Paperwork: Outsourcing

Module title: Economics of Corporate Strategy
Module Convenor: Jason Lee, Economics Lecturer Nottingham University Business School
Date Work Handed in: 19 April 2006

It is not a new phenomenon for outsourcing, originally called the contracting out of organisational activities, in today's world. In eighteenth and nineteenth century, England public services were serviced by the private sector in the form of street lighting, prison management, road maintenance, the collection of taxes, and other public revenues. Similarly, private operations provided mail delivery in America and Australia, and the construction and management of the railway network was contracted out to commercial companies through competitive tendering in France. As the industrial revolution proceeded, the activities of outsourcing dominated the organisation of production and distribution throught the western world. The mechanism of outsourcing involves contracting with a third party to provide goods and services to the host organisation that would have been available in-house. The basic objective for sourcing out the responsibility for managing particular resources to other parties is that it has become unprofitable for the host organisation to maintain them within the corporate framework.

The Boston Consulting Group concluded that most western companies outsource primarily to save on overheads through short-term cost savings. The 1990's global competition compelled large companies to apply greater discipline over costs and over product to market time cycles, resulting in a smaller product and services portfolio and a loosening of the vertical links in the production process. As a result, firms have divested what they regard as elements peripheral to their business so as to focus upon their 'core' business. Reliance on the vertically driven organisation has been reduced. In turn, greater emphasis has been given to the horizontal relationships so as to improve quality, whilst paying attention to cost effectiveness. In 1999 Unilever, the Anglo-Dutch group, with a portfolio of 1600 food, toiletries, and household products announced that it would focus on a smaller number of 'power brands' (core products) which would have greater worldwide reach in enhancing sales growth and profitability. The aim is to reduce costs and exploit new channels of distribution, such as the internet. The search for greater efficiency, leading to increased specialisation, coupled with attempting to achieve other value adding objectives, added a new dimension to outsourcing, that of attempting to manage multiple, but, at times, ill fitting sourcing strategies. Such managerial gymnastics have masked a more fundamental issue, which is determining what is core to the host organisation so that those processes and activities that are considered peripheral can be passed over to an external service provider.

Determining what is core and non-core to the organisation, whilst attempting to attain multiple outcomes through outsourcing, has been a focal point of debate. Some regard core activities as representative of core competences, in that those ares in which the firm is continuously engaged are fundamental to the survival of the firm. Certain writers consider that what is core and what is peripheral is an academic debate, as outsourcing decisions should be driven by the nature of sourcing contracts and the contractual and informal relationships between the purchaser and supplier, which in turn, lead to the development of a new cluster of core competences. Still, others advocate concentrating solely on competitive advantage, arguing that core competences are those activities that offer long-term competitive advantage and thus should be kept in-house. Nike, for example, outsourced shoe production and manufactures only the key elements of its 'Nike Air' system on the basis that Nike creates maximum value by concentrating on what is unique to them, namely, research and development and post-production activities. Other Nike activities like distribution, sales and marketing (exception: advertising) have been outsourced. In a similar vein, Argyle Diamonds, a major diamond producer, has outsourced all aspects of its operations (earth-moving operations, housing and services for workers, distribution) to best-in-class suppliers. However, the separation and the sorting of diamonds (which is considered core) has been kept in-house.

In the IT industry; global competition, downsizing, the move to flatter organisations, the search for greater flexibility, and rapid changes in technology are cites as the causes of the upsurge in IT outsourcing. Data storage capability has dramatically increased in quality and at the same time has become significantly cheaper, to the extent that data storage services are being charged on a cost-per-megabyte-per-month basis, in a similar way that clients pay for utilities like electricity and water. Therefore, IT has acquired more of a 'commodity' status. Consequently, firms in their pursuit of gaining competitive advantage have been increasing their reliance on external suppliers of information services. Thus, the outsourcing of IT has grown at a phenomenal rate over the past decade in North America, United Kingdom, and Australia. Analysis shows that Western Europe, South America, and parts of South East Asia, including Japan, are now following suit, having previously resisted the trend. For example, the IT market analysts, the Gartner Group, have projected a 16.3 per cent growth rate world-wide between 1997 and 2002, estimating a $120 billion IT outsourcing market by 2002.

Outsourcing in the future, as identified by researchers and practitioners like Justin Jewitt (CEO, Nestor Healthcare Group Plc), emphasises that the present trend of effectively managing a number of horizontal contractual relationships with key trusted suppliers, with each supplier in the chain focusing on providing best-in-class service to give the host organisation competitive advantage, will gain momentum. Enabling the host organisation to gain greater competitive advantage and to be repositioned up the value chain is considered as likely to be achieved by simultaneously pursuing a number of outsourcing strategies, like improving service quality whilst striving to attain cost advantage. Such goals will be realised through a variety of outsourcing arrangements, principally with preferred suppliers with whom there exists an established relationship through performance-based contracts. Such efforts to externalise and become an extended enterprise bear a remarkable resemblamce to the Japanese 'keiretsu' model. Historically, a keiretsu (consortium) of independent Japanese companies were created out of the giant, family-owned Sumitomo zaibatsu (business combine), which was broken up after World War II. Keiretsu based enterprises are accustomed to managing long-standing relationships involving explicit (equity holdings) and implicit (reputational) aspects. The relationships are considered to enable greater focus and business discipline for the benefits of the partners by the partners. This is because they create conditions that permit suppliers to make the investments that will help them to accelerate through their learning curve of providing high-quality service, principally through showing them the advantages of having a volume based and lower cost-per-unit-based relationship with the 'mother company'. For example, by the early 21st century, the Sumitomo group comprised several dozen firms, and all of the major firms were large multinational corporations based in Tokyo or Osaka, such as the Sumitomo Mitsui Financial and Sumitomo Chemical Group.

However, a number of elements has to be considered in the light of outsourcing. Transaction cost theory highlights the significance of transaction cost in market exchanges. When relying on market to provide needed products or services, organisations must invest considerable resources in mechanism designed to guard against the opportunistic behaviour by the trading partner, thus incurring transaction costs. The costs include the costs of writing, negotiationg, monitoring, and enforcing contracts as well as the internal costs related with contract management (Poppo and Zenger 1998). For example, OMB Circular A-76 in the United States provides guidance on how to prepare the extensive in-house cost estimate and the team will need detailed costs that are not normally readily available such as personnel costs, expenses for materials and supplies, other attributable cost like depreciation, overhead and administrative costs, and inflation adjustments. From the perspective of transaction cost theory, transaction costs reflect the diseconomy of market and thus directly influence the firm boundary.

In addition, agency problem occurs when the principal and the agent have different goals and different attitude toward risk. While traditional agency model is primarily concerned with preventing the agent's shirking behaviour, critics of agency theory have pointed out that neither risk-aversion nor effort-aversion is as important as the classic agency model suggests. Instead, the real agency conflict has less to do with getting the agent to work harder, but more to do with getting the agent to choose the right combination of actions and decisions that maximises the principal's welfare. This problem would be particularly salient when the agent is faced with multiple objectives competing for finite resources and the optimal solution requires to strike a balance between the different dimensions. In response to this criticism, agency theory has evolved to address the more complex agency issues such as multi-tasking and measurement imperfection in principal-agency relationships (Indejejikian, 1999). From an agency theory perspective, firm governance is no more than an agency contract between employees or divisions and the organisation or senior management. In this sense, insourcing simply substitutes the agency cost related with the employment contract for the agent cost associated with the client-vendor relationship, which has the same underlying contents as the transaction cost defined by transaction cost theory. Therefore, the firm boundary choice is of limited significance in terms of mitigating the agency cost inherent in the delegation relationships (Alchian and Demzetz 1972; Jensen and Meckling 1976; Poppo and Zenger 1998).

Other element is asset specificity; defined as the degree to which the assests in an exchange are more valuable in their current application than in their next best use (Leiblein and Miller 2003). Vis-a-vis transaction cost theory, specific assets create the incentives for trading partners to appropriate returns from the specialised investments through post-contractual bargaining or threats of termination (Poppo and Zenger 1998; Klein et al. 1978). To safeguard this possibility of 'opportunistic expropriation', organisations have to invest more resources in contract negotiation, enforcement and management, thus leading to increased transaction costs.

In today's business world. it is crucial for a firm to practice 'smart' sourcing, in the sense of weighing up circumstances and being both efficient in the use of resources and delivering the desired outcomes. In outsourcing, 'smart' denotes having considered how to gain advantage through repositioning of enterprise resources and then effectively managing a number of supplier relationships. It focuses as much on the transformational capabilities of identifying ways forward and being effective at the motivation of and communication with people, as on the transactional skills of managing the detailed aspects of business and the routine application of technology. A general manager in a business consultancy firm explains "a smart company anticipates the challenges associated with the outsourcing of its activities and for example takes an active approach to minimise the discomfort of its employees. My experience shows that it is impossible to avoid some dip in employee morale when a company makes an outsourcing announcement, but it is possible to avoid its long term effects. Human Resource arrangements can make or break an outsourcing initiative".