Outsourcing Theory

Outsourcing theory

International business theorists have long been fascinated by the way in which companies opt for internalization solutions, in which in-house units take responsibility for most value chain operations, versus externalization approaches, in which most value chain work is outsourced. Some view this arbitrage in national, macro-level terms, one example being a recent study showing that MNEs headquartered in mid-sized countries with an abundance of skilled labour tend to prefer outsourcing, unlike MNEs from smaller countries with an abundance of skilled labour, who tend to 'offshore' production to overseas units owned by the MNE itself (Alyson 2006). Theories like transaction cost analysis (see Chapter 8 ORC extension material), on the other hand, highlight more internal, micro-level considerations like the relative advantage for a firm of dealing with external partners instead of fulfilling a function through its own 'internal market'. Such externalization advantages can be calculated in different ways. Sometimes, the goal is strategic. For instance, in sectors where technological aptitudes are a key factor of success, it may be in companies' interest to access the capabilities of a specialist firm by purchasing its products or services instead of spending a great deal of time and money trying to develop similar competencies internally. In more commoditised sectors, on the other hand, cost is usually the key factor of success. By acquiring inputs from specialist suppliers that already benefit from unparalleled economies of scale, and even after paying their mark-up profit margins, companies may be able to access inputs more cheaply than if they were to produce them directly. In this case, the externalization advantage is being calculated in financial terms.

A more advanced approach to outsourcing is the 'resource-based view (RBV) of the firm' construct, arising from a seminal text by Edith Penrose (1959). This is an analysis that identifies a firm's managers, and the 'constraints' that they create, as crucial factors in identifying its capabilities. RBV highlights the competitive advantages that firms try to derive from the competencies of their human resources, and how they deploy such resources to maintain their existing advantages for as long as possible while diversifying into new fields to create new advantages. Diversification becomes possible due to the fact that managers' competencies are fluid and can be applied to different ends. The focus here is on the choices that firms make in terms of which activities they wish to pursue - or conversely, which they decide not to pursue. For a certain period of time, such choices can translate into above-average profitability, justifying the strategy chosen. The length of this period of success will depend on the competitive structures characterising the particular market in which the company is operating.

An offshoot of RBV, is the 'knowledge-based view of the firm' (KBV). This is an analysis where knowledge is viewed as companies' most important strategic resource. It lay the foundations for the emphasis on 'learning companies' that became so prevalent during the 1990s (see Chapter 9 ORC extension material).

Alyson, C. (June 2006), 'On the choice of in-house production versus outsourcing by multinationals',Journal of International Trade and Economic Development, Volume 15, Number 2.