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This term paper is concerned with explanations for outsourcing activities form the viewpoint of organizational theories. Based on the evolution of outsourcing research and findings about organizational theory, the authors find the resource based view, transaction cost economics, as well as core competences to be the most frequent explanations for outsourcing. The relations of these theories to outsourcing as well as their differences are investigated. The term paper at hand concludes that these theories provide a solid basis for explaining the increasing outsourcing activities of companies, but further research on case examples in this field is needed to strengthen the theoretical linkage between organizational theory and outsourcing.
Table of Contents
Due to the relentless trend of globalization, outsourcing is a topic of ever increasing importance - not only in business life, but also in academia. From a business perspective, most companies justify outsourcing activities by highlighting the savings potential and therefore the increase or maintenance of international competitiveness.
In academia, several research streams investigate the justification for outsourcing. A thorough review of theories applied to this field in peer-reviewed academic journals between 1995 and 2006 is provided by Perunovic and Pedersen (2007). A similar study is conducted by Gottschalk & Solli-Saether (2005). In order to narrow down the exhaustive research findings towards the most commonly used ones, this seminar paper investigates the resource based view (RBV), the transaction cost economics (TCE), as well as core competences (CC).
The academic relevance of this paper is a thorough explanation of the outsourcing process and theory by the application of important concepts of organizational theory. This approach is somehow different from the ones of the above-cited papers, because instead of giving an overview of all theories related to outsourcing, this seminar paper focuses on the seemingly most-researched ones. A business-related relevance of this paper is the finding that outsourcing need not only be a reasonable practice due to possible savings and cost-cuttings, but also because of other factors that are explained in more detail later on.
The remainder of this paper is as follows: Chapter 2 is concerned with the concept of outsourcing and the processes and steps related to it. The following chapter provides an overview of the evolution of outsourcing in academic research. Chapter 4 is the core of this seminar paper and investigates the relation of RBV, TCE, and CC to outsourcing and provides reasons for outsourcing by applying these theories. Chapter 5 summarizes and discusses the results, while chapter 6 concludes the paper with suggestions for further research.
Concept of outsourcing and its processes/steps in the academic literature
According to academics, the concept of outsourcing is a process that involves three aspects. Firstly, the activity which is outsourced is a specific asset. Secondly, the strategic partnership needs to be secured by a complete contract to ensure adherence from both parties. Lastly, outsourcing always goes hand in hand with ex post transaction costs (Barthélemy & Quélin, 2006).
Perunovic and Pedersen (2007) cluster the outsourcing process according to five stages. These are preparation, vendor selection, transition, managing relationship and reconsideration. Especially the first three are given significant importance in academic research. This can be inferred from the vast amount of frameworks describing the stages. In addition, the authors create a framework, which includes several key questions for companies per outsourcing stage. These questions need to be answered in order to complete an outsourcing process successfully (Perunovic, Christoffersen, & Williams, 2006).
Espino-Rodriguez and Padrón-Robaina (2005) emphasize that outsourcing only takes place if the service provider can offer superior capabilities, resources and knowledge to its customers and is able to conduct the processes more efficiently. Hence, it is a win-win situation for both parties in the relationship. Nevertheless, the basis for a working strategic relationship is always mutual trust (Greaver, 1999).
A major benefit of outsourcing is that the freed financial and human resources can be employed for activities with higher returns. In addition, the outsourcing service provider usually is more efficient, and therefore the performance of the buying firm increases considerably (Quinn, 1992). Instead of sorely focusing on cost reduction, like McIvor (2009) proposes in his paper, companies follow another reason for taking an outsourcing decision. It is quality problems with the processes realized in-house. Hence, the outsourcing partner is used to increase the product or service quality (Teng, Cheon, & Grover, 1995).
In the recent past, companies tend to outsource more and more strategically important activities and the related resources (see Chapter 4). McIvor (2009) mentions the example of customer relationship management.
Evolution of outsourcing research
In this chapter we would like to give a short overview over the evolution of outsourcing theory. The research of outsourcing gained first interest in the field of Information Systems functions. In the beginning, the outsourcing of IT systems was only interesting for medium sized departments. But in the 1990s "outsourcing became a serious strategic choice for firms and emerged as one of the top ten issues for survival" (Lee at al., 2000).
In the 1990s, a variety of studies have been conducted and addressed a variety of outsourcing research issues like make or buy, motivation, scope, performance, insourcing-or-outsourcing, contract and partnership (Lee et al., 2000). In addition a lot of organizational theory approaches are applied to this field: Transaction Coast Economics, Relation View, Core Competences, Evolutionary Economies, Incomplete Contracts, Resource-based View, Agency Theory, Knowledge-based View, Neoclassical Economy Theory, Social Exchange Theory and Economics of Information (PerunoviÄ‡ and Pedersen, 2007). This short overview shows that the theory of outsourcing was applied to several field and theories in the last twenty years.
Theoretical concepts to explain the phenomenon of outsourcing
Many papers including the one from Perunovic and Pedersen (2007) explain the outsourcing process by matching the different phases with theories. On the one hand this approach helps to increase the understanding of the concept of outsourcing, and on the other hand we can infer various reasons for companies to engage in this strategic alternative. Academic literature examines a long list of theories applied to outsourcing activities (Gottschalk & Solli-Saether, 2005). According to McIvor (2009), applying only one theory to the phenomenon of outsourcing is not sufficient, because the term of outsourcing created a lot of buzz in management theory. According to Gottschalk & Solli-Saether (2005), the resource based view (RBV), the transaction cost economics (TCE) and Core Competencies (CC) showed particular importance for the success of the outsourcing process.
4.1) Resource-based view
Many scholars argue that the resource-based view has its origin in the book "The Theory of the Growth of the Firm" by Penrose (1959). Here the author describes the firm as an organization which employs resources to produce goods and services in order to sell them profitably on the market. The output is constraint by the available resource base. Still, the author does not consider outsourcing processes to remain competitive or to grow. Instead, he sorely focuses on the organic growth prospects of a firm for instance through foreign direct investment (Penrose, 1959). RBV explains the firm's positioning in the market and also examines how the internal knowhow and abilities evolve over time (McIvor, 2009). In addition, early research results like the paper by Marris (1963) also focus merely on the internal financial strength to explain a firm's expansion and the rate of growth. Collaborations with other firms or outsourcing activities in order to be able to concentrate on the core business play still a minor role (Marris, 1963).
In the 1990s, Barney and Hesterly (1996) define the resource-based view as an important theory to explain outsourcing since companies consist of differing resources and capabilities. Therefore, firms desire to obtain the lacking resources through partnerships or combine their own knowledge with the capabilities of a third party. Together this might then lead to a competitive advantage (Barney & Hesterly, 1996). A resource needs to be valuable, rare, inimitable and non-substitutable (VRIN) in order to create a competitive advantage (Barney, 1991). Many scholars like for example Peteraf (1993) show that resources can create lasting competitive advantages for companies if these resources are hard to imitate and non-substitutable. McIvor (2009) emphasizes in his findings that it is not enough for a resource to fulfill only one or two of these conditions. In contrast, Wernerfelt (1984) argues that the companies' products strongly depend on the available internal resources of the firm. In addition, the size of an organization is limited by the amount of resources it possesses. Hence, this constraint partly explains why companies start outsourcing relationships. Arthur supports this view and argues that companies follow a path-dependent process which is defined by the resources gathered (Arthur, 1994). As a result, it can be stated that companies, which apply this path-dependent resource usage, show better growth perspectives (Pettus, 2001). Furthermore Wernerfelt (1984) suggests that a company is positioned in the market according to its inherited resources which also define the existence of several strategic options as well as the firm's negotiation power with counterparties and they also create entry barriers. In conclusion, Connor (1991) states that the resource-based view can not only explain the foundation of a corporation, but also is a viable theory to determine the evolution process as well as the survival probability of a firm. Hence, from all this we can clearly infer that the RBV is also applicable to bring light into the motives of outsourcing related to the growth and proliferation of companies.
In general, Perunovic and Pedersen (2007) suggest in their empirical study that the resource-based view can be applied to four out of the five outsourcing process steps. Only in the transition phase the authors do not identify the RBV as an explanatory theory. Being in an outsourcing relationship for many years, companies are concerned with resources. Hence, in order to explain the rationale behind practitioners' actions we can use the RBV. In particular the preparation phase and the vendor selection stage are interesting for the RBV perspective (Perunovic & Pedersen, 2007).
The concept of strategic networks introduced by Gulati, Nohria and Zaheer (2000) introduces buyer-supplier partnerships to the academic research of RBV. As we have seen before outsourcing is a process where one company buys services from another. Therefore we need to investigate these networks to fully understand the extent of the explanatory power of the resource-based view for the practical phenomenon of outsourcing. In addition, the authors mention that the strategic networks enable companies to outsource activities in the value chain (Gulati et al., 2000).
Another article determines which activities can be outsourced. This is done by looking at the characteristics of these business processes. New major influencing factors to outsource an activity are its transferability, the degree of interchangeability with another one and of course its performance (Espino-Rodriguez & Padrón-Robaina, 2005). As a result this includes that a third company needs to possess capabilities to conduct these activities and therefore can offer its competitive advantage to other firms as an outsourcing service. Besides the before mentioned characteristics a major constraint limiting outsourcing is the strategic importance of the activity. Less important activities usually imply resources which are strategically not crucial for the company (Espino-Rodriguez & Padrón-Robaina, 2005). The more valuable the business process is for the company, the more it should be protected and executed internally. Cox supports this finding by stating that resources which are essential for the company's core competence are to be conducted within the firm (Cox, 1996).
A major contribution of the RBV perspective on outsourcing is that it helps to explain why activities increasing the relative position of the firm are held within the company and other less important activities with non-strategic resources are outsourced to suppliers (McIvor, 2009). Hamel and Prahalad (1994) build upon the resource-based view and divide the firm's activities into core and non-core resources. Another finding based on the RBV approach by two scholars is that organizational boundaries of companies and its competitive positioning are established by their capabilities. As a result, companies start to outsource activities if they realize that the own internal capabilities cannot compete with the ones from their competitors. To counteract this performance loss companies outsource less strategic activities (Langlois & Robertson, 1995). According to the author RBV is also useful to explain the degree of inter-organizational cooperation. The reasoning behind these outsourcing collaborations is to combine complementary capabilities and resources which end up in a superior competitive positioning of the firm (McIvor, 2009).
A topic which still needs to be examined in depth is the organizational learning and past experience concerning outsourcing within the company. According to the authors, previous experience with outsourcing influences current outsourcing decision-making. Hence, we can identify an interrelatedness or dependency of the level of outsourcing activity on the company's past outsourcing experience (Barthélemy & Quélin, 2006).
But the resource-based view on outsourcing also carries some limitations. Firstly, the RBV approach concentrates on economic explanations. Secondly, we should not forget that major strategic decisions like outsourcing do not only look at economic benefits and costs. Rather individual goals, politics as well as power relationships within the organization and during the decision-making process are important. These aspects should not be neglected (McIvor, 2005).
In conclusion we observe that the resource-based view contributes to a significant part in explaining the rationale behind outsourcing decisions on an operational level. Nevertheless it is not a completely comprehensive explanation and further theories need to be analyzed in order to fully grasp the complexity of this phenomenon.
4.2) Transaction cost economics
The foundations of transaction cost economics (TCE) have been laid by Coase (1937), who argued that the existence of companies is a direct consequence of transactions costs. These costs occur whenever companies use the market place to exchange goods or services. The main argument, on which his fundamental research on TCE is based, is the usage of the market place as a costly and time-intensive action, which incentivizes companies to produce necessary goods on their own. By producing these goods themselves, they incur the production cost, but avoid the transaction costs. Therefore, the goal of TCE is the identification of those conditions, under which decide whether to produce goods themselves or procure them on the market place (Coase, 1937).
His study "The problem of social cost" (Coase, 1960), in which he developed the so-called Coase Theorem, is concerned with the external effects of economic transactions, and provided the result that it is not clearly determinable, where the blame for certain externalities lies in case of unclear property rights. Some researchers (e.g., McCann et al., 2005; Masten, 2006) find this work to be a cornerstone of TCE as well.
For the decision of whether or not to pursue outsourcing, the academic literature finds three criteria of special importance, namely asset specificity, uncertainty, and infrequency (e.g., Lee et al., 2000; Wang, 2002). The first factor hereby defines how specific the products or services in question are. This specificity is defined by the uniqueness of the products and the difficulty to produce them. The second factor, uncertainty, describes the degree of bounded rationality that underlies the transaction, and thereby aims to measure how certain the execution of the transaction is. Thirdly, the frequency or infrequency of the transaction can be a decisive factor for a company of whether or not it is cheaper to produce the good itself in the long run (Dibbern, Güttler, & Heinzl, 2001; Wang, 2002; Williamson, 1989).
TCE as well as the tree factors mentioned above have an influence in all stages of the outsourcing process, but especially in the first, i.e. pre-contractual, phase. In this phase, where the analysis of the outsourcing decision is conducted, TCE supports the development of a make-or-buy decision. The goal of this decision is to minimize the transaction cost, be it through a transaction on the market place (buy-decision), or by producing the good or service oneself (make-decision). Factor specificity describes the degree to which the product is useful outside the company, i.e. how high its value for other companies is (Williamson, 1989).
If the product possesses a high degree of uniqueness, it is of little value outside its intended area of use. Arnold (2000) argues that high product uniqueness is likely to be an indicator for an advantage of producing the product instead of buying it on the market place. His argument is that high asset specificity and uniqueness may well result in little knowledge about the product and its characteristics at possible producers, which in turn leads to the necessity of intensive knowledge exchange. This exchange can result in high transaction costs, which put outsourcing at a disadvantage compared to in-house production. Furthermore, external producers might not be willing to incur possible setup costs for production equipment, which is only needed for one client's product. In contrast, objects with low asset specificity have a better chance of being suitable for outsourcing. Thus, the lower the degree of asset specificity, the higher is the probability of outsourcing.
Further influential factors in the pre-contractual phase are uncertainty and infrequency. According to Koopmans (1957), uncertainty can be distinguished between primary and secondary uncertainty, where primary uncertainty is of state-contingent kind, while secondary uncertainty arises from a lack of communication between the parties involved. The influential factor of infrequency describes how often a transaction is likely to take place. Both of these factors, uncertainty and infrequency, have an impact on outsourcing decisions in the pre-contractual phase due to several reasons. Firstly, the uncertainty about possible transaction partners and the contingencies involved in each transaction can impede outsourcing, if the decision-makers deem the uncertainty involved in the transaction as being too high. In this case, some companies might prefer to reduce the uncertainty by coming to a make- instead of a buy decision. Secondly, the degree of infrequency of the specific transaction can impact the ability of finding potential transaction partners as well as the costs for the transaction (cf., Williamson, 1989; Wang, 2002).
Based on the above-cited empirical investigations, this term paper has outlined the importance of TCE for explaining the outsourcing process and its emergence, which stems from Coase's (1937) first publication on this subject. However, numerous academic research publications investigate this topic in recent years, and thereby broaden the findings on this subject.
Ang and Straub (1998) investigate the impact of TCE on outsourcing decision in the information systems industry. Their paper focuses on economic determinants of outsourcing information systems in the financial industry and explains outsourcing within the context of TCE and the larger organizational strategy and environment. Aubert, Rivard, and Patry (1996) describe outsourcing of information services as a fast-growing trend and find the framework of TCE to be suitable to explain outsourcing behavior at two different levels. The first level of analysis is "the role of asset specific, measurement problem, and frequency in explaining the choice of the outsourced activities" (Aubert, Rivard, & Patry, 1996, p. 51), whereas the second level of analysis refers to the influence that asset specificity and measurement problems have on the terms of outsourcing contracts. Thus, their study emphasizes the role of the TCE elements on contractual aspect and incomplete contract theories.
In contrast to the investigations that focus on the outsourcing of information services, Ulset (1996) studies the outsourcing of R&D activities in relation to TCE and property rights theory, whereby he depicts the interplay of Coase's 1937 and 1960 findings. The result of his study is that in case of a substantial amount of externalities being involved (as it happens to be in R&D), TCE alone cannot explain the underlying mechanisms of governance and outsourcing decisions. In these cases, property rights theory has to be applied as a supplemental theory to explain the behavior of companies and decision-makers. Aubert, Rivard, and Patry (2004) apply both theories similarly. However, they argue less from a perspective of governance mechanisms, but emphasize the deterring influence of uncertainty on outsourcing, while naming the lack of technical skills in the own organization as a major reason to outsource products or services.
Similar to other research on TCE and outsourcing, Whitten and Wakefield (2006) conduct a survey in the IT industry. However, their study aiming to explain the outsourcing process by means of TCE or property rights theory, but investigates switching costs as an important transaction cost of IT outsourcing services. They find that switching costs are a main obstacle for changing the IT provider, which supports the notion of the importance of TCE and outsourcing for the IT industry.
Lacity, Willcocks, and Khan's (2011) study is also concerned with outsourcing of IT services, but aims towards establishing a theory on IT outsourcing by applying previous research findings about TCE.
4.3) Core competencies
According to Gottschalk and Solli-Sæther (2005) core competencies are the most crucial success factor of the outsourcing process. The main question, which this approach is trying to answer, is which transactions are really important for a company. The main idea is to only produce those goods or services internally, which are based on the core competencies (Prahalad and Hamel, 1990). In order to deepen the understanding of the core competencies approach, various research efforts have been undertaken in the past. Most of them have been case studies based or new conceptual frameworks, which were often based on case studies as well.
Brandes, Lilliecreutz and Brege (1997) analyzed which facts are responsible if outsourcing is successful or fails. Their theoretical approach has a closer look into three different dimensions: The outsourcing decision, the outsourcing process and the outsourced unit. The authors emphasized three reasons for decisions towards outsourcing. Firstly, the literature shows a high strategic need on focusing on core competencies. These kinds of competencies should retain in-house (Brandes et al., 2007, Prahalad and Hamel, 1990). Secondly there is a cost efficiency reason: External providers can often supply a competence more cost efficiently than the company is able to do it by itself. Thirdly, financial problem are a reason. Companies often have to get leaner and slim down. Only the really important resources are held in the company. The authors also had a closer look at the outsourcing process and at the outsourced unit which both has an impact on the future performance of the company (Brandes et al., 1997).
The very well-known approach by Prahalad and Hamel (1990) was the standard of outsourcing theory during the 1990s. Baden-Fuller, Targett and Hunt (2000) challenged this approach with their case-study based research with the question if there are also core competencies which should be outsourced. Besides this question the authors identified circumstances under which outsourcing of core skills can be very beneficial for companies. In addition to Brandes et al. (1997) Baden-Fuller et al. (2000) mentioned four circumstances which could lead to an outsourcing decision. The first reason could be, that the company has fallen behind, due to a slow moving environment (catch-up). Secondly the firm missed to respond to changing customer needs (changing value chains). Thirdly the firm missed to catch up with technology shifts. At last the firm has to target new opportunities arising due to new technologies and customer needs (emerging markets). So this approach is focusing "on the changing external circumstances which drive the firm's decision to outsource" (Baden-Fuller et al., 2000, p. 286).
The main reason for the added value of outsourcing is that the core competence the firm currently occupies is derogating (Baden-Fuller et al., 2000). The erudition can be seen in the first three circumstances mentioned above: In the case of catch-up, the companies's core competences are eroded by competition; in the event of changing value chains the customer demand has changed and in the case of a technology shift the core competence is being eroded by new technologies. Therefor Baden-Fuller et al. (2000) state that by taking the external perspective it gets clear that the company must reconsider its position.
In addition to the mentioned reasons above the authors showing that the choice of the right partners is a very crucial point. The authors state that there is no one right solution. But they use again their four circumstances to illuminate which partner suits the best in which particular situation (Baden-Fuller et al., 2000). In case of catch-up, itÂ´s the best solution to partner up with the best in the industry. When the case of shifting value chains occur, the best partners are, according to the authors, typically found by spin offs from the company itself. In the event of technology shifts, the partner firm must has demonstrable technological capability (Baden-Fuller et al., 2000).
The research topics changed over the years and focused other crucial capabilities. Gottschalk and Solli-Sæther (2005) stated that core competence management and the management of stakeholder are the most critical success factors of outsourcing processes.
The authors state that all functions, which are "peripheral to the company's production of goods and services for the market" (Gottschalk & Solli-Sæther, 2005, p. 692) should be outsourced. Gottschalk and Solli-Sæther (2005) also analyzed under which conditions outsourcing arrangement succeed. The main success factors is that the organization need to build the capability to define its needs and manage its services from the vendor represent the core competence within needed in the client organization to succeed in an outsourcing arrangement.
4.3) Comparison of the different approaches
After showing three different approaches in the outsourcing literature we are going to show on two short examples how the approaches could be compared linked or differentiated.
Arnold (2000) developed an outsourcing model, which is based on institutional economic theory. The author combined the transaction cost economics and the core competencies approach. As a result, the managerial applications of both approaches are compatible.
RBV and TCE take a different look on outsourcing and therefore come to somehow different results. Whereas RBW analysis the firm's position, its inherent resource based, and the output constraints caused by the available resource base, TCE looks at the advantages and disadvantages of transactions. Therefore, the reason for outsourcing from a resource based point of view is a company's limitation in available resources, and the necessity of outsourcing several processes that need these resources. TCE finds the reason for outsourcing to be driven by transaction cost advantages, which might be realizing form giving away certain tasks instead of producing them in-house.
Discussion & conclusion
In the last three decades a lot of research was conducted with the topic of outsourcing (also see Perunovic & Pedersen, 2007; Gottschalk & Solli-Sæther, 2005). In most theories about outsourcing processes the perspective has been focused on exploring certain issues emerging within the outsourcing process. As this topic is very complex the problem occurs to choose between many different options which are resulting in different possible outcomes.
Perunovic & Pedersen (2007) state, that it is possible to find an optimal solution but that it could be an useful approach to take the dynamics of these kind of processes in account. The main idea of the authors is to learn from the past, which means taking results of former decisions in similar cases into account. This leads to the need of studding "the outsourcing process as an evolutionary process" (Perunovic & Pedersen, 2007, p. 13). Evolutionary thinking in social sciences as organizational theory has used these insights to draw one important conclusion namely that structure is not sufficiently to make an optimal solution in outsourcing considerations.
It is also necessary to take into the problematic of the structure - actor problem into account. In terms of the outsourcing topic not only to focus on theoretical models or explanations or cases from the past of the outsourcing phenomenon for an management implication we also suggest doing matters in another way next time because you have some mistakes and failures done first time. Therefore we think there is not a best solution or spoken in other terms there is no one size fits all solution in beforehand. To make a best possible choice it is crucial to learn from similar cases a thus from the history but on the other hand don't stick to close to this cases and make an own decision.
To conclude our paper we would like to show where we see a need for further research. First of all we would like to state, that a lot of the research papers focus on the outsourcing of IT Services, which was the first sector of doing outsourcing at a high rate. Thus we suggest to transfer the done research on other industries, which also outsource a lot, like for example the automobile industry or the electronic industry. Also it would be useful to do some research in the field of outsourcing core competencies itself.
The conceptual foundation of TCE, beginning with Coase's (1937 and 1960) studies and continuing with the investigations of Lee et al. (2000), Wang (2002), and Williamson (1989), is already well developed. However, its applications in practice have mostly been centered on outsourcing in the IT industry. Therefore, one area for further research is the application of TCE on other outsourcing-heavy industries, and the development of frameworks for successful outsourcing in them. Possible applications about the feasibility of outsourcing from a TCE point of view include investigations about its success in (for example) the electronics and automobile industry, which both outsource a comparably high percentage of their workflow as well.
Barney and Hesterly (1996) argue that due to the application of the RBV in the 1990s, the theory is perceived as a viable way to determine outsourcing decision-making within corporations. Even though Perunovic and Pedersen (2007) explain the scope of the RBV's applicability to the different outsourcing process steps, academic researchers could put more effort in providing thorough empirical studies about this finding. As mentioned before, an interesting field of research would be to further examine the relationship of the RBV and strategic networks. Langlois and Robertson (1995) state that companies begin to outsource activities after realizing that the capabilities of other companies are superior to the own ones. Hence, an additional research area could be to investigate the relative performance differences between companies who chose to outsource and the ones who hesitated.
For the research field of core competencies there should be more research in field of outsourcing key competences. This research field established by Baden-Fuller et al. (2000) is very promising. Here it would not only be interesting which other factors could lead to this kind of outsourcing but also which repercussions on the business model of a firm this has on the long run.