benefits;
  • A major assumption is that firm resources within an industry may be heterogeneous and immobile;
  • Four resource traits drive the ability to generate a sustained competitive advantage:
    • Valuable: A resource may lead to a competitive advantage if it is valuable. The firm must be able to apply the resource to take advantage of an opportunity or to thwart a threat;
    • Rarity: A resource should be rare in that if all firms in an industry possess a valuable resource, then the ability to create a sustained advantage is limited;
    • Imperfectly imitable: A resource should be difficult to copy. Three forces drive this imperfection: (1) long term historical conditions specific to the firm (2) the connection between the competitive advantage and the resource is fuzzy and not well understood (causal ambiguity); and (3) the resource is highly complex from a social perspective;
    • Substitutability: there exist no substitute resources that act as proxies for the original resource.[24]

The application of the RBV to the make-versus-buy decision is more recent and limited relative to the application of TCE. Idiosyncratic investments by the firm in the form of shared knowledge routines with suppliers and customers[41] and relationship building,[42] both of which are treated as resources, may positively affect the performance of outsourcing efforts. Performance, in terms of product quality, improved continually when component design and production was retained in-house. Firms that outsourced the same process immediately reaped the rewards of partnering with leading outsourcers, however quality performance remained flat across time. The explanation is in-house work allowed adaptive, feedback behaviors and knowledge acquisition (resource), while outsourced work tapped the extant knowledge of the partner, but never allowed the client firm to acquire knowledge itself.[43] Pharmaceutical businesses are more likely to outsource clinical trials when the purpose is the production data from and they are less likely to outsource clinical trials when the purpose is the production of knowledge (a resource).[44] The effective adoption of fleet monitoring technology (a resource) associates with shippers integrating into private carriage[8]

Practical Implications

According to Chopra and Mendl,[45] outsourcing is feasible if the supply chain surplus can be increased without affecting risk for the client company. The supply chain surplus equals the difference between the value of the product to the end-user and all supply chain costs. The supply chain surplus thus equals the supply chain profit. In general, a third party (or contractor) can increase the supply chain surplus if they can combine activities or processes across customers (or clients) such that the scale of the contractor efforts and their size provide benefits that exceed what the client firm is capable of by itself. Combining activities and processes across potential clients may be accomplished through a combination one or more of the following functions:

  • Combining Production Capacity: A contractor can generate economies of scale in production by combining small scale requirements of indvividual clients into significantly larger facilities.
  • Combining Transportation Assets: A contractor may combine the transportation asset and management requirements of a large number of clients, thereby creating sigificant scale and learning effects. Examples include DHL, UPS, and Deutsche Bahn Mobility Logistics.
  • Combining Warehouse Assets: Again, the assets needs of clients may be aggregated by a contractor to a higher level thereby creating scale effects.
  • Combining Knowledge and Learning: A contractor may offer specialized services and combine the service requirements across clients. Potential clients lack the scale required to invest and generate a return on these specialized services. Examples include customs brokerage, inventory management services, and network design services.

The largest outsourcing contractors offer a wide variety of services to potential clients and create customized packages. The ability of a contractor to take advantage of the supply chain surplus and the reduction of risk by the client follow from the three critical transaction variables identified by TCE and from RBV insights:

  • Asset Specificity: A high level of asset specificty on the part of a specific client reduces the ability of the outsourcing contractor to combine the functions, activities, and processes with other clients. This reduces the ability of the contractor to create scale effects. Furthermore, client risk may increase due to the potential for opportunistic behavior by the contractor. The large body of research supporting the connection between asset specifcity and the lack of vertical integration and/or outsourcing empirically supports the difficultes in outsourcing when asset specifcity is high.
  • Frequency and Scale: Although higher transaction frequency and certainty on the part of the client would seem to reduce the ability of a contractor to create supply chain surplus and thus favor vertical integration, TCE research does not provide consistent support. In practice, we can identify large clients that outsource a signifcant part of their supply chain operations: e.g., HP with UPS Supply Chain Solutions. The supply chain asset specificity of these large clients is typically low.
  • The decision to outsource is frequently couched in terms of whether a process or function represents a core capability. The RBV would advocate that the critical factor is whether the resources behind a function or process lead to a long term sustained competitive advantage. If so, then the firm should put let of an emphsasis on outsourcing.

While a nubmber of benefits are assicated with outsourcing, risks and problems may be present.

  • Several industry experts have advocated that outsourcing a broken or ill-conceived process does not solve the problem. Rather, the broken process is simply outsourced and may be more difficult to manage from a remote distance.
  • Contracting is critical to the succes of an outsourcing arrangement. As mentioned before, contracts seem to behave as respoitories of knowledge, however, they are much more in terms of setting expectations, controlling opportunistic behavior, and regulating price and volume. A senior manager at UPS Supply Chain Solutions has said that "the most important elements of a contract are the performance measures."[46] Shared and detailed performance metrics allow the parties to create a common knowledge base and shared expectations (thereby building trust) while simultanesouly reducing opportunism.
  • Outsourcing may result in the contractor increasing and improving their knowledge base relative to that of the client, whose knowledge base may remain static. There are several fashions in which knowledge (a resource) may be impacted by outsourcing. A contractor may take over specific marketing functions and thus the client's knowledge about certain aspects of the market is not direct, but filtered through the contractor. A contractor may provide immediate access to frontier knowledge in product design, however, across time the client fails to build additional product resources that might lead to a long term sustained competitive advantage.
  • Despite effective contracts, outsourcing may associate with higher than expected coordination costs. This is a fundamental TCE concept. Market, hybrid, and vertcial integation modes all consume coordination costs. The issue is how these costs for each of the contractor and client are balanced against the risks and the increase in the supply chain surplus.
  • A 2008 Deloitte Consulting report[47] on the results of a survey of 300 businesses found that:
    • 39% of respondents had, at some during their career, cancelled an outsourcing contract and shifted to another vendor.
    • Functions had been in-sourced 50% of the time when managers were disatisfied with an outsourcing arrangement. These same dissatified managers realized that more time should have been spent on vendor evaluation (55%) and that more time should have been spend on defining key performance measures (49%).
    • Outsouring problem resolution had been pushed up to senior management 61% of the time during the first year of an outsourcing contract, although this percentage diminished across time.
    • Despite these problems, the majority stated that ROI goals had been met.


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