The Outsourcing Of Primary Activities

The Outsourcing of Primary Activities: Theoretical Analysis and Propositions

Roger Strange (University of Sussex)

ABSTRACT

There is a considerable literature comparing the virtues of markets and hierarchies as alternative governance structures for economic transactions. But governance decisions are not simple dichotomous choices, and there has been increasing recent interest in the ‘swollen middle’ of hybrid organisational forms that combine market and hierarchical elements. One such hybrid is outsourcing, which has become a topic of considerable contemporary interest both in business circles and within the academic literature. The main contribution of this paper has been to combine the insights of resource dependency theory, the resource-based view of the firm, and transaction cost economics to provide both an explanation for the outsourcing of primary activities and a set of testable propositions about firms’ propensities of outsource.

Key words: externalization; outsourcing; resource dependency theory; resource-based view; transaction cost economics

Address for correspondence: School of Business, Management and Economics, Mantell Building, University of Sussex [e-mail: [email protected]]

Acknowledgements: I would like to thank Peter Buckley, Grazia Ietto-Gillies and Antonio Majocchi for helpful comments on earlier drafts of this paper. My special thanks are due to Howard Gospel. The comments of two anonymous referees are also gratefully acknowledged. 2

The Outsourcing of Primary Activities: Theoretical Analysis and Propositions

INTRODUCTION

There is a considerable literature comparing the virtues of markets and hierarchies as alternative governance structures for economic transactions. But governance decisions are not simple dichotomous choices, and there has been increasing recent interest in the ‘swollen middle’ of hybrid organisational forms that combine market and hierarchical elements. One such hybrid is outsourcing, which has become a topic of considerable contemporary interest both in business circles and within the academic literature. A range of managerial motives have been put forward for the apparent rise of outsourcing as a corporate strategy in recent years, notably to enable the lead firm to concentrate on ‘core competencies’, or to gain access to expertise and competencies not available in-house, or to take advantage of economies of scale and/or scope enjoyed by external suppliers. Much of the literature provides illustrations of outsourcing of ‘support activities’ (Porter, 1985: 40-43) such as IT or other back-office services (Quélin and Duhamel,

2003; Berggren and Bengtsson, 2004), and here the above arguments clearly have some validity.

But such arguments appear to have less validity for many firms which have outsourced

‘primary activities’ (Porter, 1985: 39-40) in a range of industries which produce goods as diverse as footwear, clothing, cars, or pharmaceuticals1. The footwear manufacturer Nike has long been renowned for the fact that it does not own any manufacturing facilities, but subcontracts out the manufacture of its products to independent suppliers (Donaghu and Barff, 1990). The clothing industry, particularly in the United States, the United Kingdom and Continental Europe, has undergone a ‘retail revolution’ (Gereffi, 1994: 104-105) over the last thirty years, and the

1 According to Porter (1985), these ‘primary activities’ include inbound logistics, operations (production), outbound logistics, marketing & sales, and services. Porter categorises procurement, technology development, human resource management, and firm infrastructure (accounting, legal, financial planning, quality assurance etc) as ‘support activities’. 3 industry is now dominated by large retailers (e.g. J.C. Penney, Marks & Spencer), branded marketers of fashion garments (e.g. Liz Claiborne), and branded manufacturers of standardised garments (e.g. Levi Strauss). There is a sharp distinction between garment retailers and manufacturers (Gereffi, 1994; Gibbon 2001), and most of the main garment retailers no longer have any significant manufacturing interests. In car manufacturing, long a bastion of vertically- integrated production, many observers have predicted that today’s major firms will become

‘vehicle brand owners’ with all parts’ manufacture and assembly undertaken by suppliers (The

Economist, 2002: 71). Indeed firms like Toyota are well-known for their systems of tiered suppliers (Fujimoto, 1999). In pharmaceuticals, Astra Zeneca announced in September 2007 that it was planning to outsource all of its drug manufacturing activities within ten years (The Times,

17 September 2007). Initially the company intends to outsource the manufacturing of the active pharmaceutical ingredients, but will later move to outsource more sophisticated manufacturing activities. Its ultimate aim, according to senior management, is to control the research, the intellectual property, the branding, and the health and safety issues, but to outsource everything else. And Astra Zeneca is not alone: other pharmaceutical companies (e.g. Pfizer) have also begun outsourcing their manufacturing activities. In each of these illustrative cases (and similar cases could be found in many other industries), it does not appear that the external suppliers have any special expertise or competencies that are not available in-house, nor do they appear to enjoy economies of scale and/or scope which the ‘lead firm’2 would not also be able to exploit.

This paper draws upon resource dependency theory, the resource-based view of the firm, and transaction cost economics to provide a comprehensive explanation of the conditions under

2 We use the term ‘lead firm’ in this paper to refer to the firms (e.g. Nike, Levi Strauss, Toyota, Astra Zeneca) which have outsourced significant primary activities within their production chains. A ‘production chain’ is defined as a vertical series of exchange relationships that combine resources at each stage in order to produce and distribute a finished good or service. Dicken (2007) comments that the ‘chain’ metaphor has been adopted by many writers, but using slightly different terminology: value chain, commodity chain, supply chain, demand chain, filière. See also Porter (1985), Sturgeon (2001), Raikes et al (2000), and Selen and Soliman (2002). 4 which lead firms resort to the outsourcing of primary activities, and of the reasons why such outsourcing has grown in importance in recent years. It is argued that certain firms choose to outsource primary activities within their production chains to independent suppliers, not because of relative capability considerations, but because they are able to leverage their resources to appropriate the rents from the chain whilst reducing their asset base. Furthermore, this ability to leverage its resources enables the firm to maintain control over the activities within the chain, even without equity participation in the subordinate suppliers. In short, we would suggest that the outsourcing of primary activities should not be viewed simply as a manifestation of the classic

Coasian ‘make or buy’ decision but that it is a hybrid governance structure, that lies between pure contract-based market relations and internal managerial hierarchy, for exploiting the firm’s capabilities whilst retaining effective managerial control over the production chain.

The paper is structured as follows. The next section provides a working definition of the term ‘outsourcing’, and briefly contrasts outsourcing with the related, but conceptually distinct, phenomenon of ‘offshoring’. The third section contains a succinct review of traditional explanations for why firms engage in outsourcing. The following section addresses the questions of how the process of outsourcing of primary activities might be explained theoretically, and what is driving the recent growth in such outsourcing? We then use the insights from this discussion to advance a number of testable propositions delimiting the firm attributes associated with firms which are likely to externalise the production of primary activities. The final section considers some of the implications of the analysis, and suggests areas for further research.

THE DEFINITION OF OUTSOURCING

The term ‘outsourcing’ is used in this paper to refer to the procurement by a lead firm of goods and/or services from independent outside suppliers, when those goods and/or services had 5 previously been provided internally within the firm3. Two points in particular should be stressed.

The first is that the goods and/or services had previously been provided internally within the firm, so that outsourcing is a process which involves the firm externalising elements of its production chain. This requires a physical ‘slicing-up’ of the production chain, and involves a change in the firm’s boundaries. There is an organisational fragmentation4 of production (Venables 1999: 936).

The second is that the typical outsourcing contract is not a one-off arm’s length purchase of a standard ‘commodity’, but involves an ongoing relationship between the firm and the outside suppliers with the latter providing the goods and/or services to the former’s specification. The transactions effected under the typical outsourcing contract are thus not pure market transactions, even though the firm has no ownership rights over the external supplier.

The outsourced activities may be undertaken by suppliers located within the same country as the firm, or may involve the relocation of production overseas. A related phenomenon is

‘offshoring’, but it is important to understand that outsourcing and offshoring are conceptually different. Offshoring5 refers to the relocation of the production of goods and/or services overseas, and thus involves an international fragmentation of production (Feenstra, 1998). The offshored activity may or may not take place under the direct control of the firm: if it does, then foreign direct investment (FDI) is involved. Thus sometimes outsourcing and offshoring take place contemporaneously, but they may also happen independently. Most importantly, each strategy involves different considerations and has different determinants.

TRADITIONAL EXPLANATIONS OF OUTSOURCING

3 See Espino-Rodriguez and Padrón-Robaina (2006: 51) for a list of many of the different definitions of outsourcing used in the academic literature. 4 The term ‘vertical disintegration’ is also commonly used as a synonym for the ‘organisational fragmentation of production’. 5 The terms ‘delocalisation’, ‘global outsourcing’, ‘super-specialisation’, ‘global production sharing’, and ‘co- production’ have all been used in the literature as synonyms for offshoring. 6

As noted in the introduction, a range of managerial motives have been put forward in the literature for the apparent rise of outsourcing as a corporate strategy in recent years, notably to enable the firm to concentrate on ‘core competencies’, to gain access to expertise and competencies not available in-house, and to take advantage of economies of scale and/or scope enjoyed by external suppliers.

The first, and perhaps the most popular, explanation of why firms engage in outsourcing is that they are concentrating on their core competencies (Prahalad and Hamel, 1990; Quinn and

Hilmer, 1994; Gilley and Rasheed, 2000), and are thus concentrating their resources and capabilities on activities which have the greatest potential benefits in terms of improvements in competitive advantage. The second explanation (Grant, 1991; Diaz-Mora, 2007) draws upon the observation that all firms specialise in a limited range of activities because of the scarcity of resources (Coase, 1937), and outsourcing allows the firm to complement its own scarce resources with those owned by the external suppliers (Gottfredson et al, 2005). Outsourcing thus allows the firm to address perceived deficiencies in its own resources and capabilities (Lorenzoni and

Lipparini, 1999). The third explanation (Monteverde and Teece, 1982; Abraham and Taylor,

1996; Chiles and McMackin, 1996) goes further by suggesting that the external suppliers are better able, perhaps because they supply multiple clients or because they specialise in the production a variety of similar outputs, to provide the requisite goods and services with greater efficiency and at lower cost. This specialisation may also enable the suppliers to make product and/or process innovations (Leiblein and Miller, 2003; Mol et al, 2005) that give rise to supply cost reductions that benefit the firm, though it has been noted that suppliers exhibit different levels of improvement capability (Peteraf, 1993).

A common feature of the above explanations is that outsourcing is the preferred organisational form because the external supplier is somehow able to provide the requisite goods 7 and services at lower cost than the firm is able to do internally. These arguments clearly have merit as explanations for the growth of outsourcing of IT and other back-office services, but they are less convincing in the illustrative cases cited in the introduction. Does Nike outsource the manufacture of its footwear because an external supplier can manufacture at lower cost than the company could do itself at an overseas subsidiary? Can outside firms manufacture pharmaceutical ingredients more efficiently than Astra Zeneca or Pfizer? In all these cases, the lead firms have chosen to externalise the production of primary activities that had previously been undertaken in-house, but it not obvious that there are any direct cost benefits. So why is this happening, and why is it happening across a range of industries in the latter part of the twentieth and early part of the twenty-first centuries?

One common argument (see, for example, Malone et al, 1987; Brynjolfsson et al, 1994;

Evans and Wurster, 2000) is that advances in information and communication technologies

(ICT), and in particular the internet, have reduced substantially the transaction costs of effecting exchanges through the market. Thus it is suggested that these developments should lead to less vertical integration, and moreover favour smaller, more specialised firms which are not encumbered with obsolete assets and archaic systems and mindsets. But these same advances in information and communication technologies have also facilitated the central control and coordination of activities that are both geographically dispersed, and many authors have suggested that such developments thus favour greater vertical integration. Indeed Coase (1937:

397) pointed out6 seventy years ago that ‘Changes like the telephone and the telegraph which tend to reduce the cost of organising spatially will tend to increase the size of the firm. All changes which improve managerial technique will tend to increase the size of the firm.’ A more

6 Coase (1937) did, however, concede ‘that most innovations will change both the costs of organising and the costs of using the price mechanism. If the telephone reduces the costs of using the price mechanism more than it reduces the costs of organising, then it will have the effect of reducing the size of the firm.’ Clearly, however, he believed that most innovations led primarily to reductions in the costs of organising. 8 contemporary discussion is provided by Afuah (2003), who suggests that the emergence and diffusion of the internet has reduced not only transaction costs, but also component production and bureaucratic coordination costs. He suggests that the internet may either expand or shrink firm boundaries, depending upon the firm’s determinants of costs, moderated inter alia by the firm’s organizational technology. So how may the growth in the outsourcing of primary activities be explained, if neither ICT advances nor the traditional arguments provide a compelling rationale?

WHY OUTSOURCING?

How may the process of outsourcing of primary activities be explained theoretically? Our starting point is the exchange relationship between a supplier (A) and a buyer (B) and, in particular, the power structure of the relationship between the two independent parties. According to resource dependency theory (Cook, 1977; Pfeffer and Salancik, 1978; Pfeffer, 1981; Cook and

Emerson, 1984; Ulrich and Barney, 1984), limitations on the availability of resources foster specialization and necessitate organizational interdependence, and thus create resource dependencies. Each party will try to alter its dependence relationships by acquiring control over resources that either minimises its dependence on the other party, or maximises the other party’s dependence on itself. Power derives from dependence in exchange relationships and, the more power a party has, the more influence it has to determine the nature of the exchange between the organizations, both in terms of the form of the interaction and the terms of the exchange.

Furthermore, the power of each party in the exchange relation is increased as the scope of the resources (or the numbers of different resources) mediated by the party increases. If a party has alternative sources available in an exchange network, then its dependence is less and it will have more bargaining power in terms of negotiating the terms of the exchange. 9

The fundamental question to be asked about the exchange relationship is thus how scarce are the resources on either side of the exchange (Cox et al, 2002: 34)? According to the resource- based theory of the firm (Lippman and Rumelt, 1982; Wernerfelt, 1984; Barney, 1986, 1991;

Dierickx and Cool, 1989; Peteraf, 1993; Teece et al, 1997), each party will typically possess some heterogeneous capabilities and resources, which may be both valuable and hard for competitors to imitate. The absence of competitors with imitative or substitute resources provide the basis for parties to earn entrepreneurial rents: i.e. to earn profits in excess of the costs of production and which are not eroded by normal competition. The capabilities and resources owned by each party may be valuable, but will only sustain a competitive advantage if there are ex post limits on their acquisition and/or imitation by potential competitors. These limits are provided by the existence of ‘isolating mechanisms’ (Rumelt, 1984, 1987). One such isolating mechanism is the allocation of property rights by the State, in the form of patents, trademarks, licenses etc. But, as Rumelt points out (1987: 146-8), no such legal protection exists for most product, process, or supply chain innovations, but that there are a variety of potential first-mover advantages that make it costly for followers to duplicate an innovator’s position. These advantages may include economies of scale, information impactedness, response lags, organisational learning, buyer evaluation and buyer switching costs, reputation effects, communication goods effects, and advertising and channel crowding. The greater the protection afforded the firm by any or all of these mechanisms, the more scarce will be its resources, and hence the more it will be able to resist the appropriation of its rents, at least in the medium-term7.

We may thus construct a matrix of possible power structures for the exchange – see

Figure 18. The situation in the top left-hand quadrant is that, although both A and B possess

7 See also Dyer and Singh (1998) on isolating mechanisms. 8 Cox et al (2002) provide a similar treatment of potential power structures but, unlike us, their main concern is not with the boundaries of the firm. 10 resources that the other requires, there are plenty of alternative sources so that neither A nor B enjoy a position of power relative to the other. In contrast, in the opposite quadrant, both have scarce resources that the other values, and this generates a situation of bilateral dependency or interdependence. The other two quadrants refer to situations where one actor has dominance over the other because of differences in the relative scarcity of their resources.

***** Figure 1 about here *****

But an understanding of the power structure of the relationship between A and B is not sufficient to explain how that relationship will be organised. It is also necessary to take into account the relative costs of effecting the exchange through the market or through a hierarchical relationship. Transaction costs economics (TCE) has long provided an explanation of firms’ boundary choices by focusing on the minimisation of transaction costs. TCE theory has its origins in the paper by Coase (1937) who pointed out that there were costs involved in using the price mechanism to coordinate the provision of goods and services through arm’s length contracts. These costs include not only those involved in effecting the exchange, but also the costs of measuring and monitoring performance and the costs associated with negotiating, monitoring, and enforcing the contract. If such costs are sufficiently large, then Coase maintained that the firm would emerge to provide more efficient central coordination.

More recent work has tried to identify the conditions under which such transaction costs would be significant (Williamson, 1975, 1985, 1996). Williamson argued that transactions are characterised by differing degrees of asset specificity and uncertainty, and that transaction costs may be minimised by assigning appropriate governance structures to different transactions.

Furthermore, he suggested that the parties to such transactions are both subject to bounded rationality and predisposed to opportunistic behaviour. This combination of uncertainty and the parties’ bounded rationality means that contracts are necessarily incomplete. Although this 11 provides scope for flexibility, it also creates an environment for opportunistic behaviour by one party or the other in the exchange, which may be enhanced by information asymmetries between the parties. In such circumstances, the parties to the exchange might attempt to establish credible commitments to counter the risks of opportunism or, if the associated costs are substantial enough9, might choose to internalise the transaction within a vertically-integrated hierarchy (the firm). Thus, if the transaction costs of undertaking a market exchange are high, then TCE suggests that a hierarchical solution will be preferred. But TCE does not take account of the power structure in the exchange relationship. As Williamson (1998: 30) acknowledges, TCE has been widely applied to exchanges of intermediate products10 because ‘the two parties can be presumed to be risk-neutral and, roughly, to be dealing with each other on a parity [emphasis added]. Each has extensive business experience and has or can hire specialized legal, technical, managerial, and financial expertise.’ But, as the above discussion makes clear, we would argue that the contracting parties often do not deal with each other even on a rough parity. We would thus suggest that the preferred organisational form for the exchange relationship thus depends both upon the power relationship between the parties and the relative transaction costs of effecting the exchange though the market or within a hierarchy. Figures 2 and 3 detail the eight possible outcomes, taking into account the relative scarcities of the supplier’s and the buyer’s resources, and whether market transaction costs are high or low.

Suppose first that the supplier (A) possesses scarce resources that are of value to the buyer

(B), whilst at the same time having many alternative customers for its output: B is thus in a position of dependence with little power in negotiating the terms of the exchange. If the costs of effecting the transaction through the market are also relatively high – see the bottom left quadrant

9 Notwithstanding the avoidance of market transaction costs, the transfer of intermediate products within the firm is still costly as it requires the functioning of complex internal information communication systems, organisation structures, and accounting systems. 10 In contrast to contracts for labour, with consumers, or for capital. 12 of Figure 2 – then there will be an incentive for B to internalise the transaction though backward vertical integration, and thus ensure a stable supply of inputs of the requisite quality. This situation corresponds to the traditional approach in the early Twentieth Century of Ford and other automobile companies, who tried to reduce costs by bringing together the manufacture of the cars and their component parts. A second possibility is that there are few potential buyers but many alternative suppliers, hence A is the one in the position of dependence. If the costs of effecting the transaction through the market are again relatively high – see the top right quadrant of Figure

2 – then there will be an incentive for A to internalise the transaction though forward vertical integration. Examples might include major airlines taking over the activities previously undertaken by independent travel agents, and the acquisition of cinema chains by film companies.

***** Figure 2 about here*****

If both parties possess scarce resources that are valuable to the other, then they are interdependent – see the bottom right-hand quadrant of Figure 2. There is then a measure of mutual interest between the contracting parties, and the organisational solution to effecting the exchange will reflect this. Given the assumed high transaction costs of undertaking the transaction through the market, it is likely that the two parties will establish a joint venture with the respective shareholdings reflecting the relative scarcity and value of the resources held by each party. The final possibility is that there are many potential suppliers and also many potential buyers – see the top-left hand quadrant of Figure 2 – so that neither A nor B currently enjoys any power in the exchange relationship. Given that both parties operate in competitive markets, the scope for opportunism by one party or the other is heavily circumscribed but there may yet be scope for post-contractual ‘hold-up’ if the costs of searching for alternative transactors are suitably high. There will thus be some incentive to formalise the exchange relationship, perhaps 13 through a joint venture or maybe through some non-equity form of long-term contractual arrangement. There is again a measure of mutual self-interest.

In the four outcomes described above (with the possible exception of the last), the result is that a vertically-integrated firm emerges which ‘makes’ in-house the input provided by A. It may also be noted that, if A and B undertake their activities in different countries, then the resultant firm will be a multinational enterprise (MNE).

In contrast, if the transaction costs of effecting a market exchange are relatively low, then

TCE suggests that a more ‘market-based’ solution will tend to emerge, although once again the nature of that solution will depend crucially upon the power structure – see Figure 3. Thus when neither party possesses scarce resources – see the top left-hand quadrant - and the transaction costs are low, it is likely that an arm’s length exchange will take place. This is the economist’s competitive market, where neither party to the transaction is able to call upon any isolating mechanisms. Neither party thus has any power over the other, but then neither is in a position of resource dependence. This is the typical ‘buy’ situation in most supply relationships: there is no imperative to internalise the transaction because the costs of effecting the exchange through the market are lower than the alternative costs of transferring the intermediate products within a firm.

***** Figure 3 about here *****

In contrast, if both parties possess scarce resources – see the bottom right-hand quadrant – then there is a bilateral monopoly. It is difficult to conceive of a real-world example of bilateral monopoly involving different actors within a production chain, because their mutual dependence would be such that there would be bargaining over both price and quantity, and it is highly unlikely that the transaction costs of effecting a market exchange would be low. The likelihood is that the market transaction costs would be substantial enough to favour integration. 14

The remaining two possible outcomes correspond to the situations where one party enjoys position of dominance over the other, and there is a situation of unequal bargaining power. In the bottom left-hand quadrant of Figure 3, it is the supplier (A) which possesses the scarce resources so that the buyer (B) is in the position of dependence. There is thus (as above) an incentive for B to internalise the transaction, but it may be that the relative sizes of the two parties are now such that the costs to B of implementing a hierarchical solution are too high. Meanwhile A is content with the market solution, as its power enables it to determine the terms of exchange so B simply pays a premium price for A’s output. An example might be the supply of popular children’s toys to stores at Christmas time. No store could possibly afford to acquire any of the major toy manufacturers, so they have to accept restricted supplies and higher prices.

The final possible outcome is that depicted in the top right-hand quadrant of Figure 3.

Here it is the buyer that possesses the scarce resources, and the supplier which is in the position of dependence. The buyer thus has more bargaining power, and thus is able to determine the nature of the exchange between the parties, both in terms of the form of the interaction and the terms of the exchange. The supplier (A) may wish to internalise the transaction but B is content with the market solution, and the situation will persist if the relative sizes of the two parties are such that the costs to A of implementing a hierarchical solution are too high. The buyer (B) is thus able to insist upon assured supply at a given specification to a minimum quality and at a low price. This is the situation that is apparent in many outsourcing arrangements, such as the examples cited above of Nike, Levi Strauss, Toyota, Astra Zeneca etc. The buyers all possess scarce resources, which act as powerful isolating mechanisms and enable them to resist the appropriation of the rents. In the cases of Nike, Levi Strauss, and the other clothing companies, it is the possession of brand names (with the associated substantial expenditure on advertising) that confers the power in their relationships with the suppliers and enables them to externalise 15 production. In the case of Toyota, it is the brand name, the sheer size of the company and the spread of its distribution network. And in the case of Astra Zeneca, it is the R&D expenditure, the drug patents, and the privileged access to the medical communities. In all cases, the common factor that provides the rationale for the outsourcing is the asymmetry of power between the buyer and the supplier.

Two final points should be emphasised. First, the typical production chain involves not just one, but an extended series, of dyadic exchange relationships such as that between the supplier (A) and the buyer (B). Global Commodity Chain (GCC) analysis (Gereffi, 1994, 1999) suggests that profitability will be highest in those segments of the production chain where the parties possess valuable and hard-to-imitate resources, and where these resources are characterised by significant isolating mechanisms that permit protection against the appropriation of the rents. Second, it should be apparent that the outsourcing of primary activities does not come about as a result of the lead firm focusing on its core competencies, or taking advantage of external competencies, or reducing costs by taking advantage of suppliers’ potential economies of scale or their ability to provide better service quality. Rather the lead firm opts to outsource its manufacturing because its resources and capabilities permit the appropriation of the total rents from a smaller asset base, even though there are no direct cost advantages. One could couch this proposition from a resource-based perspective that the lead firm is simply taking advantage of its capabilities in coordinating the activities along the production chain, but this is close to being a tautological statement: the key to the ‘improved’ performance of the lead firm has not been greater efficiency but rather its ability to leverage its power over its suppliers. In the following section, we develop these insights into a set of testable propositions about the firm attributes that are likely to be associated with a high degree of outsourcing. 16

PROPOSITIONS

The above analysis suggests that the level of engagement of lead firms in the outsourcing of their primary activities will depend both upon the power structure of the exchange relationship with its suppliers, and upon the relative costs of effecting the exchange through the market or through a hierarchical relationship. In other words, outsourcing should be more prevalent in firms

(a) which possess resources and capabilities that are considered valuable by their suppliers, and which are scarce because potential competitors are unable to acquire or develop suitable substitutes; (b) which use external resources and capabilities that are relatively abundant; and (c) whose transaction costs of acquiring intermediate goods and services through the market are relatively low. In this section, we develop these insights into a set of testable propositions about the firm attributes and industry conditions that are likely to be associated with a high degree of outsourcing11.

We first consider which firm attributes are least conducive to the ex post imitation and substitution of the lead firm’s resources by potential competitors, and which are thus likely to be scarce and underpin a position of power in the exchange relationship. First, there is the extent to which the firm provides customised products to its final consumers. As noted above, several authors have argued that the widespread diffusion of ICT has substantially reduced the transaction costs of effecting exchanges through the market, and thus may be credited with facilitating the growth in outsourcing. Certainly ICT has reduced some market transaction costs, notably those associated with identifying and comparing possible partners, and coordinating geographically-separate activities. But it will have little effect upon the costs of negotiating and

11 At any point in time, the average level of vertical integration will typically vary by industry, due to a range of technological, institutional and historical factors. An appropriate measure of outsourcing for any firm might thus consider the change in the ratio of its cost of the bought-in goods and services to the total cost of bringing the final goods to market. An appropriate time period would need to be specified for the change to take place. Diaz-Mora (2007) reviews various measures of outsourcing intensity used in the limited empirical literature on the subject: all focus on the level, rather, than the change in the ratio of bought-in goods and services. 17 enforcing contracts, particularly when there are imperfect markets for intermediate goods and/or when firm-specific tacit knowledge is involved. Indeed, it is possible that the widespread availability of the internet might in such circumstances have increased the possibility of opportunistic behaviour, and thus favour greater integration. But the development of the new technologies not only affects the relative costs of market and hierarchy in ways that vary across sectors, but it also has a marked impact upon the potency of the isolating mechanisms that enable agents to earn sustainable rents. Buyer switching and evaluation costs will typically be reduced

(Bakos, 1997), response lags will be shortened, learning by imitative producers will be facilitated, information impactedness will be reduced, and alternative marketing and distribution channels will emerge. At the same time, many of the advantages accruing from property rights will be eroded by the liberalisation of trade and investment worldwide, as various barriers to entry

(including those related to economies of scale) become less important.

In short, the adoption of the new technologies has both increased competition between suppliers at various stages of the production chain, and also shifted power within the chain away from suppliers towards buyers. As recent developments such as ‘lean retailing’ (Abernathy et al,

1999), ‘mass customisation’ (Pine, 1993), and ‘demand chain management’ (Selen and Soliman,

2002) imply, the crucial stage of the chain is increasingly control over the interface with the final customer with many firms putting greater emphasis on their downstream activities (Wise and

Baumgartner, 1999). We would argue that the extent to which the lead firm provides customised products, perhaps through preferential access to the final customer (Ghemawat, 1986), provides the basis for a significant isolating mechanism that enables the firm not only to resist the ex post dissipation of its rents but also to outsource the production of intermediate goods and/or services.

Thus our first proposition is that: 18

P1: The degree of outsourcing will be greater for firms with a high degree of product

customisation.

In this regard, one very important resource is brand-name capital. Osegowitsch and

Madhok (2003: 28-9) comment that ‘in many mature industries, the product has reached levels of performance that already satisfy the requirements most customers. Further refinements of the technical/functional performance of mature products tend to confront severely diminishing returns… In a bid to escape the commoditization of their core product or service, corporations are desperately trying to differentiate themselves from competitors. Where previously they aimed for differentiation based on the technical/functional merits of their offerings, they now supplement them with sophisticated downstream services [and] the adoption of total brand management.

Managers in mature industries as diverse as banking, cars, airlines, foodstuffs, beer, utilities, and resources have embraced branding in an effort to create a differentiated identity for their wares.’

Gereffi (2001: 33) also claims that brands are a way to resist commoditization when production chains disintegrate as a result of externalisation. He suggests that ‘sellers use brands to lock in customer relationships and to compete when reach (choice) goes up. Thus building brand awareness is a fundamental challenge and a major source of market power for firms [in buyer- driven production chains].’ To the extent that consumers place value upon a particular brand, and competitors are unable (because of legislation on the protection of intellectual property, or otherwise) to copy the brand, then the owners of the resource will be able to outsource the manufacture of the good safe in the knowledge that there is a strong isolating mechanism which will prevent the dissipation of the rents. Thus:

P2: The degree of outsourcing will be greater for firms with high levels of brand name

capital. 19

Next we consider the circumstances under which the external resources and capabilities sought by the lead firm are abundantly available, and thus reinforce the firm’s power in the exchange relationship. First and foremost, there is the thickness of the market for the intermediate goods and services, in terms of the number of potential suppliers and the extent of the search costs. If the lead firm has made a relationship-specific investment and there are only a few potential suppliers of the required intermediate goods and services, then the potential for opportunism is severe and the lead firm may choose to vertically integrate to alleviate the possible hold-up problem and ex post bargaining difficulties. On the other hand, if there are a large number of potential suppliers of suitable inputs12, then the lead firm will have more bargaining power, particularly if its purchases account for a significant proportion of the supplier’s business. In such cases, as illustrated in the numerical example above, the lead firm may choose to outsource production. Furthermore search costs are reduced in thicker markets

(Grossman and Helpman, 2002), and this too should favour outsourcing. Thus:

P3: The degree of outsourcing will be greater for firms which use intermediate goods

and services for which there are many potential suppliers.

Outsourcing can only take place if the technology of production is such that the production chain can be split into different stages that can be carried out in different locations.

This spatial disaggregation may take place within a single country. Antras (2003) demonstrates theoretically that outsourcing increases in attractiveness as the capital-intensity of the process decreases. If the different stages in the chain are characterised by different factor intensities, and the costs of transporting the intermediate goods are low enough to make the process economically viable (Deardorff, 2001), then it is likely that the outsourcing arrangement will be

12 McLaren (2003) suggests that the outsourcing decision may be endogenous in that there will only be a significant number of non-integrated suppliers if other firms also choose to outsource rather than to vertically integrate. 20 concluded with a foreign supplier as factor price differentials are generally more pronounced between countries. Production will thus be offshored as well as outsourced, and the international fragmentation of production will typically give rise to new patterns of international trade. For a lead firm located in a high-wage developed country market, the potential for outsourcing – both in terms of the numbers of competing suppliers and the scope for leverage – will be greatest if the intermediate goods and services are labour-intensive products. Thus:

P4: The degree of outsourcing will be greater for firms that use a large proportion of

labour-intensive intermediate goods and services.

As indicated in the previous section, the existence of power asymmetries between the lead firm and its suppliers does not provide a sufficient explanation for the chosen governance structure to be an outsourcing relationship. It is also necessary to establish the conditions under which market transaction costs are likely to be lower than the costs of hierarchical coordination.

Four firm attributes are likely to be associated ceteris paribus with low market transaction costs: firm size, the technological sophistication of the intermediate goods being exchanged, the firm’s sourcing experience, and the volatility of demand for the firm’s output.

The first attribute is the size of the firm. The ‘traditional’ explanations of outsourcing suggest that there should be an inverse relationship between firm size and the degree of outsourcing, as small firms will wish to take advantage of the economies of scale and scope provided by external suppliers whilst large firms are more likely to be able to provide a wider range of expertise and competencies in-house than small firms. However, agency theory considerations suggest that there are strong theoretical reasons to expect a positive relationship.

The costs of effecting transactions through the market include those associated with searching for suitable partners, the measurement and monitoring of performance, those related to establishing and enforcing the contract, and those related to effecting the exchange. Large firms are more 21 likely to have the necessary resources to facilitate the search for suitable partners, to monitor the performance of any suppliers, and will typically have more experience of contract enforcement.

In contrast, small firms may be obliged to limit the search for potential partners, and may not have the resources to monitor and enforce the contracts effectively (Tomiura, 2005).

Furthermore, large firms are more likely to have the bargaining power to extract safeguards for their vulnerable relationship-specific investments (Subramani and Venkatraman, 2003). In conclusion, it is likely that market transaction costs will be lower for large firms.

A second important attribute will be the technological sophistication of the intermediate goods and services that are exchanged. If the intermediate goods in question are technologically sophisticated, then it is likely that both partners will have made high levels of transaction-specific investments, and moreover that high levels of tacit knowledge will be involved on both sides.

Hold-up and other potential ex post maladaptation costs will be more severe, and the likelihood of opportunistic behaviour will be higher. Furthermore the potential rents that might be appropriated by opportunistic partners will be higher, whilst the contract negotiations are likely to be more complex. In such circumstances, the market transaction costs are such that a hierarchical organizational solution would be preferred in order to align the interests of the exchange parties - though, as indicated above, the exact form of that solution will depend upon the relative scarcity of the buyers’ and sellers’ resources. In other words, it is likely that market transaction costs will be lower for firms which use low-tech intermediate goods and services.

A third important attribute that is likely to mitigate market transaction costs is sourcing experience. Following Leiblein and Miller (2003), firms with greater experience of sourcing externally are likely to have developed the necessary organizational routines to enable them to collaborate efficiently with a broad range of suppliers. ‘Experience’ in this sense might be defined by reference to both the extent of external sourcing and the duration of that external 22 sourcing. Experienced firms are more likely to select better partners, organize relationships more effectively, and anticipate and respond better to market or technological contingencies over time.

In short, the costs of effecting transactions through the market should be lower for firms with greater sourcing experience.

Fourth and finally, Buckley and Ghauri (2004) note that volatility has become a much more significant feature of the global economy since the 1980s, and this has led firms to search for more flexible forms of organisation13. In situations where market demand is stable or predictable, the firm might opt for the necessary resource commitments to make the requisite intermediate goods and services in-house. But if market demand is uncertain or volatile, then vertically-integrated production would provide rather less flexibility than market contracting

(Carlson, 1989; Klein et al, 1998; Leiblein and Miller, 2003). Greater outsourcing would provide the firm with real options to change its use of intermediate goods and services relatively easily and at lower cost, and would allow the firm to avoid various fixed costs.

DISCUSSION AND CONCLUSIONS

The approach in this paper has been theoretical, and has addressed the conditions under which a lead firm might outsource its primary activities to an independent supplier in preference to adopting an alternative governance structure. The traditional explanations for outsourcing are applicable to a limited range of instances of support activities (typically IT and other back-room services) in which the external suppliers are able to provide the requisite goods and/or services more efficiently than the lead firm. However, these explanations do not provide a compelling

13 See also Buckley and Casson (1998) who suggest that the three main reasons for the increased volatility are the international diffusion of modern production technology, the liberalisation of trade and capital markets, and increased exchange rate fluctuations following the breakdown of the Bretton Woods system. 23 rationale for the outsourcing of primary activities in many other circumstances, nor do they identify the types of firms that are more likely to outsource.

An alternative, but complementary, perspective comes from the work of Chandler and

Langlois. In The Visible Hand (1977), Chandler chronicled how, in the late nineteenth and early twentieth centuries, the coordination needs of high-throughput technologies, and the abilities of contemporary institutions and markets to meet those needs, had led to the growth of the large vertically–integrated firm. According to Langlois (2003), the process of the division of labour predicted by Adam Smith as a response to the growing extent of the market always tends to lead to a finer specialization of function, but that the components of the process (markets, institutions, technology) change at different rates. Langlois asserts that the managerial revolution witnessed by Chandler as a replacement for the invisible hand of the market was an adaptation to a particular set of historical circumstances, during which the costs of coordinating though markets were high because the existing market-supporting institutions were inadequate for the profitable opportunities offered by the new technologies. In his ‘vanishing hand’ hypothesis, Langlois suggests that managerial hierarchies are second-best solutions that emerge in the absence of better alternatives but that, given time and a greater extent, markets ‘catch up’ and it starts to pay to delegate more and more activities. Langlois further suggests that, by the late twentieth and early twenty-first centuries, the extent of the market had grown and the institutions to support market exchange had evolved, and hence the vertically-integrated firm was increasingly succumbing to the forces of specialization: the result was widespread vertical disintegration or outsourcing.

The process of manufacturing outsourcing is associated with a narrowing of the formal boundaries of the firm. But, given the degree of control that the lead firm is able to exert over subordinate parties in the production chain, this raises questions about whether a more useful 24 definition of the ‘firm’ might incorporate various quasi-market transactions, such as those involving outsourced activities, over which the firm has substantial control (Richardson, 1972;

Ietto-Gilles, 2002). This echoes similar points made by Hymer over thirty years ago (Cohen et al,

1979: 248; Strange and Newton, 2006), and by Cowling and Sugden (1987, 1998: 67) when they define the modern corporation as ‘the means of coordinating production from one centre of strategic decision-making’. There are also interesting historical parallels between the process of outsourcing manufacturing and the system of ‘putting-out’ under which most non-agricultural work was organised prior to the Industrial Revolution. Under the putting-out system, merchants contracted with individual workers, or families, who worked at home and were willing to accept low piece rates. Most labourers were hirelings, generally tied to a particular merchant, who used their own machinery to turn raw materials provided by the merchant into intermediate and finished goods which were then purchased by the merchant. The putting-out system was eventually superseded by the factory system, though there has been considerable debate as to whether this was because the latter was more organisationally efficient (Landes, 1986) or because the former did not permit the merchant-entrepreneur to extract sufficient surplus from the labourers (Marglin, 1974). We would suggest, following Hymer and Marglin, that outsourcing provides a means by which modern merchants (the retailers and brand-name merchandisers) in buyer-driven production chains may maximise their surplus.

This leads on to the question of who gains, and possibly who loses, from the ‘slicing-up’ of the production chain. The potential benefits to the firm undertaking the outsourcing seem clear enough from the arguments above, and include higher profitability and the possible gains from access to the expertise and competencies of external suppliers14. Notwithstanding these potential

14 On the other hand, Liebeskind (1996) notes that firms may prefer to remain vertically-integrated rather than risk the loss of proprietary information. 25 benefits, there will only be a positive empirical relationship between outsourcing and firm performance if firms choose correctly when to outsource, and when not to, and also administer the outsourcing relationship effectively. Moreover, as Cook (1977: 67-68) points out, the use of a power advantage to obtain increased rewards increases the firm’s dependence upon the supplier over time. Over time, the exchange relationship tends towards balance unless the firm counteracts this tendency by only forming short-term contractual relations. The very process of outsourcing undermines the power asymmetries that enable the lead firm to appropriate the rents from the production chain15. This is what Williamson (1995: 230) refers to as the fundamental transformation ‘of what had been a large numbers bidding competition at the outset into one of bilateral exchange during contract execution and contract renewal intervals.’

From the perspective of the supplier, the outsourcing of primary activities offers opportunities for smaller firms, particularly those in developing countries, to specialise in the labour-intensive stages of a production process which, as a whole, may be capital or technology- intensive (Yeats, 1997). Subramani and Venkatraman (2003: 58) suggest that suppliers, who are vulnerable to the ex ante exercise of power by more powerful firms, may be able to craft governance mechanisms such as quasi-integration and joint decision-making that safeguard ex post their relationship-specific assets by increasing buyer switching costs.

There is considerable scope for future work on this topic. First, the various propositions put forward in this paper should be tested using data on a cross-section of firms. These analyses should also be extended to a variety of countries as it is likely that the potency and sustainability of the isolating mechanisms will vary in different institutional environments (Priem and Butler,

2001).

15 In this regard, it is interesting to note that Benetton – often cited as the archetypal network organisation – has recently instituted direct control over key purchases throughout its production chain (Camuffo et al, 2001). 26

Second, the concept of power needs to be refined theoretically and validated empirically.

In a study of the effects of power on profitability in the supply chains of French manufacturing firms, Cool and Henderson (1998) identified multiple dimensions of both supplier and buyer power. Interestingly, from the point of view of this paper, they found that buyer power explained a much larger percentage of the variance in seller profitability than did seller power.

Third, there is a considerable literature on the management of firms’ relationships with independent suppliers (see, for example, Levy, 1995; Kotabe, 1998; Murray, 2001; Kotabe and

Murray, 2004). But how are relationships managed and coordinated between parties in outsourcing relationships (Mayer and Salomon, 2006; Tadelis, 2007), and how are such mechanisms circumscribed by suppliers’ and/or buyers’ participation within other chains in broader production networks?

Fourth, there are numerous policy issues related to the gainers and losers from the process of the outsourcing of primary activities. For instance, what are appropriate strategies for firms entering international production chains? Should policy-makers in developed countries be concerned about the greater international fragmentation of production, or is outsourcing yet another manifestation of the old adage that ‘it’s the rich what gets the pleasure and the poor what gets the blame’? Does outsourcing provide lead firms with a hedge against workplace militancy and union pressure (Coffee and Tomlinson, 2004)? To what extent do lead firms, which have outsourced the production of primary activities, have responsibility for human welfare throughout production chains that are under their effective control (Kolk and van Tulder, 2002; Adams,

2002)? To what extent does outsourcing involve the transfer of environmental problems (e.g. pollution, carbon emissions) to other (often overseas) members of the production chain? Whilst lead firms may be able to leverage their power and drive down wages and costs in their suppliers, should they pay more attention to ethical issues? 27

In conclusion, the main contribution of this paper has been to combine the insights of resource dependency theory, the resource-based view of the firm, and transaction cost economics to provide both an explanation for the outsourcing of primary activities and a set of testable propositions about firms’ propensities of outsource. TCE addresses the conditions under which particular exchanges might be effected through the market rather than within a vertically- integrated firm, but does not explain why an outsourcing relationship might be chosen by the lead firm. Resource dependency theory emphasises that power underpins the outsourcing relationship, but does not say much about the sources of that power, whilst the resource-based view identifies the requirements for sustained rent generation from scarce resources. All three theories are needed to explain outsourcing. We have argued that outsourcing should not be viewed as a simple example of a ‘make or buy’ decision, but that it is also necessary to take into account the power asymmetries between the parties within the production chain, and we have drawn on the work of Rumelt (1984, 1987) in identifying isolating mechanisms that potentially enable parties to appropriate rents from scarce resources. Furthermore we have suggested that the development of new communications and information technologies, and in particular the internet, has both eroded the potency of many of these isolating mechanisms with the result that power has shifted from suppliers to buyers in the chain, and also reduced many market transaction costs. The result has been the greater outsourcing of primary activities by many firms in many industries. 28

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Relative scarcity of B’s resources ------Low High ------

Low A and B independent B has power over A Relative scarcity of A’s resources High A has power over B A and B interdependent ------

Figure 2: The Potential Organisational Outcomes with High Market Transaction Costs

Low Long-term contract, Forward vertical or strategic alliance integration Relative scarcity of A’s resources High Backward vertical Joint venture integration ------

Figure 3: The Potential Organisational Outcomes with Low Market Transaction Costs

Low Competitive market Outsourcing exchange Relative scarcity of A’s resources High Monopoly Bilateral monopoly 34

------