Chapter 1 Introduction
Life is all about choices. Throughout the life development, people always have to make choices such as career decisions, marriage decisions, and retirement decisions at each juncture in their lives. For the most part, the objective is to live better and have a better life.
In a similar fashion from the perspective of industry development, firms in the industry always have to make choices from selecting of Research and Development (R&D) strategies to quality control standards throughout each stage of their corporate lives. The goal of any decision is to optimize gains while minimizing risks. However, risks constitute an unavoidable part of any decision.
There is a constant tradeoff between risk and benefit. Firms in the industry have to make these types of tradeoff as the industry evolves through various stages. At each evolutionary stage, managers have to make decisions from dealing with product uncertainty in the early industry development stage to undifferentiated products available in the market at the latter stage. Regardless of the stage of industry development, there is no doubt that the primary objective of any strategic decision is to ensure the basic survival of the firm. Outsourcing is implemented because the firm is in a technological development stage where outsourcing becomes one of the strategic options that enables the firm to survive or to thrive better under the competitive industry environment. The validity of outsourcing related benefits or risks depends on the stage or state of technological development of an industry.
Outsourcing is one of these strategic options in dealing with the unique characteristics in each evolutionary stage. The overall development of the industry is shaped by the strategy selection of its participants, namely the firms. What are the factors that influence the strategy selection? It is undisputed that one of the primary goals of the firm is to survive and to thrive under its constantly changing competitive environment. However, one thing is certain in life -- that change is a certainty. Everything is conditioned to change from technology, market demand, industry concentration, macroeconomic growth, to firm related resources. Firms have to survive and grow under these constant changes. These changes in economic condition are the basis of industry evolution or development. Evolutionary theory is a study of change in which the fundamental explanation involves both random elements, which generate or renew some variation in the variables in question, and mechanisms that systematically winnow on extant variation (Dosi & Nelson, 1994).
Change could be biological, sociological or economic. In economics, change is the basic selection mechanism that weeds out the uncompetitive firm and preserves the adaptive firm. The ability of the firm to adapt and to create variation is the key to survival under economic changes. The survival of the firm depends on its ability to select appropriate strategy that assists its adaptation with economic changes.
Hence, one of the primary factors influencing strategy selection of the firm is economic change, whether it be the present or forecasted one.
The main objective of this research is to supplement the deficiencies in the current analysis on outsourcing by using the perspective of evolutionary economics with a special focus on technology and innovation. The main deficiency in the current discourse on outsourcing is that the existing analyses often overlook the role of economic change when explaining outsourcing. The conventional analysis of outsourcing often focuses on the effects of outsourcing such as cost savings and core competency; however, such “effect view” is unsatisfactory in explaining many
outsourcing situations. This study would like to supplement the conventional “effect view” of outsourcing from the cause perspective. The primary cause of outsourcing is economic change. Economic change is the basis of industry evolution that forces firms in the industry to be concerned about their core competencies and transaction costs. The connection between outsourcing and economic change is based on a cause and effect relationship. Economic change is the primary cause that drives the firm to consider outsourcing. Consequently, it is insufficient to explain outsourcing without identifying economic change and would only render such investigation incomplete. In addition, most of the analyses on outsourcing are often based on the benefits and risks perspective (Quinn & Hilmer, 1994; Domberger, 1998; Kakabadse
& Kaabadse, 2000); however, such analyses are often too static. Such analysis is often confusing since it is hard to match the relevant benefits and risks with various outsourcing situations. The conventional explanation on outsourcing fails to fully explain at which stage which of the benefit or risk is more prevalent than others.
The fact is that firms in the industry value different strategies in each stage of industry development. Such static view cannot explain the evolving strategic changes in each stage of industry development. The industry develops or evolves on the basis of economic change. Economic change is a constant factor and essential to the strategy formation of the firm. In light of economic change, it is seemingly impossible for a certain benefit or risk to remain the same throughout the industry development or evolution. Not only does everything change in life, outsourcing benefits and risks change throughout development stages as well. The relativity or importance of these outsourcing risks and benefits change as the firm faces different challenges in each stage of development. In the early stage of development, the cost saving benefit of outsourcing is relatively unimportant since it is always possible for the firm to sustain its economic rent through intensive product innovation. At this stage, the survival of the firm depends on its ability to innovate.
However, in the latter stage of development when products available in the market become undifferentiated, the cost saving benefit of outsourcing is relatively critical to the survival of the firm. The survival of the firm depends on its ability to control costs. In addition, it is possible that at a certain stage of development, the firm might be willing to assume a certain degree of risk associated with outsourcing in order to utilize the benefit. In the early stages of industry development, firms compete against each other in terms of speed to create the industry’s standard product. Consequently, it is possible for the firm to utilize the speed to market benefit of outsourcing while assuming the risk of potential loss of control associated with outsourcing. In the latter technological development stages, the risk of leaking out technological know-how is relatively limited since products available in the market offer little variation. It is evident that the strategy of the firm changes along with economic changes. The conventional static perspective in explaining outsourcing is certainly insufficient in dealing with economic changes since it lacks an indicator to explain the changing role of the benefit and risk of outsourcing.
Another theme of this research is to provide a systemic framework to explain outsourcing using technology evolution as an indicator. The current discourse on outsourcing lacks an indicator that connects the changing role of the benefits and risks associated with outsourcing. Without an indicator, it is hard to explain when and why a certain risk or benefit is more prevalent than others. In addition, another deficiency in the conventional explanation of outsourcing is that most of the discourse has been focused on the effect of outsourcing but ignores the
cause of outsourcing. The effects of outsourcing include specialization, cost reduction, and so forth. But the question is what are the causes leading to these effects? What is the role of outsourcing at each stage of industry evolution? The analysis of outsourcing is incomplete without a proper analysis of the cause and effect relationship. To provide a proper analysis of outsourcing it is only logical to also provide explanations on the causes of outsourcing such as technological change and changes in industry structure. The main assumption is that outsourcing is the result of changes in technology and industry structure. In order to accommodate economic changes into the analysis, it is only essential to explain outsourcing from the evolutionary economics perspective. The conventional theories on outsourcing are often based on transaction cost and core competency perspectives. The fundamental weakness of these theories is that they fail to accommodate economic change into the analysis. The assumption of the transaction cost theory on outsourcing is that the firm outsources to reduce various costs associated with conducting its business activities. On the other hand, the core competency perspective on outsourcing suggests that the firm should outsource its non-core activities while keeping the core activities in-house. However, the main question is, why do some firms choose a particular point in time to outsource? Why and when do these firms all of a sudden decide to concern themselves with transaction cost or core competency? Certainly, the conventional major theories on outsourcing could not provide a sufficient answer since they often ignore economic changes in their analysis. Economic change is the main driving force that stimulates industry evolution. The question of time is essential to the evolutionary theory. Firms outsource at a particular point in time because of economic change. In addition, it is seemingly impossible to use a single perspective to explain various outsourcing situations. Outsourcing is an important and complex issue. It usually requires various theories to be fully explained. The question is, how is it possible to know when to apply a certain theory to explain outsourcing? Depending on the situation, some theories are more prevalent than others but overall, it is apparent that there is a lacking of a single theory or an indicator that connects all aspects associated with outsourcing together in a systemic framework. Attempting to provide such a systemic framework from the technology evolutionary perspective, which serves as an indicator is one of the goals of this research.
Although some studies on outsourcing do very briefly mention about economic change (Domberger, 1998), these studies often do not go into further analysis of these changes and the scope of these changes often focus solely on macroeconomic changes such as overall economic growth. However, this study would like to suggest that there are various aspects of economic change, in addition to macroeconomic changes, and these changes are related to market, industry, firm, product, technology, and so forth. In light of Schumpeter’s argument on economic changes, this study would like to suggest changes that influence outsourcing are as follow:
1. Changes in macroeconomic conditions such as interest rates, availability of credit, unemployment rate, and general economic performance at the national level or international level and so on.
2. Changes in market conditions such as supply, demand and market growth.
3. Changes in industry condition such as intensity of inter-firm rivalry, concentration of the industry, barriers to entry, and bargaining power of suppliers.
4. Changes in firm condition such as cost structure, core competency, and resources.
5. Changes in product condition such as the stage of the product life cycle
6. Finally, changes in technological condition such as technological performance, intensity of process innovation, or product innovation.
The economic changes related to outsourcing can be viewed from both firm-related internal perspectives and external industry and macroeconomic perspectives. Both internal and external points of view are essential to the evaluation of outsourcing and any analysis of outsourcing would not be complete without both perspectives.
However, this study would like to suggest that before the internal evaluation of firm-related resources and core competency, it is essential to start the analysis of outsourcing from the external perspective. This study will restrict its analysis of the external perspective to the fundamental role economic change plays in industry evolution. The forces that drive industry evolution are changes associated with exogenous and endogenous technical change, rates at which firms imitate each other, differences in segmentation of customers, variation in the initial efficiencies of firms, and random factors that set the industry along a specific evolutionary path (Baum & McGahan, 2004). However, it is mostly believed that the general forces that drive the industry evolution are demand (Levitt, 1965) and technology (Utterback & Abernathy, 1978). Since technological innovation is the main factor that creates a new product market and the stagnation of the rate of product innovation is what causes the market decline, the scope of analysis of this study will be focused on technological changes. The general theory is that technologies and industry co-evolve through time and the outcomes of these co-evolution are aggregate phenomena such as the growth of labor productivity and per capita incomes, relatively regular patterns of innovation diffusion, persistent fluctuations in the rates of income growth, a secular increase in capital intensities, and other
‘stylized facts’ (Dosi & Nelson, 1994). Industry can be interpreted as “a population of business units that is defined by the technology that is common to all of them”
(Bejar, 1998: 62). Technology is defined by Christensen (1992) as “a process, technique, or methodology – embodied in a product design or in a manufacturing or service process – which transforms inputs of labor, capital, information, material, and energy into outputs of greater value” (Christensen, 1992: 336). It is believed that technology and industry co-evolve through time and the development of a technology is one of the factors that coincides with the overall development of an industry. The discussion of technology in evolutionary economics has generally been focused on the innovation and diffusion aspects of technological change. The life cycle of innovation starts from a fluid phase with constant changes in the design of the product. The firms are experimenting with various technologies. The fluid phase is marked by significant uncertainties in terms of research direction and market demand. The sense of the market is lacking since the general public acceptance and awareness of the product is very limited. At the same time, firms tend to be small, and market entry is relatively easy. With time and further product innovation, there is a tendency towards product standardization which signals the increase in entry barriers because of the capital needed to remain competitive. With the
accumulation of technological and market knowledge, the incumbents are at an advantage compared to new market entrants. Later on, the rate of innovation slows down and the innovation life cycle moves into the maturity stage. The firms in the industry also begin to consolidate into several large firms. Finally, the emergence of the replacement technology becomes apparent which marks the decline stage of the innovation life cycle. The replacement technologies usually come from an outsider of the industry. As the industry characteristics change along with the technological evolution, the role of outsourcing is also shaped by such evolution.
The argument is that outsourcing is one of the outcomes of the co-evolution between technology and industry. The role of outsourcing also evolves based on its risks and benefits, along with the co-evolution of technology and industry. In the early stage of this co-evolution, some firms might be willing to take on some outsourcing risks in order to achieve market advantage. However, for the most part, outsourcing is most prevalent in the later stage of this co-evolution between technology and industry. The characteristics of the later stage of the co-evolution are as follows: slow down in innovation, product indifference in the market place, and firms in the market are competing against each other on the basis of price.
Firms in the industry can no longer rely on innovation to maintain or achieve market advantage. At this stage, the benefits of outsourcing such as specialization, flexibility, and cost savings are highly valuable in sustaining the market advantage of the firm; moreover, at this stage, risks associated with outsourcing in terms of potential loss of control over product development, product know-how, and loss of skill become more manageable. As the general focus of the firm changes along with evolution, different aspects of outsourcing are also utilized along with such technological evolution. Outsourcing is primarily a decision based on risk and benefit analysis, and as in any other business decision, the key is to optimize benefit while minimizing risk.
In addition, the evolution economics perspective also allows a systemic analysis that serves as an indicator in explaining outsourcing. Evolution is a gradual and dynamic process of development with a selection mechanism, which weeds out the unfit and only the fit survives. This dynamic process can be patterned and studied in the scale of time unit. The events whose likelihood depends on what happened last, and the condition of the industry in each time period bears the seeds of its condition in the following period (Nelson & Winter, 1982). The evolution of industry follows certain regularity in a form of a life cycle, which evolves from introduction, fragmentation, shakeout, maturity, and decline. Since the role of outsourcing changes along with the development of the life cycle, it provides a sound foundation for the analysis of outsourcing. To explain outsourcing from the evolutionary economics perspective, the idea is to first identify the stage of evolution and industry specific characteristics. The objective is to establish the connection between the specific characteristics associated with the stage of evolution and that of the benefits and risks of outsourcing. However, it is essential to note that outsourcing is only one of the options available to the firm. Adapting to technological and industrial change is one of the main objectives of a firm’s strategy formulation. In light of this aspect, the analysis would then shift to the examination of all available options such as international diversification, merger and acquisition, and so forth.
The importance of this study is to provide an indicator to explain various roles of outsourcing related to the technology evolution which recognizes the
changing industry structure with respect to technological development. The main implication of the technology evolutionary framework is to assist the decision making of the firm in channeling its R&D resources throughout various evolutionary technological stages. The main argument is that the firm should allocate its resources and innovation effort towards product oriented innovation in the early stage and process related innovation in the latter stage of the technological development. However, when the existing technology reaches its inflection point or limitation point, it is only fitting for the firm to focus its effort on new technology. Technology evolutionary theories serve as the bases for R&D decisions. Similarly, technology evolutionary theories should also be sufficient to serve as indicators in explaining outsourcing decisions. As the role of outsourcing changes throughout each technological development stage, it is crucial that the firm should base its outsourcing decision on speed to market and flexibility perspective in the early stage; whereas in the later stage, the decision should be oriented on the basis of cost saving and specialization. On the other hand, from the outsourcing service supplier’s standpoint when making a market entry decision, it is fundamental to examine the unique characteristics of each technological development stage in connection with its capability. In the early technological development, the success of the entry for the outsourcing service supplier depends on its ability to foster speed to market and flexibility; on the other hand, it is also critical to have the capability to reduce costs and enhance specialization in the latter stage. One of the themes of this study is to serve an effort in examining the status of outsourcing during each technology evolutionary stage.
The outline of this research starts from the discussion on the importance of outsourcing. Chapter 2 covers the analysis of the importance of outsourcing in 2.1 and the implementation of outsourcing in 2.2. The originality in Chapter 2.1 is that most of the current discourse on the importance of outsourcing often uses industry figures and numbers to demonstrate the importance of outsourcing; however, the analysis of this study will begin from how outsourcing changes the industry structure through the case of the personal computer industry and also how outsourcing plays a critical role at the national level using the case of how Taiwan was able to escape the Asian financial crisis in the 1997 through its outsource based economy. In Chapter 2.2, conventional literature on outsourcing often treats implementation as a given but the fact is that the actual implementation of outsourcing plays a deciding role in the success or failure of outsourcing. Since implementation is critical in the overall scheme of outsourcing, it should be described in some detail. Outsourcing could not be implemented without a proper partner who is willing to accept the outsourcing contract. Furthermore, in Chapter 3, the originality of this chapter is the inclusion of two additional benefits in the discussion of outsourcing: speed to market and commitment to cooperation.
Outsourcing plays a critical role in the early development of the personal computer when IBM was able to increase its speed to market through outsourcing most of the components to various firms such as Intel and Microsoft. In addition, in many cases such as that of the golf equipment and the handset phone industry, the partnership between outsourcing supplier and purchaser is a form of alliance even though often the supplier and purchaser are also competitors in the market. Through outsourcing, these market competitors complement each other’s strengths and weaknesses. In addition, the objective of Chapter 4, theoretical foundation of outsourcing, is to point out the general theories on outsourcing. Instead of the traditional benefits and
risks perspective, this study would like to explain the major theories on outsourcing through a cooperation and competition point of view, tackling the fundamental issues in outsourcing, which is to cooperate with outsourcing partners to be competitive in the market place or to cooperate with competitors through outsourcing. Outsourcing has traditionally been viewed as a cooperative practice.
However, it is critical to note that the basis of the cooperation depends on the improvement of firm related competitive advantage. Outsourcing is not possible if firms practicing outsourcing cannot achieve better competitive position.
Consequently, it is only fitting to examine the major theories on outsourcing from a cooperation and competition perspective. Moreover, in Chapter 5, the goal is to explain the importance of evolutionary economics from an outsourcing perspective.
The argument is that economic change is critical in explaining outsourcing and the role of outsourcing changes along with industry evolution. The conventional view of outsourcing which mostly focuses on benefit and risk analysis is too static in explaining outsourcing since the role of outsourcing changes from various stages of industry evolution. Through case studies of the personal computer and the golf equipment industry, the objective is to demonstrate that outsourcing in the early industry development is often being valued for its ability to foster speed to market and flexibility; however, in the latter stage of development, outsourcing is critical in terms of cost saving and specialization. The advantage of outsourcing to complement in-house production is also analyzed in this chapter. The main purposes of in-house production are to protect production know-how and ensure product quality control; however, it is evident that in the latter stage of the technological evolution most products available in the market become undifferentiated. Unless in-house production still ensures a good degree of product quality control, it is increasingly unnecessary to maintain production within the boundary of the firm. Furthermore, in Chapter 6, the theme is to introduce evolutionary economics with special analysis on the evolution of technology. The S-curve sequence and dynamics of innovation framework are especially critical to the explanation of outsourcing as indicators. The analysis of outsourcing would not be complete without establishing the current stage of industry technological evolution. As argued earlier, outsourcing is based on a cause and effect relationship.
It is insufficient to explain the effect of outsourcing without taking account of the causes. The changes in technological evolution are one of the main causes of outsourcing. Therefore, it is only fitting to first consider the general theories on technological evolution. Finally, one of the objectives of this research is to provide a systematic framework that serves as an indicator to explain outsourcing and such framework is discussed in Chapter 7. The theme is to provide a framework based on the evolution of technology and industry structure that serves as an indicator to explain the evolutionary role of outsourcing within various stages of industry development. The idea is to first establish the stage of current technology evolution in connection with industry structure, which is the main cause of outsourcing, before extending further on the effect and possible implementation of outsourcing.
An application of the framework as an outsourcing indicator is also supplied in Chapter 8 through the analysis of outsourcing in the golf equipment industry. The general focus is outsourcing of critical components in the golf equipment industry in the latter stage of industry and technology evolution. Outsourcing becomes a common practice in an industry where technology is relatively matured and the rate of production innovation is stagnated.
Before proceeding to the analysis, it is fundamental to clarify some of the frequent terms used in this study. Outsourcing is defined as a “processes involving activities traditionally carried out internally which are subsequently contracted out to external providers” (Domberger, 1998: 12). Outsourcing specifically refers to the change of production from within the boundary of the firm to outside suppliers.
Firms that contract out their production to outside firms will be referred to as outsourcing service purchasers. On the other hand, firm that receive the outsourcing contract is the outsourcing service suppliers or outsourcing service providers. It is also important to distinguish the difference between outsourcing service supplier and component supplier. Outsourcing service supplier is the one that responsible for the production of a certain product that was conducted before within the boundary of the outsourcing service purchaser. However, the component supplier is the one that is responsible for the production of a certain product that has never been produced within the boundary of the purchasing firm. The main difference depends on whether such production actually took place during the production history of the firm or not. Production of components that have never been performed in the firm is considered as supplying goods. On the other hand, production that used to be done in-house but then outsourced is considered as outsourcing goods. This study focuses on the outsourcing of the production goods.
Moreover, by outsourcing, it specifically refers to outsourcing of critical components.
In addition, technology is defined as innovative ways to transform inputs of labor, capital, information, material and various resources into outputs of greater value through a process, technique and methodology. Technology and innovation will be used inter-changeably throughout this study but they all refer to the above definition of technology.
Chapter 2 Outsourcing: its importance and implementation
2.1 Outsourcing and its importance
Before proceeding to the explanation of outsourcing and its importance, it is fundamental to first set up the scope of this research in connection with outsourcing.
The scope of this study with respect to outsourcing can be described as follows:
1. A firm as defined by economists is “an institution that buys or hires factors of production and organizes them to produce and sell goods and services” (Parkin
& Bade, 1994: 1077). The analysis of this study will be based on firms that produce and sell goods instead of services because of the stronger association between technology evolution and firms that produce or sell goods.
2. In terms of production activities, Quinn and Hilmer (1994) distinguish these activities into pre-production (research and development), production, and post-production (marketing, distribution, and sales). In addition, since factors associated with production of goods in-house or production via outsourcing it to outside firms is the general focus, this study will not address areas associated with outsourcing of marketing, advertising, accounting, information technology and so forth. The inclusion of the non-production activities might distract from the main concern of this research.
3. Production can be divided into assembly goods and non-assembly goods.
Assembly goods are products such as televisions, computers, automobiles, various home and office appliances, and so forth. Examples of non-assembly goods are petrochemicals, sulfuric acid, nylon, synthetic fibers, etc. Assembly goods and non-assembly goods need to be distinguished since the dynamics of innovation for non-assembly goods is different from that of the assembly goods according to Utterback (1994). The process innovation for the non-assembly goods emerged in the dynamic of innovation cycle earlier than that the assembly goods as well as the dominant design. Factors for outsourcing of assembly goods and non-assembly goods will be examined separately.
According to Greaver (1999) , outsourcing is a term created by the information system trade press in the late 1980s. The basic connotation is to explain the growing trend of large firms transferring their information systems to outside agents. Outsourcing involves a making or buying decision on whether a certain activity is to be conducted in-house or through an outside agent. However, outsourcing can be interpreted differently based on various situations and needs.
Outsourcing can occur for the purpose of utilizing outside resources to complement one’s own organizational design and development effort (Prahalad & Hamel, 1990:
83). On the other hand, outsourcing can be defined as “processes involving activities traditionally carried out internally which are subsequently contracted out to external providers” (Domberger, 1998: 12). The main difference between these two interpretations is that in the first interpretation, outsourcing refers to a firm related activity that has never been performed within the organization and the latter one refers to a firm related activity that used to be performed within the organization but subsequently outsourced to outside suppliers. The primary concern of this study is the latter interpretation that is the outsourcing of a firm related activity traditionally executed within the organization but subsequently outsourced
to outside suppliers. In order to study economic changes and the evolutionary process of the industry, it is essential to focus on the latter interpretation in order to study the changes in production activities in the industry.
Brief history on outsourcing
The origin of outsourcing can be traced back to at least the eighteenth and nineteenth century England when outsourcing or contracting “services provided by the private sector under contract included prison management, road maintenance, and the collection of public revenue. Street lamps were made, fixed, cleaned, and lit under contract. Early convict fleets, excluding the First Fleet (to Australia), which left Portsmouth in 1787, were also operated by private contractors” (Domberger, 1998: 8). The early outsourcing activities from the public sector are common phenomena not only in England but also in France: “Similar, in early nineteenth century France, the rights to build and operate railways and water storage and distribution facilities were auctioned by competitive tender” (Domberger, 1998: 8).
Outsourcing first started from the public sector as governments outsourced many of their responsibilities to private contractors. Compared with vibrant outsourcing activities in the public sector, it is relatively recent to witness extensive outsourcing in the private sector. A good illustration is the wide spread outsourcing practices of information systems in the information technology industry: “the outsourcing of information system can be traced back to 1963 when Ross Perot and his company Electronic Data System (EDS) signed an agreement with Blue Cross of Pennsylvania for the handling of its data processing services. This was the first time a large business had turned over its entire data processing department to a third party” (Hirschheim & Dibbern, 2002: 5). However, outsourcing practices in the private sector really took off in the 1980s when EDS signed outsourcing contracts with Continental Airlines, First City Bank and Enron: “these deals signaled an acceptance of outsourcing which heretofore did not exist. These three deals were financially motivated deals where EDS took an equity position in its client and paid handsomely for certain software products which it thought could be extended and used to attract new clients” (Hirschheim & Dibbern, 2002: 5). Since the late 1980s, outsourcing becomes a common practice both in the public and private sector;
however, this study will focus the analysis on the private sector specifically. The reason for selecting the private sector as the unit of research is that industry evolution does not play a foundational role in the decision making process of public sector outsourcing. For the most part, outsourcing in the public sector is usually based on the cost motive. In addition, outsourcing in the private sector is a growing phenomenon that requires further examination in some areas within the private sector. Outsourcing revenue from information technology (IT) for instance is estimated by Dataquest, to be $194 billion in 1999 and to grow to $531 billion in 2002 (Hirschheim et al., 2002). At the firm level, outsourcing is a widely practiced phenomenon based on a 1996 survey conducted by KPMG Peat Marwick LLP of Fortune 500 management. 94 per cent of these firms responded that they outsource and predicted a market increase. Of these respondents, 86 per cent expect to see a further increase of their outsourcing activities over the next five years (Greaver, 1999). There is no doubt that outsourcing has become a common business practice around the world. Outsourcing is a trend that is growing at a tremendous pace.
Importance of outsourcing
The conventional analysis of outsourcing often explains the importance of outsourcing based on the statistical figures and industry size. However, this study would like to attempt to explain outsourcing from the industry and national economic structure perspective through the case of the personal computer industry and the case of how Taiwan was able to escape the 1997 Asian financial crisis with its outsourcing based economic structure.
2.1.1 Firm and industry level
It is argued that the development of technology shapes the overall industry structure (Mueller & Tilton, 1969; Abernathy & Utterback, 1975). Especially, the intensity of innovation plays a fundamental role in determining the industry structure as innovation introduces new products to the market, standardizes the product and finally the slow down in innovation that brings the market into a decline. Through an illustration of the computer industry, the first part of this chapter would like to argue that the outsourcing decision of the firm that shapes the
“dominant design” might also have an impact on the development of industry structure. The dominant design is defined as “a product class is, by definition, the one that wins the allegiance of the market place, the one that competitors and innovators must adhere to if they hope to command significant market following”
(Utterback, 1994:24).
IBM (International Business Machine) was the firm that brought the dominant design of microcomputer or personal computer to the market: “the personal computer was IBM’s second foray into this market, after the 5100 – it even had the designation 5150 in some product literature. Neither IBM nor anyone else foresaw how successful it would be, nor that others would copy its architecture to make it the standard for the next decade and beyond” (Ceruzzi, 1998; 272). The IBM personal computer was introduced on August 12, 1981, and soon became the industry’s dominant design, with an open system. The microprocessor selected was the Intel 8088 operating at 4.77 MHz, the operating program (BASIC) was provided by Microsoft, the printer was an Epson MX-80 with an IBM label, and so forth. The price of the basic system unit was around $1,565 and an upgraded unit was about
$2,235 (Allan, 2001).
One of IBM’s main businesses before the 1980s was the development of computers for institutional application since IBM produced most of the computer tills and terminals in banks. IBM was largely absent from the rapidly growing microcomputer market for personal application. The leading manufacturers of microcomputers were Apple Computer, Commodore and Tandy Radio Shack (Allan, 2001). Of these producers, Apple Computer with its Apple II, a microcomputer without a monitor but with keyboard built into a plastic case which allows people to play games, was the most prominent player in the market (Wurster, 2002). IBM realized it could not ignore the potential business opportunity in the microcomputer market. In order to enter the microcomputer market, IBM made two proposals: the first proposal was to buy a personal computer company or a personal computer design, such as that from Atari. Or IBM could also design and build a new personal computer but to do it outside of the normal corporate structure (Allan, 2001).
Eventually, IBM decided to build its own personal computer and dispatched twelve
engineers to develop the prototype of the personal computer. This team was coded with the name of “Chess” and was stationed in Boca Raton, Florida. With the success of the personal computer, this team of twelve engineers grew into a work force of 9,500 by 1984 (Allan, 2001).
IBM’s introduction of personal computers in August 1981 not only standardized the market for microcomputer but also shaped the future development of the industry structure. The future development of the industry structure for personal computer was determined when IBM made the decision to outsource the processor and the operating system: “as a break with IBM tradition, neither the processor nor the operating system (DOS) were developed in house but were brought in from outside” (Wurster, 2002: 311). Although IBM had the capability to manufacture its own process, the processor that went into IBM’s personal computer in 1981 was produced by Intel: “IBM had plenty of technology of its own, so it could have done its own processor, but Estridge never considered that seriously. IBM had been too slow in turning earlier processor technologies into products, so they had bombed when they were introduced. (In computer industry, the speed of the development process largely determines the speed of the chip. If companies building chips have access to the same basic technologies – as usually happens – whoever can use them in a new chip first has the fastest chip on the market)” (Carroll, 1993:
128). In addition to processor, in order to keep up with the fast pace of the industry development, IBM decided to outsource the operating system to Microsoft:
“Microsoft was best known for its version of BASIC (a computer programming language). IBM had developed a version of BASIC for a product called the System/23 Datamaster, but the need to reconcile this version of BASIC with other IBM products caused delays. The Chess team saw what was happening in the personal computer field, and they recognized that any delays would be fatal. As a result they would go outside the IBM organization for nearly every part of this product, including the software” (Ceruzzi, 1998: 169). In light of the decision to outsource every part of the personal computer, the IBM’s personal computer became an open system that allowed others to copy its architecture to make it the dominant design for the industry. The decision of IBM to adopt Microsoft’s software also transformed Microsoft from a small company to a dominant firm in the computer operating system: in 1979 Microsoft had only 28 employees with a turnover of almost 2.5 million dollars from a firm with 90% of the market share in operating system (Wurster, 2002). In addition, IBM’s outsourcing decision also transformed Intel from a money losing company to a dominant firm in the processor industry.
IBM’s decision to outsource almost every parts of its personal computer shapesdthe development of the industry structure. IBM lost control of its outsourcing service suppliers and the personal computer industry became an industry that was dominated by Microsoft and Intel: “most of IBM PCs, including the 8088 microprocessor, consisted of parts made by other manufacturers, who were free to sell those parts elsewhere. Microsoft, for instance, retained the right to sell its operating system to other(s)” (Ceruzzi, 1998: 277). Furthermore, the earlier decision of IBM to outsource almost every part of the components allowed IBM’s competitors to clone similar products and compete against IBM in the market: the founders of Compaq Computer “conceived of the idea of reverse engineering the IBM PC and producing a machine that would be 100 per cent compatible…the Compaq computer, delivered in 1983, was portable, although heavy…what made it a success was its complete compatibility with IBM PC at a competitive price”
(Ceruzzi, 1998: 277). In addition to Compaq Computer, there was a series of producers that made their products completely compatible with IBM’s product. In a test of compatibility between IBM’s product and that of its competitors, the result indicated the perfect compatibility. IBM’s product is no different from that of its competitors and all of them were based on Intel processors and Microsoft’s operating system: “the biggest winner was Microsoft, whose operating system was sold with both IBM and their clones” (Ceruzzi, 1998: 279).
IBM’s decision to outsource in the early development of personal computer industry created a structure that was dominated by component suppliers.
Outsourcing provided IBM with speed to market; however, IBM eventually had to suffer the price for this, losing control over its outsourcing suppliers. In addition, under creative imitation of the product, IBM also eventually lost control of the architecture of its product and the market became an open market for competition:
“there was a little discussion about whether using outsiders’ parts would mean IBM couldn’t control the direction the market would take, the way IBM controlled everything abut the lucrative mainframe market. But nobody in the room had the foresight to realize either how important the personal computer market would become or how little control IBM would, in fact, have” (Carroll, 1993: 22). It is obvious that IBM’s outsourcing decision changed the development of the personal computer industry. The question to ask is that had IBM retained most of its production in-house would it have altered the eventual industry structure?
2.1.2 National level
It is well documented that many of Taiwan’s main business segments are outsourcing oriented such as the semiconductor industry, computer industry, golf equipment industry, scanner industry, athletic wear industry and so forth. In an analysis of how Taiwan was able to escape the 1997 Asian financial crisis, Huang (2004) points out the sound economic performance, small and medium size firm based with outsourcing oriented economy, and stable credit cycle are the main reasons that Taiwan was able to withstand the crisis. In addition to the strong economic fundamentals, it is important to note that Taiwan also has a different business structure from the crisis-inflicted Asian countries such as Korea. Chen and Kuo (2000), Shea and Shih (1999), and Noble and Ravenhill (2000) point out that differences in terms of the business structure between Taiwan and the distressed countries, especially Korea, allowed Taiwan to escape the crisis. It is exactly these differences that gave the Korean firms lower return on assets than that of the Taiwanese firms. The differences between Taiwan and Korea, in terms of business structures, can be summarized as follow: the size of the firms, the targeted markets of the firms, and the sales strategies of the firms and finally capital requirements of the firms.
The composition of the size of the firms in Korea and Taiwan is very different.
In the case of Taiwan, the majority of firms could be categorized as small to medium sized enterprises (SMEs); about 98 percent of enterprises in Taiwan would fall into the SMEs category (Chow et. al, 2000: p.160). On the other hand, the domination of large conglomerates, the chaebol, in Korea was very significant. The top five conglomerates in Korea contributed 75 percent of manufacturing GDP (Nobel &
Ravenhill, 2000: p.87). Most analysts have agreed “the division of labor between SMEs and large enterprises provides Taiwanese industry with flexibility and timely
delivery” (Chow, 2000: p.160). The flexibility of the SMEs provided the economy with maneuverability in dealing with financial fluctuations. In a booming economy, the big firms enjoy selling standardized products through mass production, but it is harder for the big firms than the SMEs to adjust to over-capacity in a time of economic slowdowns.
The less flexible conglomerate-based economy placed Korea in a disadvantaged position during the economic slowdowns; on the other hand, the production capability of the big firms gave Korea an advantage during economic booms.
Consequently, Korea should choose its market carefully; avoid a low growth market and target a high growth market. Unfortunately, as Nobel and Ravenhill (2000) point out, “Korea’s concentration on a slow-growing market was one reason why its exports fared less well in the mid 1990s than those of Taiwan. In electronics, almost 60 percent of Korea’s exports were directed towards markets where demand is declining or stagnant; in contrast, about 55 per cent of Taiwan’s electronics exports went to a rapidly growing US market and to the European Union” (Noble &
Ravenhill, 2000: p.89). In addition, Nobel and Ravenhill (2000) reveal further that a large part of Korea’s exports concentrated in sectors such as memory chips, automobiles and shipbuilding, which were characterized in the mid 1990’s by world over-capacity and declining prices.
In addition, Taiwanese firms maintained a different sales strategy than that of the Korean firms. The Taiwanese companies have concentrated on original equipment manufacturing (OEM) contracts for products sold under the brand names of US and Japanese firms; whereas, the Korean companies usually market their products under their own brand names (Wang, 2000: p.160). Taiwan’s SMEs often develop into specialized satellite firms with core competence in production of key components. The Taiwanese SMEs do not become a subordinate of a specific big enterprise; they undertake OEM orders from several big firms. It is exactly this kind of division of labor between Taiwanese SMEs and international large enterprises that gave Taiwan more national flexibility in dealing with financial fluctuations (Chow, 2000: p.160). On the other hand, selling their products under their own brand names gave the Korean firms an advantage of brand loyalty and higher margins, but it also placed them in direct competition with companies from larger industrialized economies. The Korean firms did not gain the advantage of having their own brand names because “ Korean brands in various sectors-especially automobiles and consumer electronics-acquired a negative reputation in the North American market in the late 1980s that hindered their efforts to penetrate the world’s largest single market” (Noble, 2000: p.89). In fact Korea’s exports to the industrialized countries declined from 70 percent to 43 percent (Noble, 2000, p.89) during that time.
In addition, the nature of the large firms required more capital than that of the SMEs, since to remain competitive the large firms have to reach economies of scale and a large market share, in order to be sufficient. As Chen and Kuo (2000) point out “ …when interest rates were suppressed and credits were rationed, large business conglomerates were induced to maximize their assets and growth rather than to strive for immediate profitability” (Chow, 2000: p.123). The result of the above situation was over-investment and over-capacity. The Korean firms were highly leveraged because of their dependency on loans and other instruments of debt, rather than that of equity shares. Table 2.3 shows two indicators of the financial leverage of Korean and Taiwanese private manufacturing firms.
Table 2.3 Financial structure of private manufacturing firms in Korea and Taiwan, 1991-1996
Korea Taiwan
Year Loan ratio Debt-equity ratio Loan ratio Debt-equity ratio
1990 44.59 285.52 33.95 111.31
1991 44.51 306.68 34.64 115.22
1992 47.18 318.73 35.19 119.89
1993 46.75 394.88 33.74 118.95
1994 44.54 302.52 33.15 118.35
1995 44.76 286.75 33.20 126.62
1996 44.66 317.11 28.18 111.04
Source: Chow and Gill (2000)
From the business structure perspective, the less flexible and highly leveraged Korean conglomerates were the factors that pushed Korea into the crisis.
In contrast, the outsourcing based Taiwanese SMEs pulled Taiwan away from the Asian financial storm. The outsourcing oriented Taiwanese SMEs allows Taiwan to diversify its market and also fosters the specialization of business activities in production instead of marketing. In the wake of market demand fluctuation in the early 1990s, Taiwan was able to channel these risks to multinational firms through outsourcing.
The importance of outsourcing at the industry level as indicated in the personal computer industry is to increase the speed to market and create flexibility for the outsourcing service purchasers such as IBM in the early stage of industry development. In addition, in the wake of financial uncertainty, the outsourcing oriented economy such as that of Taiwan, outsourcing provides a better market diversification, hence, reduces risks associated with market uncertainty as well as fosters business specialization. At the national level, outsourcing provides the benefit of risk reduction associated with market demand.
2.2 The implementation of outsourcing
A good decision can be easily sabotaged by poor implementation. Although outsourcing has been the topic of discussion on several volumes of study, the actual implementation of outsourcing has often been overlooked in academic oriented literature. Academic studies have often been criticized as unpractical, out of touch with reality, and most of all inapplicable in a real world setting. Therefore, it is unwarranted and dangerous to ignore how outsourcing is actually done in a real business environment. Outsourcing in this study is not only a term but it should also connote with a sense of how outsourcing has actually been implemented in a real business setting. The actual implementation of a decision to outsource is an inseparable part of the process which could strongly affect the outcome of the outsourcing venture. The conventional literature on outsourcing often perceives implementation of outsourcing as given and should be easily implemented if the analysis has been done in advance. But it is important to note that the analysis of outsourcing is only a step in the entire scheme of things related to outsourcing. The actual implementation and execution of outsourcing arrangements is a complex strategic issue and should not be treated lightly. The success or failure of a decision to outsource depends on issues such as trust, coordination, and so forth, which are
strongly connected with implementation. Without a successful implementation, the entire outsourcing process would not be fruitful to the firm. In short, the analysis of outsourcing is only a part of a process not the end result but conventional analysis of outsourcing often overlooks the implementation part. Greaver (1999) suggests seven steps to a successful outsourcing endeavor:
1. planning initiatives
2. exploring strategic implications 3. analyzing costs and performance 4. selecting providers
5. negotiating terms 6. transitioning resources 7. managing relationships
The seven steps of outsourcing as indicated above can be divided into two parts:
the internal and external arrangements. Step 1 to step 3 involve internal arrangements and decision making within the firm on the topic of whether to outsource or maintain in-house production. These are treated as internal arrangements because these units are on an inter-personnel basis within the boundaries of the firm. The topic on issues related to internal arrangements of outsourcing is actually one of the objectives of this thesis, that is to supplement the internal decision making process of outsourcing through evolutionary economics.
Since the analysis of outsourcing has been discussed in other parts of this study, the subject of this section will focus on the external arrangements of outsourcing.
Unlike internal arrangements of outsourcing, the external arrangements of outsourcing are based on the unit of inter-firm perspective as described in the above list, from step 4 to step 7. The external arrangements of outsourcing will be further elaborated in the remaining part of this section.
2.2.1 The selection of outsourcing service provider
It is believed that in any business venture the characteristics of the venture partner greatly affects the success or failure of the project. Outsourcing would not be successful without an efficient partner. Outsourcing is a form of cooperation between firms. The first step in any cooperation is to locate the partner. The ability to coordinate and cooperate with outsourcing service providers is very critical to the overall success of the outsourcing venture. It is very common to see that firms keep more than one outsourcing service provider in order to reduce risks and provide a better position to negotiation on price, delivery, and so forth. The guidelines for selecting outsourcing service providers depends on the characteristics of the industry involved, the policy of the firm, degree of services required and so forth.
For example, Nike stresses on the importance of labor conduct in locating its outsourcing service providers since poor labor conduct of its outsourcing service providers often reflects on the overall imagine of the Nike brand. In the automotive industry where efficiency strongly associates with the coordination of production, Toyota emphasizes the ability of its outsourcing service providers to coordinate with its “just in time” production system. In the computer industry where time to delivery is critical to the overall customer service satisfaction, Dell computer requires its outsourcing service providers to be fully integrated into its logistic and
delivery networks in order to execute a purchase order more efficiently. In general, Greaver (1999) points out the importance of networking with contacts in addition to looking at industry association directories when locating outsourcing service providers. The first step is to identify the greatest number of outsourcing service providers who might have the right capabilities and might be interested in providing outsourcing services. After the determination of the possible pool of outsourcing service providers, the next step is to narrow down the list of possible providers through the following general points in addition to price and cost consideration as suggested by Greaver (1991):
1. demonstrated ability to deliver today 2. experience to deliver
3. provider strength 4. superior performance 5. deserved positive reputation 6. proven customer satisfaction
7. strong capitalization / financial stability 8. proven management capabilities
9. shared approach to problem solving 10. commitment to continuous improvement 11. strong transition experience
12. commitment of specific resources 13. trust, security, confidentiality 14. positive attitude
15. good chemistry 16. good cultural fit 17. flexibility to change 18. cost conscious
19. willingness to share cutting-edge knowledge 20. clear vision of their market
The above list provides the general direction for firms when looking into narrowing down its list of potential outsourcing service providers. Even though the above list provides a general direction, it does not include the actual evaluation of points in the list. The evaluation process focuses heavily on the past result and general reputation of outsourcing service providers. Consequently, Greaver (1991) further suggests that the firm could actually discover a lot of characteristics of outsourcing service providers through the following methods:
1. observation of their existing operation
2. in-depth technical interview with the key personnel to be assigned 3. role-playing with the key personnel to be assigned
4. examination of the resulting product or service
5. reference checking on a test basis from a complete customer list 6. review of relevant documents and independent reports
7. discussions with suppliers
8. discussions with former customers 9. discussions with former employees 10. discussions with competitors
11. discussions with knowledgeable consultants or advisers in the industry 12. actual test runs through their process
The first step of the outsourcing implementation is the selection of outsourcing service providers which is a complex process and should be determined based on several factors as described above. In general, outsourcing involves a contractual relationship between the outsourcing service purchaser and the outsourcing service providers. Once the outsourcing service providers have been decided, the next step is to negotiate contract terms regarding outsourcing.
2.2.2 Negotiation of outsourcing terms
Contract is an official written agreement between two or multiple parties.
In the case of outsourcing, it is a form of agreement between the outsourcing service purchaser and the outsourcing service providers. Contract is an essential part of outsourcing. A contracting agreement, by specifying the rights and obligations of purchasers and suppliers in various future states of the world, supply incentives for the efficient sharing of risk and information (Deakin and Michie 1997). An outsourcing agreement results in a risk-sharing venture between purchasers and suppliers. Domberger (1998) distinguishes the difference between outsourcing and contracting: “contracting refers to the design and implementation of contractual relationships between purchasers and suppliers. Outsourcing refers to the process whereby activities traditionally carried out internally are contracted out to external providers” (Domberger, 1998, pp.12). Although this study focuses on outsourcing instead of contracting, by the above definition, it is clear that contractual agreement is also a critical part of outsourcing. The content of the outsourcing agreement is negotiated between the parties involved in advance. The contract negotiation part of outsourcing is very critical since any acceptance of unfavorable terms might be detrimental to the overall performance of the firm. Once the number of eligible outsourcing service providers have been narrowed down to a short list, it is suggested by Greaver (1991) that the negotiation part of outsourcing involves a series of sharing information, bidder’s conference, interviews and so forth. Greaver (1991) reveals that a sufficient working outsourcing contract should include the following terms:
1. scope of services
2. performance standards 3. pricing
4. factors of production 5. management and control 6. transition provisions 7. billing and payment terms 8. termination provisions 9. other issues
① contract term
② confidentiality
③ warranties / indemnities
④ limits of liability
⑤ use of subcontractors
⑥ third party licenses
A contract is an agreement between parities involved on several major issues but the top 3 issues from the above list are the most important ones. First, the scope of services, both parties need to reach an agreement on the duration of the contract, outline specific activities required, as well as the specific services prescribed. Often, for the purpose of the production planning, the outsourcing service providers would like the service purchasers to be very specific on the duration of the contract. However, the outsourcing service purchasers usually would like to free themselves from committing to a fixed contract in case of change in the demand. Although both sides are concerned about risk, each side looks at the contract from different perspectives: outsourcing service providers look at the contract from the production angle; on the other hand, the service purchasers are concerned about market demand and change in consumer tastes. In addition, it is very common for outsourcing service purchasers to maintain two or more service providers in order to reduce risks associated with production. In addition, with two or more service providers, the outsourcing service purchasers would have opportunity to keep service providers’ price and services in check. Once, the scope of services has been decided, the next step is to discuss the performance standards:
“ideally, the contract should specify, with as much precision as possible, a standard for each significant activity that is being performed – and perhaps more than one standard, if the activity is directly related to the reasons to outsourcing. For example, if a particular activity had a significant impact on both quality and cycle time, and these were the reasons to outsource, then the performance of this activity should be measured against both standards” (Greaver, 1999: 239). It is only appropriate that the outsourcing service provider follow the prescribed standard and measurement and be subjected to regular audit in order to ensure that the products or services are delivered according to the requirements. In the case of non-performance of the contract, there should always be an option for an early termination of the contract. Finally, the pricing schedule is also a very crucial factor in the process of negotiation. It is a common practice to have a price adjustment mechanism in place in order to ensure the rights of both parties in the case of sudden changes in the organization’s business. The terms related to price adjustments are changes in the cost of living standards, foreign currency translation, and so forth. The purpose of the price adjustment is to reflect the economic reality and it is analyzed on the basis of the nature of costs and changes in the broader business conditions.
2.2.3 Managing relationships
Outsourcing is a form of alliance between firms. Hence, trust is a very critical issue in any alliance. An alliance based on cold contract terms is hard to last and almost impossible to be sustainable in the long run. Therefore, it is essential to maintain regular contact between firms in order to foster understanding and build trust. The meeting and discussion should be held regularly both at the senior management level and regular personnel level. In order to foster understanding and effective coordination, it is only reasonable to exchange ideas on the future development plan of the firm or problems encountered in the transaction process and so forth.
The implementation of outsourcing is a complex issue, which involves partner selection, negotiation of terms, and managing outsourcing relationship. In this section, the theme is to explain how outsourcing is actually conducted in a business environment. Outsourcing is impossible without a reliable partner and certainly would not be mutually beneficial without managing such a relationship.
Outsourcing is not a simple issue, which certainly does not end with just a risk and benefit analysis. Furthermore, when problems associated with outsourcing occur, it becomes critical to rely on the previously negotiated terms in order to protect each party. A proper analysis of outsourcing has to consider the possibility of implementation. Outsourcing could not occur if there were no sight of a reliable partner. A sound analysis of outsourcing should also include the implementation aspect.
Chapter 3 The benefits and risks of outsourcing
The issue of benefits and risks are central to the adoption of outsourcing.
Outsourcing is more than a means to reduce short term direct costs. To a certain degree, effective outsourcing can lower the level of uncontrollable risks and unwanted management problems onto outsourcing service providers. Quinn and Hilmer (1994) describe the case of Gallo, the largest producer and distributor of wines in the United States, which manages the risks associated with weather, land prices, and labor problems onto its outsourcing service providers. To a greater extend, Argyle Diamonds, one of the world’s largest diamond producers, outsources virtually all aspects of its operation except the critical steps of separation and sorting of diamonds. One of Argyle Diamonds’ efficiencies rests on the fact that it outsources its huge earth moving operations to avoid capital and labor risks, its housing and food services for workers to avoid confrontations on non-operating issues, and its distribution to De Beers to protect prices, to finance inventories, and to avoid the complications of worldwide distribution. Although outsourcing is an effective means to transfer unwanted risks to the providers, the fact is that risks can not be fully transferred to providers or anyone else (Greaver, 1999). Risks can only be transferred to a certain degree but not completely since outsourcing service providers might not be able to perform satisfactorily and customers are lost. The labor conduct of Nike’s outsourcing service providers strongly reflects on the corporate and brand image of Nike. The firm might run into the risks of tarnishing its long term reputation because of unsatisfactory conduct of its outsourcing service providers. While it is possible that contractual liquidation damages might salve the wounds but the losses can not be fully compensated. Contractual damages such as losses of business reputation, customers, and revenues are very difficult to recover and to calculate in financial terms. In addition, there is always a possibility that outsourcing service providers might default on financial compensation or obligation when losses incurred during a transaction.
According to David Ricardo, the accumulation of wealth depends on the extent to which the production and exchange are realized. The efficiency in utilizing production and exchange is crucial to the long term survival of the firm. Therefore, the benefits of outsourcing stem from the efficiency gained through exchange instead of production. By exchange, the nature should be the one that combines market discipline with long term, cooperative relationships (Domberger, 1998). The discussion on the benefits of contracting has received intensive attention recently (Quinn & Hilmer, 1994; Greaver, 1999; Lacity & Willcocks, 2001; Milgate, 2001;
Gouge, 2003). However, the argument for the benefits of contracting has primarily been made from the outsourcing service purchaser’s perspective instead of the provider’s point of view. Domberger (1998) summarizes four main benefits of contracting including specialization, market discipline, flexibility, and cost savings.
It is beneficial for firms to conduct their core activities in-house and contracting out their non-core activities. Through specialization, firms can concentrate on value added activities and contracting out supporting activities to other firms. In addition, outsourcing also allows the separation of purchaser from provider. The purchaser will focus on the demand side and concentrate on consumption whereas the supplier will place its emphasis on the production side. Furthermore, contracting also provides flexibility in which firms could adjust the scale and scope of production more freely according to market demand. Last, contracting is also an effective cost
reduction tool: “international studies show that significant cost savings are achieved by contracting, on average, in the order of 20%” (Domberger 1998, pp.51).
Through contracting, the purchaser can focus on higher value added activities in a more flexible and cost efficient posture.
On the other side of the coin, the cost of outsourcing might out weigh the benefits in some instances. The costs of outsourcing can be identified as follows:
hollowing out, loss of skills and corporate memory, weakened innovative capacity, transition and switching costs, and loss of control over suppliers (Kakabadse &
Kakabadse, 2000; Quinn & Hilmer, 1994). Hollowing out means “turning an organization into an ‘empty box’, by performing manufacturing and other operations outside” (Domberger, 1998: 69). One of the risks of hollowing out is the possible loss of skills such as production skills, quality control skills, and inter-firm coordination skills. The primary concern with loss of skills is the possible loss of the ability of the organization to recover necessary skills when required (Domberger, 1998). In addition, the firm might also lose the innovative capability with extensive outsourcing. In connection with the outsourcing of production, it is possible that the firm might lose the critical innovative production capability since production activity is no longer performed in-house. Furthermore, there are also various costs associated with outsourcing: costs such as transacting costs, monitoring costs, and switching costs. The inefficient management of these costs might lead to great financial losses for the firm.
The initiation of the decision to outsource heavily depends on the analysis of benefits and risks. The objective of the analysis is to utilize benefits while containing, or if possible, minimizing risks. Outsourcing is implemented only when risks are perceived as manageable. Since the decision making process of outsourcing is one of the themes of this study, with the critical role of risks and benefits analysis, it is only logical to further elaborate on such aspect in detail.
Regarding the benefits analysis of outsourcing, Domberger (1998) points out four main benefits of outsourcing which have been referred to extensively by literature on outsourcing: specialization, flexibility, market discipline, and cost saving.
However, the point regarding market discipline which is described by Domberger (1998) allows purchasers to focus on output instead of input (follows the line of argument in the point about specialization) and creates competition between suppliers (similar to that of price competition in the cost saving analysis). The separation of market discipline from the rest of the benefits is unnecessary since it is redundant: As a modification, this study would like to replace the point on market discipline with commitment to cooperation. The reason for such a replacement will be explained in the latter part of this section. On the other hand, this study would like to re-organize risks analysis of outsourcing into the following perspectives:
potential loss of skill, trust and potential loss of control, and various costs associated with outsourcing.
3.1.1 Specialization
Specialization in outsourcing refers to the concentration on the core competence of the firm and outsourcing the supporting goods and services to outsourcing service providers. The idea of specialization is closely connected with the “core competence” school (Hamel & Prahalad, 1994). In the late 1980s and early 1990s, America suffered a long wave of recession which signifies the trend towards
