Outsourcing

Conceptual Overview

Outsourcing is not new. Whereas contractual relationships dominated the economic organization of production prior to and during the industrial revolution, from the mid-19th century until the past 20 years, the internalization of transactions within organizations became the dominant trend. However, since the 1980s, there has been a retreat from internalization. In the first years of this outsourcing trend, mainly noncore and less strategically important activities were subcontracted, such as cleaning, catering, and maintenance, also called bluecollar activities. Increasingly, however, organizations have begun to outsource white-collar business services, which many might claim are strategic, such as information technology and telecommunications.

There are two main forms of outsourcing: (1) Long-term outsourcing is characterized by a long-term partnership between the outsourcing organization and the outsourcing provider (e.g., a strategic alliance or network). It involves an intensive interaction, open communication, and the sharing of risks and outcomes. (2) Arms-length subcontracting is characterized by a loose relationship between the outsourcing organization and the outsourcing provider, similar to the traditional market relationship. These two outsourcing forms differ in their economic implications for the outsourcing company and in the associated requirements on the management of the outsourcing process.

The economic effects of long-term outsourcing and arms-length subcontracting are discussed in the literature as a part of the broader issue about the boundaries of the firm—seeking to explain why certain transactions are governed in-house (through hierarchy or vertical integration) while others are governed through market relations (arms-length subcontracting) or through networks (long-term outsourcing). Two theoretical streams, the transaction cost theory and the knowledge-based view of the firm (and its extension in the capabilities approach), concentrate on the question, what are the conditions that make one or the other governance form more efficient in governing economic activities?

Critical Commentary and Future Directions

Transaction cost theory has its origins in economics. Williamson, one of the leading figures of the transaction cost perspective, argues that the main motive of organizations to outsource activities is to reduce transaction costs. Assuming bounded rationality and assuming that individuals might behave opportunistically, he suggested that three exchange conditions—uncertainty, asset specificity, and frequency—determine when long-term outsourcing (called hybrid within the transactioncost approach), arms-length subcontracting, or vertical integration is more efficient. Asset specificity—the degree to which an asset can be redeployed to alternative uses without sacrifice of value—is the central category in the argument. Asset specificity creates bilateral dependency and poses contracting hazards to the involved organizations. Transactions with a fairly high degree of asset specificity and a middle frequency should be outsourced and executed in close cooperation with the outsourcing provider because hybrids are the governance form with the lowest transaction costs in such cases. Arms-length subcontracting is, in contrast, the most efficient governance form in all cases of low degree of asset specificity.

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