Why Outsource? - A Comparative Test of the Efficiency, Focus and Learning Perspectives of Outsourcing

Over the half-century that vertical integration has come under the spotlight of management studies, a number of possible explanations for the outsourcing decision have been posited. The issue has been examined in the frameworks of transaction cost economics, industrial organization and strategy. Each of these has come up with reasons to support or explain the decision to outsource. In an attempt to unify and test the veracity of these theories Professors Frédéric Dalsace of HEC and Karel Cool at INSEAD join with INSEAD Ph.D. candidate Nicola Dragonetti to formulate eight hypotheses. Measured against a broad dataset, their results imply that the learning rationale turns out to be the most important predictor of the decision to outsource.

by Karel Cool, Nicola Dragonetti
Last Updated: 23 Jul 2013

The enthusiasm among firms to outsource activities has been booming in recent years. Between 1992 and 1997, the number of major US firms involved in outsourcing increased from 52% to 86%. While this affects mostly back-office functions like IT, logistics and payroll management, increasingly sensitive functions such as customer service, R&D and production are being outsourced. Despite the increasing depth and breadth of outsourcing, the topic has not been looked at through a multi-theoretical lens. In this Working Paper, Professor Frédéric Dalsace of HEC, Karel Cool, The BP Chaired Professor of European Competitiveness and Professor of Strategic Management at INSEAD join with INSEAD Ph.D. candidate Nicola Dragonetti to expand the traditional single-theory approach.

They begin by discussing the main theories regarding vertical integration and outsourcing, highlighting three primary rationales for the decision: cost reduction (efficiency view), focus on core activities (focusing view), and learning from suppliers (learning view).

Cost reduction can happen either in transaction costs or in production costs. Starting from the former, previous research suggests that low transaction costs will encourage use of outsourcing. These costs in turn depend on asset specificity, demand uncertainty, and frequency. Asset specificity is thought to be negatively correlated to outsourcing, as firms are more likely to integrate to avoid being held up by suppliers. Demand uncertainty, because it increases the likelihood of renegotiations with suppliers, causing decreased efficiency and increased exposure to opportunism, is posited to be negatively related. Thirdly, some have argued that transactions with low frequency are more likely to be outsourced, it being cheaper to do so. This gives rise to the hypothesis that frequency of interaction is negatively correlated with outsourcing.

Secondly, from the focusing perspective, many have argued that costs alone should not determine the decision to outsource; doing so may also increase the firm’s ability to focus on its core competencies. Thus, the authors test this theory by hypothesizing that core activities will not be outsourced.

Thirdly, the learning motivation suggests that firms need to outsource in order to access and update its knowledge base. Given that suppliers possess knowledge valuable to the firm, constant information exchange will lead to greater levels of outsourcing. Equally, technological uncertainty will increase outsourcing.

Tested against the Sesame database of the Banque de France for the period 1996 and 1997 (with 4180 observations in French SMEs), the efficiency view and focusing view hypotheses, for the most part, were not supported. First, contrary to the efficiency view, neither asset specificity nor demand uncertainty had a significant impact on outsourcing. Neither did the frequency of transactions nor the life-cycle view of emerging and decline industries affect levels of outsourcing, though the authors point out that a weak correlation exists and a longitudinal study might yield different results. The focusing perspective held up no better as no significant relation between core activities and degrees of outsourcing was found.

The learning rationale appears to be the strongest factor influencing the outsourcing decision. When the authors tested the impact of outsourcing on performance using a smaller subset of companies, they found that outsourcing increases return on assets (performance). Thus the authors’ initial findings support the theory that outsourcing in conditions of high technological uncertainty and high information exchange with the supplier lead to higher performance.

Though the authors stress the limitations of their study (including the small sample size), it is clear that they have broken new ground for strategy studies in vertical integration.

INSEAD 2003

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