OUTSOURCING STRATEGY: A RECENT LITERATURE REVIEW AND MODEL UPDATE
CALIFORNIA STATE UNIVERSITY, FULLERTON
The importance of including an outsourcing strategy in the overall firmâ€™s operations has become increasingly important over the last decade. Companies in the U.S. pay about $68 billion every year to other companies for outsourced services and although a major part of these contracts succeed, there is an increasing concern due to recent broken deals. A recent study shows that 80% of companies that outsource their customer based functions are failing to meet their cost savings targets. Usually companies fail to budget hidden outsourcing costs such as customer dissatisfaction that can eventually jeopardize the future of the firm. In this paper I reviewed the most current literature on outsourcing and built a model that includes the principal four factors influencing the success of outsourcing strategies: the firmâ€™s Comparative Advantage, Employees, Suppliers and Customers.
Outsourcing Strategy: A Recent Literature Review and Model Update
Every year in the United States, companies pay about $68 billion to other companies for key services or products that help them focus on their core business and delegate other functions (Thurm, 2007). The value of IT Outsourcing contracts worldwide was $119 billion in 2004 (Pai, 2007). Without a doubt, outsourcing is a major part of the business strategy that drives organizations to success. Whether at its simplest version of buying raw materials from a large supplier to its most complex variation of offshoring services, outsourcing is present in all business strategies.
However, outsourcing strategies are not always successful; therefore it is crucial to understand the factors that influence a firmâ€™s outsourcing strategy. In 2004, J.P Morgan Chase & Co. took its main technology functions to be in-house again abandoning a $5 billion agreement and Electronic Data Systems Inc. backed down from a $1 billion deal (Thurm, 2007). Although a few years ago outsourcing was used by some manages as another mean to cut costs, the main reasons for outsourcing have evolved to become more strategy oriented (Pai, 2007).
The basis of outsourcing is the same one as the trade theory where two or more parties benefit from the exchange of goods or services. Outsourcing and trade are beneficial for many reasons including cost savings and increase in wealth, but the main reason companies incorporate outsourcing into their business strategy can be explained in terms of comparative advantage.
The purpose of this paper is to review the most relevant recent literature in outsourcing and to identify the key elements that connect to a proposed model of outsourcing that complements the outsourcing decision framework Figure 1 (Kremic and Tukel, 2003). A revised version of this model follows.
Strategic Outsourcing Model
This research paper differs from Kremicâ€™s in that it incorporates the comparative advantage concept as the main driver of outsourcing and it also includes other triggering factors such as the industry clockspeed and the entrance of new technology into the industry. The main contribution of this article is to gather the most important factors of outsourcing into a model. In the current literature, the risks of outsourcing are mentioned very scattered. In this paper I provide a ranking of the most important risk factors mentioned in the reviewed literature.
There are three types of functions a business can be divided into: core functions, tactical non-core functions and strategic non-core functions (Pai, 2007). Core functions are the ones that dictate the comparative advantage of the firm; they are the specialized task that makes the business unique and successful. Tactical non-core functions are most commonly outsourced. They are the functions that are necessary components of the core business but do not have a direct impact on the core functions. These are functions like payroll, accounts receivable, accounting, call centers and recruitment.
The first part of the model includes two external forces that trigger the need to outsource. The first one is the industry and the second one is the new technologies that become an important part of the core business of the firm. Following the external forces are the internal reasons that push a firm to outsource. Although many have been identified in the literature, the most relevant refer to reduction of costs, focus on the core business, avoid the investment in specific assets and increase in efficiency and performance. A ranking of these reasons is presented in Figure 2 (Pai, 2007).
The proposed model highlights the four most important forces of strategic outsourcing: Suppliers, Customers, Employees, and the firmâ€™s comparative advantage.
Comparative and Competitive Advantage
It is important to understand the implications of comparative and competitive advantage in outsourcing. Comparative advantage theory explains that it may be beneficial for two parties (countries, regions, individuals and so on) to trade if one has a lower relative cost of producing some good. It takes into account the opportunity cost instead of the absolute cost of production of one good to evaluate the sourcing strategies that are beneficial for both parties.
The gains from outsourcing are well explained by this trade theory. In a simplified world with only two firms that produce two goods, trade will allow each firm to specialize in their production in a way that allocates resources to their most productive uses. If Firm A specializes in the production of software and Firm B specializes in human resources management, the trade theory demonstrates us that both firmâ€™s wealth will be maximized if Firm A produces software and sells it to Firm B in relative terms and Firm B, in exchange for software, administrates the human resources department of Firm A. Firm A then, holds a comparative advantage in software production if its price (relative to human resources management) is lower than Firmâ€™s B.
This comparative advantage principle will also hold true, and probably more so, when offshoring is taking place. Offshoring refers to the type of outsourcing that takes place overseas. In this case, the production factors being only labor and capital, the country that will specialize in the labor intensive good will be the country abundant in labor because it will have a comparative advantage in that good in contrast with the capital abundant country.
When a firm decides to outsource, it is converting some fixed costs into variable costs and have a clearer view of returns on investment. This allows companies to make quicker decisions. (Dhar, 2006). On the other hand, suppliers who have a comparative advantage in the good or service they provide, have superior cost structures and diversification of their risk.
In terms of business strategy it is beneficial for any business entity to outsource the functions that do not compromise its comparative advantage. With this start, we must evaluate other factors that should be considered when deciding the degree of outsourcing and the functions that will be outsourced.
On the other hand, a firmâ€™s competitive advantage resides not in that firmâ€™s products but in their competencies (Hoetch, 2006). Some examples of competitive advantage are knowledge skills, management processes and routines that are difficult to duplicate. When outsourcing, risks of losing core competencies are high especially in technology based industries.
One element that Kremicâ€™s model is missing is the importance of the industry clockspeed when deciding whether to outsource or not. The industry clockspeed is the â€œvelocity of change in the external business environment that sets the pace of a firmâ€™s internal operationsâ€ (Perrons, 2005).
Outsourcing requires usually long-term relationships with suppliers. In a fast moving industry, long-term relationships are more beneficial than in medium paced industries (Perrons, 2005). It is in fact proven that different vertical integration strategies will be appropriate if the industry is fast or slow changing. The industry characteristics per se will be a trigger to outsource.
For instance, the computer industry is considered a fast-changing industry. In the early 1980â€™s IBM who was primarily the supplier of computers decided to design its supply chain to include Intel and Microsoft as it major components. Although IBM is still a big player in the industry, Intel and Microsoft have taken the most significant share of profits. With the development of the industry, customers seemed to care more about the component brands like â€œWindows XPâ€ than the brand that assembled the computers. (Fine, 2000).
Slower clockspeed industries, such as the automobile, allow assembling companies to get most of the profit. Although the electronic systems in cars have evolved quite significantly, customers still care more about the brand of the car (i.e.Toyota) than the brand of the radio or the lights. This gives automobile brands time to make choices without pressure. (Fine, 2000).
Fine recognized that there are different factors that affect the industry clockspeed. The main accelerator is obviously the rate of technological innovation and system complexity is a mayor decelerator.
A recent study on Outsourcing and Technological Change shows a strong relationship between the appearance of new technologies and outsourcing trends. The first connection is the reduction of production costs due to technical advances. As in-house cost-reduction technologies increases, the demand for outsourcing decreases. However, as the rate of technological changes increase , outsourcing becomes more desirable.(Bartel, 2004).
Secondly, there is a connection between technology development and the reduction of adjustment costs. The more IT oriented is the firm, the higher the change it will outsource because adjustment costs will be lower.
Internal Reasons to Outsource
Transactional Cost Theory
Most outsourcing strategies are motivated by cost reduction. The theory behind this concept is called the transactional cost theory that differentiates between production costs, that are the ones incurred in actually manufacturing the product and the transaction costs that are considered coordination costs. (Dhar, 2006). Outsourcing, therefore, reduces production costs because all costs become variable and increases transaction costs because vendors need to be managed and monitored.
Although costs savings were the primary driver for outsourcing, current literature demonstrates that more companies are redirecting their outsourcing efforts to improve performance. Although it was demonstrated that outsourcing reduced fixed costs that can be hard to carry specially in economic recessions, it is not guaranteed that the savings will be significant if at all existent. There is evidence that the cost savings of outsourcing have been overestimated (Kremik, 2006). In some circumstances the transactions costs exceed the savings in administrative cost. There are also some hidden costs to outsourcing that are hard to measure but are not less significant. Among them are the social costs within and outside the company, contractual costs and transition costs.
When the task that the business function requires is very specific to a physical or human asset it is considered a high asset specificity task and in those cases firms are more likely than not to outsource. (Dhar, 2006). Asset specificity is an important driver of transaction cost as they increase the costs of market exchange.
Concentration in the firmâ€™s core competency is proven to increase efficiency and overall performance. When the firm is able to allocate resources according to the greatest positive results, the firm will most likely look into outsourcing some of its tactical non-core functions.
Risk in inherent to all business decisions and strategies and although we try to eliminate risk by human nature, the best bet is to plan ahead and prepare contingency scenarios that provide security and less vulnerability to the firm in future situations. Almost all the previous factors that influence the decision of outsourcing combined represent a measurement of the risk that the strategy represents to the firm. In a study of two multinational firms, the main risk factor found was knowledge (Dhar, 2006). To relinquish key information of the companyâ€™s core business is to increase the probability that the supplier will use that information for its own interest. A large portion of the effort dedicated to the department of outsourcing of both firms went to ensuring that the core knowledge remained in-house.
Information leakage is another related dilemma of outsourcing. Firms in knowledge-intensive industries are required to sustain an extensive R&D practice to remain successful and profitable. However, it is important that some of the knowledge is shared with strategic partners in order for the firm to concentrate in its core competencies. (Hoecht, 2006). In order to facilitate this strategic sourcing, information leakage has to be budgeted into the benefit-cost analysis.
Monitoring and measurement of performance of vendors is a critical element of a successful outsourcing strategy. Reviewing the most recent literature on outsourcing risks, the primary source of risk are the suppliers. A list of the possible risks involved in outsourcing activities is presented below. Strategies to mitigate this risk include screening of suppliers, identification of best option, audits, determining adequacy and contacting the customers for feedback (Pai, 2007).
Risks of Outsourcing
ECONOMY CHANGE IN POLITICAL/LEGAL CLIMATE
FIRM TRANSITION AND MANAGEMENT COSTS
FIRM COST OF RETENTION/LAYOFFS
SUPPLIER CONFLICT OF INTEREST
ECONOMY CURRENCY DEVALUATION
SUPPLIER KNOWLEDGE TRANSFER
SUPPLIER SCOPE, COST AND TIME
CUSTOMER QUALITY STANDARDS
SUPPLIER DEPENDENT RELATIONSHIP WITH SUPPLIER
SUPPLIER INFORMATION LEAKAGE
EMPLOYEE EMPLOYEE RESISTANCE
Conflict of Interest
When an important function of an organization is delegated to an external party, the principal-agent problem arises. Each party will work toward achieving a personal or corporate goal and interest and most of the time those interests will differ from one company to another.
This challenge of outsourcing is increased when cultural and geographical differences are greater (Amaral, 2006). Thus, transactional costs increase because suppliers will need overseeing and coordination.
The problem conflict of interest problem is a factor influencing the decision of outsourcing but it can be handled by measuring the level of authority and auditing that the company has over its delegated activities. The less number of suppliers the more chance they will be opportunistic (Dhar, 2006), because the outsourcing firms will lose bargaining power. In such cases, outsourcing may not provide cost savings due to vendors charging overpriced fees.
Although outsourcing is such a primordial stage of the business strategy, many firms are not structurally designed to outsource. EquaTerra Chief Executive, a Houston outsourcing firm, says that roughly one-third of his clients end up not outsourcing mainly because they donâ€™t believe that their organization is ready for such a change. (Thurm, 2007). Internal resistance may be the main reason for the inflexibility of a companyâ€™s structure in this particular case.(Nordin, 2006)
Managers and employees may resist outsourcing if lay-offs are an imminent consequence. Also, if quality and service are compromised, employees might be reluctant to cooperate with the suppliers. The best way to approach this problem is to carefully carry out the transition and to adjust the process to the context of the change.
In the process of deciding whether and how to outsource, transition planning plays an important role and should at least include: (1) set up a team (2) audit resources to be transferred, (3) establish a plan of transition (4) communicate plan internally (5) communicate the plan to costumers (6) educate staff , and (7) set up review measures (Kakouris, 2006). See Figure 3.
Choosing the right vendor or supplier is one of the biggest challenges for firms looking to outsource. (Dhar, 2006). The selection of the supplier is a complex decision-making process and the criteria varies according a different number of factors such as the industry, the relative size of the firm, the type of product to be outsourced and the outsourcing strategy. (Kakouris, 2006). However, Andreas Kakouris, the author of â€œOutsourcing Decisions and the Purchasing Process: A Systems-Oriented Approachâ€, provides us with a most-common criteria grouped in six categories:
â€¢ Process and Design Capabilities
â€¢ Management capability
â€¢ Financial considerations
â€¢ Planning and control capability
â€¢ Working relationships
â€¢ Other: These refer to the relevant characteristics required by the outsourcing firm such as regulations specific to the industry or geographical preferences.
Once the selection of possible suppliers has been made, the following step is to decide which of those suppliers best matches the outsourcing firmâ€™s objectives. The author calls this the Supplier Identification and summarizes the main decision making methods in Table 1.
Once the methods for choosing the right supplier are in place, the SLA (Service Level Agreements) sets four key factor to help manage the service providers (Pai, 2007): The volume of work, the quality of work that can be measured by the standards of compliance practice, technical quality, service availability and service satisfaction, responsiveness and efficiency.
We have previously mentioned that having multiple suppliers reduces the risk of opportunism. However, this is not a rule of thumb for all industries. In some cases, having multiple suppliers increases the transactional costs to the point that they outweigh the benefits (Kakouris, 2006). Some of the benefits of having a reduced number of suppliers are:
â€¢ Easiness and quickness suppliers can be contacted
â€¢ Reduced transaction costs due to less coordination efforts
â€¢ Economies of scale that can lead to volume discounts
â€¢ Better customer service
Suppliers and Flexibility
The different dimensions of outsourcing flexibility are: robustness, modifiability and new capability (Tan, 2006). The first one refers to the ability of tolerate variations in the environment, perturbations and pressure. The second one refers to the ability to adjust to these changes and the third one refers to the ability to innovate in response to dramatic changes.
In Kremicâ€™s research paper flexibility is one of five potential factors to consider. Contracts usually determine the level of flexibility that a relationship with suppliers has. Long term contracts have resulted in loss of flexibility.
Although for a long time contracts have been the only indicators of how flexible an outsourcing strategy was, Chengxun Tan argues that contracts are not sufficient to ensure a flexible relationship with a supplier. He then proposes three types of maneuvers or tactics to strategically design the degree of flexibility the outsourcing relationship will have and therefore ensure the firmâ€™s proper performance in rapid changing environments. The pre-emptive maneuvers are: to minimize customization, to enhance the process maturity and to leverage vendor interoperability. Protective maneuvers are planned prior to initiation of outsourcing operations and they are to have multiple vendors which we have discussed already and to retain in-house competence. Finally, exploitive maneuvers are to take advantage of emerging changes and opportunities.
Most of the success with suppliers depends on the contractual relationship that has been established prior to the business relationship. This becomes an issue of concern especially for those outsourcing strategies that involve an offshore partner.
A contract is the only efficient mechanism of ensuring that the expectations match the results and no major disappointments are in place. Differences in governing laws have to be acknowledged and play an important role on the success of the relationship. Arjun Pai (2007) summarizes the common pitfalls affecting the legality of the contract:
â€¢ Prior to developing a contract chose a governing law that will apply. A well written and protective contract will be of no use it is not perfectly enforceable.
â€¢ Process all permission and licenses that will ensure the legality of the activities.
â€¢ Establish clear rights to intellectual property.
â€¢ Make sure the contract covers liability in the case of insolvency of the supplier.
The three most popular types of contracts are related to the level of outsourcing a firmâ€™s strategy includes. Complete outsourcing includes the transfer of activities as well as machinery and/or assets and personnel and therefore the contracts regulating these activities are extensive and very detailed. They usually last from five to ten years. Facility management outsourcing and systems integration outsourcing require provisions and warranties in the case of difficulties arising.
Termination clauses are key parts of contracts (Pai, 2007). The possible causes of a sudden termination of a contract can include failure to pay the vendor and acquisitions. Both parties can benefit if the termination of the contract is not a lengthy process. The reasons for termination of contracts are summarized in Figure 4.
Quality and Customer Satisfaction
If the firmâ€™s customer base is highly sensitive to product and service quality, outsourcing can turn into a loss of credibility and reputation. Quality drives the firmâ€™s brand and can create a demand that may be jeopardized by incompetent contractors. However, if quality is not a big concern for the company, outsourcing can be viewed as an improvement rather than a cost.
An important part of outsourcing strategy that most papers on the subject ignore is the customer relationship that the firm hopes to maintain after outsourcing and the ways to nurture that relationship. After all, most outsourcing strategies based only in cost reduction fail. This is particularly applicable for outsourcing a service, such a call center, repairs, ordering or product installation. In some cases, the basic costumer service tasks are also outsource.
The first issue that arises is whether the customer will be affected at all by the firmâ€™s outsourcing strategy. Also the firms need to evaluate their current objectives in regards to the customer satisfaction and the level of interaction the customer will have with the supplier.
When a firm makes a supplier responsible for maintaining a good image and customer satisfaction risks are high due to conflict of interest. The supplier may not have the same objective as the firm and therefore jeopardize the brand image. Kodak hired TeleTech in 2004 to handle it customer service operations but after customer complaints and satisfaction surveys, it was demonstrated that Kodakâ€™s brand image was suffering from the agreement. Kodak is currently trying to break relations with Teletech.(Astor, 2006).
One of outsourcing greatest hidden costs is the loss of valuable customers that prefer to change providers due to poor customer service. A recent survey shows that 75% of policy holders would change providers if they experienced bad customer service. (Pfeffer, 2006). This supports Domberger and Fernandez study cited in Kremicâ€™s paper that outsourcing benefits were overestimated because costs like this were difficult to be budgeted in the beginning of the strategy evaluation. A 2005 study done by Gartner shows that 80% of companies that outsource their customer based functions are failing to meet their cost savings targets. This might also be due to the fact that in-house employees are far more motivated and identify themselves with the organizationâ€™s objectives.
Conclusions, Management Implications and Future Research
In reviewing the most current literature on outsourcing two were the main findings:
â€¢ Most of them provide decision frameworks that complement each other but no models of outsourcing were found.
â€¢ Most literature ignores the competitive advantage reasoning as a way to explain the benefits of outsourcing.
â€¢ Some papers ignore the importance of keeping the customer satisfied.
Although Kremicâ€™s paper provides a complete analysis of the benefits, risks and decision factors, his decision framework lacks the important driving forces of outsourcing: The industry clockspeed, comparative advantage, the suppliers, the employees and the customers. All of these factors should be part of the decision framework since they highly influence the success of the outsourcing strategy.
Although the model provided does not include a step-by-step construction of an outsourcing strategy or a best-practices manual, managers can benefit from this study in that it helps gather all the important and relevant factors that influence an outsourcing strategy:
â€¢ The level of control over outsourced operations can determine the future success of the supply management strategy.
â€¢ Most of the times, core competencies have to remain in-house due to the high risks that information leakage imposes to the future of the organization.
â€¢ In deciding what functions to outsource, or whether to outsource at all, the industry clockspeed may determine the best practice.
â€¢ The benefits of outsourcing as a concept alone can be explained by the comparative advantage theory.
â€¢ Outsourcing greatest costs are hidden and hard to account for. For example customer services may be jeopardized by relinquishing responsibility to vendors that do not have the same interests as the firmâ€™s own employees and may therefore provide poor service.
â€¢ A healthy and informed contractual relationship with suppliers can avoid several future issues on intellectual property rights and quality standards.
â€¢ Flexibility plays an important role in the companyâ€™s overall performance. In order to keep the firm flexible certain â€œmaneuversâ€ have be applied.
â€¢ Having multiple suppliers may diminish the risk by diversifying the responsibilities.
â€¢ The transition between in-house production and operations to outsourcing can be painful to the organizational culture and therefore employees need to play an active role in the implementation of any outsourcing strategy.
It would be useful for the outsourcing firms if future research would focus on the reason why outsourcing contracts fail and to determine a current link between the firmâ€™s outsourcing strategies and the results of the agreements in terms of savings.
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FIGURE 1: KREMICâ€™S OUTSOURCING MODEL
Source: Tibor Kremic, Oya Icmeli Tukel, Walter O. Rom. (2006). Outsourcing decision support: a survey of benefits, risks, and decision factors.
FIGURE 2: REASONS FOR OUTSOURCING
Source: Arjun K. Pai, Subhajit Basu. (2007). Offshore technology outsourcing: overview of management and legal issues.
FIGURE 3: THE PURCHASING PROCESS AND SOURCING DECISIONS
Source: Andreas P. Kakouris, George Polychronopoulos, Spyros Binioris. (2006). Outsourcing decisions and the purchasing process: a systems-oriented approach.
FIGURE 4: REASONS FOR TERMINATION OF CONTRACTS
Source: Arjun K. Pai, Subhajit Basu. (2007). Offshore technology outsourcing: overview of management and legal issues.
TABLE 1: SUPPLIER IDENTIFICATION DECISION METHODS
Source: Source: Andreas P. Kakouris, George Polychronopoulos, Spyros Binioris. (2006). Outsourcing decisions and the purchasing process: a systems-oriented approach.