Outsourcing
David Lei
Outsourcing refers to the strategic decision to utilize other firms to perform value creating activities (primary and/or support) once con ducted in house (Bettis, Bradley, and Hamel, 1992; Lei and Hitt, 1996; Porter, 1985). Firms often rely on outsourcing as a vehicle to reduce the fixed costs of their operations and to exit less promising businesses, as well as to become more agile and responsive to their customers’ needs. Yet the decision to outsource has potentially profound consequences for a firm’s long term competitiveness and technological leadership, particularly if it involves core activities that emanate from highly tacit, firm specific sources of knowledge and core competencies that enhance causal ambiguity (Badaracco, 1991; Lei, Hitt, and Bettis, 1996; Reed and DeFillippi, 1990).
Nature of Outsourcing
In its most general sense, outsourcing enables a firm to substitute fixed costs with recurring variable costs for key inputs. Additionally, by furthering its reliance on suppliers, a firm also raises its transaction and coordination costs while narrowing the scope of its internal activities. A firm can choose the degree to which it relies on outsourcing to manage its current cost structure. At one extreme, a firm can outsource almost all of its value adding activities and operate in a virtual format whereby it coordinates the information and value flows among its web of designers, suppliers, distributors, and other eco nomic entities. At the other extreme, a firm may decide to perform most, if not all, of its activities in house to maximize control over the full extent of its value chain. The vast majority of firms, however, engage in varying degrees of outsourcing whereby external suppliers play some role in providing an important input to the firm’s value proposition (e.g., product and/or service).
Outsourcing approaches can vary in the extent of formalization, asset exchanges, level of managerial interaction, and procedural standardization that they involve. In some situations, outsourcing could represent a highly formalized process that requires close interaction among managers, extensive co management or transfer of assets, and a high degree of procedural/process standardization to ensure product/service quality and/or new process investment/improvement (e.g., recent moves in the automobile industry with first tier suppliers). In these relationships, there is tight coupling between the firm and its supplier(s) that is required to share and jointly manage the risks of such endeavors (Takeishi, 2001). In other cases, outsourcing may involve much less interaction among man agers, but instead culminate in a series of arm’s length contracts and asset exchanges to ensure that key economic objectives are attained (e.g., delivery, cost, quality in healthcare). These out sourcing relationships rely on well established guidelines and parameters to provide the necessary context and structure (embedded coordination) that support a more loosely coupled approach among firms and their suppliers (San chez and Mahoney, 1996; Weick, 1989).
Forms of Outsourcing
The most prototypical form of outsourcing relationships relies on an arm’s length approach to negotiating and working with external suppliers. The objective is to reduce the host firm’s in ternal fixed cost base by engaging multiple providers in order to minimize the potential risks of opportunism. More intricate forms of 196 outsourcing outsourcing rely on close personal relationships to build stronger relational and network based advantages. Closer ties may enable both parties to gain important resource based advantages, such as access to knowledge, proprietary capabilities, and other intangible assets or resources (Gulati, 1999; Helfat, 2000; Peteraf, 1993; Priem and Butler, 2001). Likewise, closer ties build the social capital necessary to provide a degree of self sustaining governance of the outsourcing relationship through shared norms, thus conferring some degree of relational advantage (Dyer and Singh, 1998; Uzzi, 1997). Over time, additional resource benefits may accrue to either the out sourcing firm or its supplier by virtue of its position within a potentially expanding network of firms (Gnyawali and Madhavan, 2001).
Perhaps the most sophisticated form of out sourcing is the notion of the extended network. In this configuration, a firm seeks to complement its internal resources with that of new capabilities that are either sourced or even absorbed from a network of cooperating and competing firms to reap external economies of scale and scope (Gulati, Nohria, and Zaheer, 2000; Lei, 2003; Zahra and George, 2002). The economic logic of the extended network stems from the growing web like configuration of multiple firms becoming increasingly specialized along a core value creating activity. Yet ‘‘coopetition’’ (Brandenburger and Nalebuff, 1996) shapes the underlying strategic context of out sourcing as relationships developed throughout the network could possibly provide important channels or conduits to key resources possessed by other interconnected firms. To the extent that an outsourcing firm may be able to ‘‘bridge’’ ties (McEvily and Zaheer, 1999) from one sup plier to another, it could exploit the centrality of its network position to enhance its resource access (Brass and Burkhardt, 1992). Moreover, highly dense or interconnected, extended net works can accelerate faster information, know ledge, and physical flows as firms begin to share increasingly similar coordination mechanisms. These interconnections facilitate the rise of modular product designs (Sanchez and Maho ney, 1996) and even corporate organization designs that enable different suppliers to com pete for network position (Lei, Hitt, and Gold har, 1996; Schilling, 2000). Increasing density, and the social ties that result, could limit direct forms of interfirm competition within the net work (Gynawali and Madhavan, 2001), but amp lify the tendency towards competence based competition (Hamel, 1991), whereby firms seek to outlearn each other in creating new, distinct ive resources and capabilities (Lei, 2003).
Cooperation, Competition, and Future Growth
Outsourcing reduces the boundaries between firms, thereby increasing both sequential and reciprocal interdependence (Thompson, 1967). Thus, outsourcing generates significant co ordination issues, particularly concerning know ledge sharing, joint investment costs, rising strategic dependency on suppliers, ‘‘hollowing out,’’ and the coordination of managers and personnel from different firms. Outsourcing strategies compel firms to balance cooperation with competition. Knowledge flows (particularly tacit skills) can unintentionally strengthen future competitors, particularly if underlying technologies are applicable across numerous products (Lei, Hitt, and Bettis, 1996), and require firms to discern their suppliers’ long term intentions (Bettis, Bradley, and Hamel, 1992). Such ‘‘coopetition’’ is particularly difficult to manage in highly extended supplier networks, especially in high velocity competitive environments. Care fully managed, selective outsourcing can help firms preserve resources needed to learn new skills and capabilities to sustain core businesses; however, financial incentives in many firms may result in excessive outsourcing to reduce short term costs at the expense of long term competitiveness. In particular, initial outsourcing of lower value added components, services, or activities may trigger escalating dependence, in which the firm begins to rely on a partner or supplier to provide an ever higher level of competence, skill, or technology. Thus, firms should adopt a measured approach towards outsourcing, and gauge its potential impact on effects on learning and building its core competencies. From a perspective of competence based com petition, the growth of outsourcing and extended supplier networks will require man agers to compete on two parallel dimensions of competitive advantage: cost improvement and interfirm learning.
Outsourcing and Entrepreneurship
A carefully balanced approach to outsourcing can promote the efficient use of capital and lay the foundation for focused growth. In particular, outsourcing plays a key part in many younger entrepreneurial firms’ business plans, as management must channel all existing resources to conceive and realize a distinctive value proposition. For example, many small firms that have successfully designed cutting edge technology products and services have relied on larger sup pliers and partners to gain access to state of the art manufacturing and distribution facilities. Some recent entrepreneurial start up firms in Silicon Valley have utilized a virtual organization design from their inception, whereby all non core functions and activities are outsourced to preserve agility in fast changing markets. Many emerging semiconductor firms are some times collectively known as the ‘‘fabulous fabless,’’ since they focus exclusively on cultivating highly tacit design based skills, while out sourcing the engineering and manufacturing of the finished chips to larger, foundry based firms. Nevertheless, larger established firms can also selectively use outsourcing in a similar manner to sharpen their focus on core businesses and activities. By freeing up capital that was once tied up in highly mature or declining businesses, outsourcing may enable established firms to invest in new activities, skills, or competencies that facilitate entry into new markets.
Bibliography
Badaracco, J. L. (1991). The Knowledge Link: How Firms Compete through Strategic Alliances. Boston, MA: Harvard Business School Press.
Bettis, R., Bradley, S., and Hamel, G. (1992). Outsourcing and industrial decline. Academy of Management Executive, 6: 7 22.
Brandenburger, A. M. and Nalebuff, B. J. (1996). Co opetition. New York: Doubleday.
Brass, D. J. and Burkhardt, M. E. (1992). Centrality and power in organizations. In N. Nohria and R. Eccles (eds.), Networks and Organizations: Structure, Form and Action. New York: McGraw-Hill, 191 215.
Dyer, J. H. and Singh, H. (1998). The relational view: Cooperative strategy and sources of interorganizational competitive advantage. Academy of Management Review, 23: 660 79.
Gulati, R. (1999). Network location and learning: The influence of network resources and firm capabilities on alliance formation. Strategic Management Journal, 20: 397 420.
Gulati, R., Nohria, N., and Zaheer, A. (2000). Strategic networks. Strategic Management Journal, 21: 203 16.
Gnyawali, D. R. and Madhavan, R. (2001). Cooperative networks and competitive dynamics: A structural embeddedness perspective. Academy of Management Review, 26: 431 45.
Hamel, G. (1991). Competition for competence and interpartner learning within international alliances. Strategic Management Journal, 12: 83 103.
Helfat, C. E. (2000). The evolution of capabilities. Strategic Management Journal, 21: 955 9.
Lei, D. (2003). Competition, cooperation, and learning: The new dynamics of strategy and organization design for the innovation net. International Journal of Technology Management, 26: 694 716.
Lei, D. and Hitt, M. A. (1996). Strategic restructuring and outsourcing: The effects of mergers and acquisitions and LBOs on building firm skills and capabilities. Journal of Management, 21: 835 59.
Lei, D., Hitt, M. A., and Bettis, R. A. (1996). Dynamic core competencies through meta-learning and strategic context. Journal of Management, 22: 549 69.
Lei, D., Hitt, M. A., and Goldhar, J. D. (1996). Advanced manufacturing technology: Organization design and strategic flexibility. Organization Studies, 17: 501 23.
McEvily, B. and Zaheer, A. (1999). Bridging ties: A source of firm heterogeneity in competitive capabilities. Strategic Management Journal, 20: 1133 56.
Peteraf, M. A. (1993). The cornerstones of competitive advantage: A resource-based view. Strategic Manage ment Journal, 14: 179 91.
Porter, M. E. (1985). Competitive Advantage. New York: Free Press.
Priem, R. L. and Butler, J. E. (2001). Is the resourcebased ‘‘view’’ a useful perspective for strategic management research? Academy of Management Review, 26: 26 40.
Reed, R. and DeFillippi, R. J. (1990). Causal ambiguity, barriers to imitation, and sustainable competitive advantage. Academy of Management Review, 15: 88 102.
Sanchez, R. and Mahoney, J. (1996). Modularity, flexibility, and knowledge management in product and organizational design. Strategic Management Journal, 17: 63 76.
Schilling, M. A. (2000). Toward a general modular systems theory and its application to interfirm product modularity. Academy of Management Review, 25: 312 34.
Takeishi, A. (2001). Bridging inter-and intra-firm boundaries: Management of supplier involvement in automobile product development. Strategic Management Journal, 22: 404 34.
Thompson, J. D. (1967). Organizations in Action. New York: McGraw-Hill.
Uzzi, B. (1997). Social structure and competition in interfirm networks: The paradox of embeddedness. Administrative Science Quarterly, 42: 35 67.
Weick, K. E. (1989). The Social Psychology of Organizing. Reading, MA: Addison-Wesley.
Zahra, S. A. and George, G. (2002). Absorptive capacity: A review, reconceptualization, and extension. Academy of Management Review, 27: 185 203.