PRACTICE :: GENERAL MANAGEMENT

Specialization and focus on a few activities is imperative for innovation in any organisation. How do managers decide which of the organisation’s activities should be conducted in-house and which should be purchased from the market?

Global organizations like Nike and Dell and Indian organizations like Bharti Telecommunications have outsourced activities that were traditionally viewed as ‘core’ to their organizations.

These organizations reclassified activities as ‘core’ or ‘non-core’ based on their decisions to outsource. Marketing became the core activity for Nike and Bharti while Dell decided to focus on supply chain management. Thus, the definition of core or non-core is based on the consequence of an outsourcing decision rather than being its determinant.

Strategic Reasons for Outsourcing
There are four strategic reasons why managers should look to derive advantages from outsourcing.

Cost minimization
If the market has the ability to reduce fixed costs derived from economies of scale, then buying from the market is likely to be more cost-efficient than in-house production. It is also easier to derive the benefit of lower factors of production, like lower labour costs in some international locations. The Indian ITES industry is a prime example. The suppliers also derive the benefit of aggregating demand from multiple customers by specializing on a narrow set of tasks, empowering them to innovate in these tasks.

Resource access
Organisations can outsource activities to access resources that they are unable to create or own themselves. It is often time-consuming to create complimentary assets like brands and distribution networks. It is more efficient to use the services of a third party. The best example is in the strategy consulting industry when organizations like Reliance hire consulting firms like McKinsey for formulating a business or corporate strategy.

Resource leverage
Organisations can leverage their internal resources by outsourcing non-critical activities and letting their skilled staff do high-value activities. This reduces the risk even in case of poor performance by the supplier as the activities are non critical. For example standardized activities like payroll processing, screening of resumes and selective human resource functions can be outsourced to specialized agencies.

Risk diversification
When suppliers aggregate demand from several customers, they can diversify risks better. For eg., in a manpower intensive activity like software development, if the outsourcing vendor’s portfolio is diversified, they will always get significant demand and deploy resources, where needed.

Deciding on Outsourcing
Outsourcing decisions are based on the ability of an organization to draw and enforce contracts. Under conditions of uncertainty, information asymmetry and absence of competition, these market transactions can breakdown due to opportunistic behaviour of suppliers. Typical situations for this are when a supplier needs to make ‘transaction specific investment’ for a buyer which the supplier cannot put to alternate use. The supplier will therefore demand a price premium which might exceed the cost that the customer would have incurred in performing this activity in-house. The decision to outsource or not can be made by comparing costs of both options.

The cost of conducting an activity in-house should include

a) Agency cost – the cost of learning or developing a specific competence
b) Production cost – the ost of performing the activity in-house

On the other hand, cost of outsourcing should account for

a) Transaction cost – these include the costs of searching for the right supplier, negotiating terms, and enforcing these terms
b) Supplier Price

Transaction costs can often exceed agency costs to a great extent. This is why managers should base their decision to outsource on more than just the difference between production cost and supplier price.

Exceptions to the decision rule

• When there is uncertainty, risks that cannot be quantified arise and transaction costs increase.
• Outsourcing can create the risk of ‘knowledge spillover’. It might result in the supplier becoming aware of confidential information.
• Poor performance by a supplier can damage other organizational resources.
• Outsourcing due to immediate cost considerations might erode an organization’s competencies, especially if the functions have critical interdependencies with inhouse functions.

Organisations that are party to bilateral contracts assess each other over a series of transactions. While organizations can behave opportunistically, they seldom choose to do so to ensure business continuity. This reputation capital is evident in the strategic consulting industry where there is no known leakage of confidential information even though firms like McKinsey work with multiple clients who are mutual competitors.

Conclusion

Organisations that intend to outsource can benefit from using transaction cost economics to generate a decision rule for outsourcing after taking into consideration notions of knowledge spillover and reputation capital.

The original article Outsourcing: Practice in Search of a Theory by Professor Sourav Mukherji and Professor J. Ramachandran appeared in IIMB Management Review, June 2007.