Outsourcing Strategy: A Recent Literature Review And Model Update

OUTSOURCING STRATEGY: A RECENT LITERATURE REVIEW AND MODEL UPDATE

By

LINA FERIA

BUAD 591

CALIFORNIA STATE UNIVERSITY, FULLERTON

Abstract

The importance of including an outsourcing strategy in the overall firm's operations has become increasingly important over the last decade. Companies in the U.S. pay about $68 billion every year to other companies for outsourced services and although a major part of these contracts succeed, there is an increasing concern due to recent broken deals. A recent study shows that 80% of companies that outsource their customer based functions are failing to meet their cost savings targets. Usually companies fail to budget hidden outsourcing costs such as customer dissatisfaction that can eventually jeopardize the future of the firm. In this paper I reviewed the most current literature on outsourcing and built a model that includes the principal four factors influencing the success of outsourcing strategies: the firm's Comparative Advantage, Employees, Suppliers and Customers.

Outsourcing Strategy: A Recent Literature Review and Model Update

Introduction

Every year in the United States, companies pay about $68 billion to other companies for key services or products that help them focus on their core business and delegate other functions (Thurm, 2007). The value of IT Outsourcing contracts worldwide was $119 billion in 2004 (Pai, 2007). Without a doubt, outsourcing is a major part of the business strategy that drives organizations to success. Whether at its simplest version of buying raw materials from a large supplier to its most complex variation of offshoring services, outsourcing is present in all business strategies.

However, outsourcing strategies are not always successful; therefore it is crucial to understand the factors that influence a firm's outsourcing strategy. In 2004, J.P Morgan Chase & Co. took its main technology functions to be in-house again abandoning a $5 billion agreement and Electronic Data Systems Inc. backed down from a $1 billion deal (Thurm, 2007). Although a few years ago outsourcing was used by some manages as another mean to cut costs, the main reasons for outsourcing have evolved to become more strategy oriented (Pai, 2007).

The basis of outsourcing is the same one as the trade theory where two or more parties benefit from the exchange of goods or services. Outsourcing and trade are beneficial for many reasons including cost savings and increase in wealth, but the main reason companies incorporate outsourcing into their business strategy can be explained in terms of comparative advantage.

The purpose of this paper is to review the most relevant recent literature in outsourcing and to identify the key elements that connect to a proposed model of outsourcing that complements the outsourcing decision framework Figure 1 (Kremic and Tukel, 2003). A revised version of this model follows.

Strategic Outsourcing Model

This research paper differs from Kremic's in that it incorporates the comparative advantage concept as the main driver of outsourcing and it also includes other triggering factors such as the industry clockspeed and the entrance of new technology into the industry. The main contribution of this article is to gather the most important factors of outsourcing into a model. In the current literature, the risks of outsourcing are mentioned very scattered. In this paper I provide a ranking of the most important risk factors mentioned in the reviewed literature.

There are three types of functions a business can be divided into: core functions, tactical non-core functions and strategic non-core functions (Pai, 2007). Core functions are the ones that dictate the comparative advantage of the firm; they are the specialized task that makes the business unique and successful. Tactical non-core functions are most commonly outsourced. They are the functions that are necessary components of the core business but do not have a direct impact on the core functions. These are functions like payroll, accounts receivable, accounting, call centers and recruitment.

The first part of the model includes two external forces that trigger the need to outsource. The first one is the industry and the second one is the new technologies that become an important part of the core business of the firm. Following the external forces are the internal reasons that push a firm to outsource. Although many have been identified in the literature, the most relevant refer to reduction of costs, focus on the core business, avoid the investment in specific assets and increase in efficiency and performance. A ranking of these reasons is presented in Figure 2 (Pai, 2007).

The proposed model highlights the four most important forces of strategic outsourcing: Suppliers, Customers, Employees, and the firm's comparative advantage.

Comparative and Competitive Advantage

It is important to understand the implications of comparative and competitive advantage in outsourcing. Comparative advantage theory explains that it may be beneficial for two parties (countries, regions, individuals and so on) to trade if one has a lower relative cost of producing some good. It takes into account the opportunity cost instead of the absolute cost of production of one good to evaluate the sourcing strategies that are beneficial for both parties.

The gains from outsourcing are well explained by this trade theory. In a simplified world with only two firms that produce two goods, trade will allow each firm to specialize in their production in a way that allocates resources to their most productive uses. If Firm A specializes in the production of software and Firm B specializes in human resources management, the trade theory demonstrates us that both firm's wealth will be maximized if Firm A produces software and sells it to Firm B in relative terms and Firm B, in exchange for software, administrates the human resources department of Firm A. Firm A then, holds a comparative advantage in software production if its price (relative to human resources management) is lower than Firm's B.

This comparative advantage