Outsourcing refers to the fundamental decision to contract out specific activities that previously were undertaken internally. In other words, outsourcing involves the decision to reject the internalization of an activity and can be viewed as vertical disintegration. As it means to obtain by contract from an outside supplier, it is also called contracting out or subcontracting.

Outsourcing is not new. Contractual relationships dominated the economic organization of production prior to and during the Industrial Revolution. However, from the mid nineteenth century until the last 20 years, the internalization of transactions within organizations became the dominant trend. From the 1880s, there was a shift from a regime of laissez faire production consisting of many small firms to a regime based on large, vertically integrated corporations, or what is called a shift from markets to hierarchies, which culminated in the large scale public and private sector bureaucracies of the post war era. Two reinforcing tendencies played an important part in this trend: the growth of direct government involvement in economic activity and the development of production technologies that favored large, vertically integrated organizations. Those same factors forced the retreat from outsourcing in the 1980s and 1990s. In the first years of this outsourcing trend, mainly non-core and less strategically important activities were subcontracted, such as cleaning, catering, and maintenance, also called blue collar activities. Increasingly, however, organizations began to outsource white collar, business services, which many might claim are strategic, such as IT and telecommunications. The off shore contracting out of manufacturing and especially of service activities to developing countries is the reason for a growing skepticism toward outsourcing in the developed countries. There are two main forms of outsourcing:

  1. Long term or embedded outsourcing is characterized by a long term partnership between the outsourcing organization and the outsourcing provider (e.g., strategic alliance, franchising). It involves an intensive interaction, the development of trust between the involved individuals, better communication, and the sharing of the cooperation of risks and outcomes. Such partnerships are usually called networks.
  2. Arm’s length subcontracting is characterized by a loose relationship between the outsourcing organization and the outsourcing provider, which is similar to the traditional market relationship. These two outsourcing forms differ in their economic implications for the outsourcing company and in the associated requirements on the management of the outsourcing process.

The economic effects of long term outsourcing (networks) and arm’s length subcontracting (arm’s length, market relationships) are discussed in the literature as a part of the broader issue of the boundaries of the firm -what explains why certain transactions are governed in house (through hierarchy or vertical integration) while others are governed through market relations (arm’s length subcontracting) or through networks (long term outsourcing)? Two major theoretical streams concentrate on the question of what are the conditions that make one or the other governance form more efficient in governing economic activities: the transaction cost theory and the knowledge based view of the firm (and its extension, the capabilities approach). These approaches discuss the motives of organizations to undertake outsourcing and the impact of outsourcing on their performance.

Transaction cost theory has its origins in economics. Williamson, one of the leading figures of the transaction cost perspective, developed a model that proposes that the main motive of organizations to outsourcing activities is to reduce transaction costs. The model is based on two underlying assumptions about the individuals involved in the regarded transactions: their bounded rationality and the potential danger that they will behave opportunistically. Furthermore, three exchange conditions -uncertainty, asset specificity, and frequency -determine when long term outsourcing (called hybrids within the transaction cost approach), arm’s length subcontracting, or vertical integration is more efficient. Asset specificity, which refers to the degree to which an asset can be redeployed to alternative uses without sacrifice of value, is the central category in the argument. Asset specificity creates bilateral dependency and poses contracting hazards to the involved organizations. It is argued that activities that are related to transactions with a mid to strong degree of asset specificity and a middle frequency should be outsourced and executed in close cooperation with the outsourcing provider because hybrids are the governance form with the lowest transaction costs in such cases. Arm’s length subcontracting is, in contrast, the most efficient governance form in all cases of low degree of asset specificity. Thus, the focus of this approach is on transaction costs – all problems of economic organization (including the motives and effects of outsourcing) are seen as a problem of reducing incentive conflicts. The role of routines, limited knowledge and capabilities, and consequently of production costs, is neglected. Dynamic aspects, such as learning and innovation, are also not discussed. Therefore, this approach delivers only a restricted explanation as to why organizations outsource and what form of outsourcing they choose.

The second approach developed in the late 1980s is still not a coherent theory of the firm but, rather, a collection of ideas and works based on the assumption that firms possess distinct, firm specific capabilities, which are the reason for differences in their production costs. It is claimed that different capabilities imply differences in terms of the efficiency with which resources are deployed. According to this approach, firms will vertically integrate those activities in which they have greater experience and/or organizational capabilities than potential external providers and will outsource marginal activities. This allows organizations to concentrate on their strengths and to profit from the expertise of specialized outsourcing providers. Furthermore, the approach states that non core activities that are to some degree strategically important will be executed in a long term partnership with the outsourcing provider. When the outsourced activities do not have strategic relevance, organizations will choose arm’s length subcontracting. A critical question related to this approach is, therefore, how to identify those activities in which a company believes it has its distinctive advantage. The reality shows that most companies struggle to find the right answer. Furthermore, unlike the transaction cost approach, this approach cannot yet generate empirical predictions but rather ex post explanations only about which activities should be outsourced. In general, the knowledge based approach cannot explain all reasons why firms outsource (e.g., to achieve specialization effects and, at the same time, to limit the negative effects of opportunistic behavior). Therefore, both views, the transaction cost approach and the knowledge based approach, contribute to some degree to a better understanding of outsourcing.

Additional to these theoretical approaches, a large number of studies are primarily engaged with the empirical proof of the existence of cost efficiencies from outsourcing (whereas most of them do not clearly differentiate between long term outsourcing and arm’s length subcontracting). As a leading figure in this research, Domberger undertook several empirical studies of outsourcing in the UK and Australian public and private sector, reporting that, on the average, organizations realized 20 percent increases in efficiency and decreases in cost through outsourcing. These cost efficiencies result, for example, from the reduced capital intensity and lower fixed costs for the outsourcing companies and in the reduced costs of the outsourced activity due to the supplier’s economies of scale and scope. Additionally, other positive effects have been proposed, such as higher flexibility through the choice between different suppliers and the easy switch between technologies, quick response to changes in the environment, increased managerial attention and resource allocation to tasks where the organization has its core competences, and increased quality and innovativeness of the purchased products or services due to specialization of the supplier and spreading of risk.

Despite the arguments that outsourcing firms often achieve better performance than vertically integrated firms, there is a lack of consistency as to the extent to which outsourcing improves the performance and the competitive situation of organizations. Several studies show that efficiency gains are often much smaller than claimed, or even that costs increased after services are contracted out. Additionally, it has been argued that using outsourcing merely as a defensive technique can cause long term negative effects. Because of outsourcing, there is the danger for firms to enter the so called ”spiral of decline” (also called hollowing out of organizations): after contracting out, companies need to shift overhead allocation to those products and services that remain in house. As a result, the remaining products and services become more expensive and less competitive, which raises their vulnerability to subsequent outsourcing. This process can lead to the loss of important knowledge and capabilities and, as a result, can threaten the long term survival of organizations. Some other important disadvantages that may result from outsourcing are a negative impact upon employees that remain in the company (e.g., lower employee commitment, drop in promotional opportunities, drop in job satisfaction, and changes in duties), declining innovation by the outsourcer, dependence on the supplier, and the provider’s lack of necessary capabilities. Especially the social cost associated with loss of employment in the outsourcing organizations has been strongly criticized by opponents of outsourcing. Partly because of such negative effects, it has been suggested that organizations adopt outsourcing because of the lure of fashionable normalization. From this perspective, efficiency arguments are of less con sequence than those that stress institutional factors, especially mimetic isomorphism. It has been claimed that modern societies consist of many institutionalized rules providing a frame work for the creation and elaboration of formal organizations. Many of these rules are rationalized myths that are widely believed but rarely, if ever, tested. They originate and are sustained through public opinion, the educational system, laws, or other institutional forms. Thus, many of the factors shaping management and organization are based not on efficiency or effectiveness but on social and cultural pressures to conform to already legitimate practices, especially when influential consultants recommend a course of action such as outsourcing. Thus, the main problem, as these authors see it, is the danger of misapplication of outsourcing simply because it is fashionable.

The problem with the debate between efficiency and fashion is, however, that outsourcing can be sought both because it is a widely institutionalized and legitimized practice and because it delivers cost reductions. Therefore, these approaches are not necessarily competing but can as well be complementary. An organization that primarily adopts outsourcing in order to conform to other organizations can, at the same time, realize some benefits, e.g., cost efficiencies from the outsourcing practice. The crucial questions are, therefore, (1) whether the cost of exchange of goods and services is significantly higher when this transaction occurs between separate organizations than when it takes place within them, and (2) whether these costs are higher when organizations engage in long term, strategic outsourcing than when they establish arm’s length, market relationships. It has been indicated that the answer to both questions is largely dependent on the management of the relationship with the outsourcing provider. Benefits and costs of outsourcing depend crucially on how outsourcing is designed and implemented.


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