Empirical Analysis of Backsourcing Rationale, Risks and Trends

Essay, 2012

38 Pages, Grade: B

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Table of Contents

1. Introduction

2. Theoretical foundation of sourcing decision
2.1 The resource-based view
2.2 Transaction cost theory
2.3 The relationship between two theories

3. Outsourcing
3.1 Outsourcing Definition and Typology
3.1.1 Outsourcing Definition
3.1.2 Outsourcing Typology
3.2 Outsourcing Decision Rationale
3.2.1 Cost and Operational Efficiency Advantages
3.2.2 Knowledge Access
3.2.3 Market Access
3.2.4 Outsourcing Scope
3.3 Empirical Evidence on Outsourcing Performance

4. Backsourcing
4.1 Backsourcing rationale
4.2 Potential problems and risks

5. Empirical evidence on backsourcing
5.1 Backsourcing in financial services industry
5.2 Literature Sentiment Index
5.2.1 Research question and methodology
5.2.2 Research results and interpretation
5.2.3 Limitations and further research
5.3 Backsourcing best practices

6. Conclusion


List ofTables

Table 1: Comparison of outsourcing and backsourcing in academic literature

Table 2: Comparison of outsourcing and backsourcing in FACTIVA

Table 3: Comparison of outsourcing and backsourcing in LexisNexis

List of Graphs

Graph 1: Negative citations in LexisNexis

Graph 2: Negative citations in Business Source Premier

Graph 3: Industry clustering backsourcing

Graph 4: Industry clustering outsourcing

Graph 5: Regional clustering ofbacksourcing hits

Graph 6: Regional clustering outsourcing hits

1. Introduction

Despite the overwhelming growth of the global outsourcing market in the past decade, results of studies suggest that as many as half of the outsourcing arrangements fail to deliver the desired or expected results. As a reaction to this unsatisfactory situation, different sourcing alternatives have evolved, among others the backsourcing alternative.

This research paper aims to address the relevance of the backsourcing agenda as one potential alternative to the continuation of the outsourcing option. After the introduction of the theoretical basis of the sourcing decision and the overview of most relevant dimensions of the outsourcing agenda, the question whether backsourcing can be identified as an evolving trend in the sourcing industry will be addressed. Here, the selected method of qualitative analysis will be used to identify any trends.

2. Theoretical foundation of sourcing decision

2.1 The resource-based view

The resource-based theory belongs to the organizational economics paradigm, which was developed in response to the limitations of and discontent with the framework of neoclassical theory. In the neoclassical theory firms do not need to exist and for instance transaction costs, limits on rationality, technological uncertainty, and informative function of prices are assumed away (Mahoney/Pandian 1992, p. 369). Furthermore, economic analysis provided by the neoclassical framework exhibits a lack of dynamism (Teece/Winter 1984, p.118). Without these frictions, the static equilibrium does not take into account the competitive processes and their consequences for strategy formulation and implementation. After definition, strategy can be viewed as activities performed by firms which are instrumental for achievement of economic rents (Mahoney/Pandian, p. 364). By taking this into consideration, the resource- based approach allows formulation of dynamic contexts, with focus on conditions and actions undertaken by firms in order to gain and sustain firm-specific advantages (Mahoney/Pandian 1992, p. 369). These advantages in specific are the ones that enable firms to develop core competencies and sustain them in a competitive environment (Prahalad/Hamel 1990).

Organizational economic paradigm attempts to explain evolution, function and sustainability of “institutions of capitalism” (Mahoney/Pandian 1992, p. 370). Therefore, the resource-based view, as part of organizational economic paradigm, focuses on evolution, function and sustainability of rent-generating, as well as on the topic of heterogeneity of firms (Mahoney/Pandian 1992, p. 370). According to the theory, firm is viewed as a unique bundle of assets and resources which can create competitive advantage. Sustainability of competitive advantage depends on the ability of competitors to duplicate the resources and capabilities which contribute to the achievement of the competitive advantage (Barney 1991, pp. 102-103).

The basic assumption of the model is that resources are heterogeneous and immobile. Heterogeneity implies that firms with different resources and capabilities are able to compete in the marketplace and at least break even. Firms with superior resources and capabilities will earn economic rents (Peteraf 1993, p. 180). Some firms implement their strategies faster than others and thus obtain first mover advantage which results in a sustained competitive advantage. Advantage is achieved only because the first mover possesses resources and capabilities which others do not possess. Without resource heterogeneity, first mover advantage would not be realized. However, the existence of entry barriers shows that resources cannot be perfectly homogeneous and mobile across firms. Firms in industries or markets protected by entry barriers implement strategies that differ from those that are still in the process of trying to enter them. Strategy implementation requires usage of resources and thus shows that in existence of entry barriers resources of firms must be heterogeneous and immobile (Barney 1991, pp. 104-105). Here it is important to note that not all resources have the potential for achieving sustained competitive advantage. To begin with, firm’s resources must satisfy four requirements to exhibit such potential, including value, rarity, inimitability and substitutability (Barney 1991, p. 105).

Firm resources must be valuable in order to potentially be a source of sustainable competitive advantage. As already mentioned, implementation of strategies implies usage of resources. If valuable resources enable a firm to implement specific strategy, then this strategy will result in increased efficiency and effectiveness. Thus, valuable resources implicitly contribute to the increase in efficiency and effectiveness of a firm (Barney 1991, p. 106). A resource must also be rare in order to have the potential for creating a sustainable competitive advantage. If a resource is possessed by several firms then all these have the capabilities to exploit the resource in the same way and benefit from its exploitation. Rarity of a resource restricts the number of firms which possess the valuable resource and can earn economic rents from its exploitation. However, rarity is not precisely defined and depends on the resource and number of firms in the market (Barney 1991, p. 107). Further condition for sustainable competitive advantage is the imperfect imitability of resources. If firms possess valuable and rare resources, they can only generate a sustained competitive advantage if competitors are not able or are impeded to imitate these resources. Resources are imperfectly imitable if one or more of the following conditions are applicable: ability of firms to obtain resources depends on unique historical conditions, the resource is socially complex, and the existence of causal ambiguity (Barney 1991, p.107). In the case of first condition, firms are endowed with resources which are inimitable because of historical developments. Valuable location, human capital and organizational culture are examples of such endowments which exhibit history- dependent nature. Regarding the condition of social complexity, resources are imperfectly imitable when due to factors such as organizational culture, reputation and relations between managers, other firms find it hard to duplicate. Finally, causal ambiguity exists if the firm rivals poorly understand the link between its resources and sustained competitive advantage. Inimitability here results simply from the fact that competitors do not know which resources to imitate in order to duplicate the competitive advantage because the link between resources and competitive advantage is ambiguous (Barney 1991, p. 109). Substitutability is the last requirement for a resource to be a potential source of competitive advantage. It means that there is no strategically equivalent resource that is itself either not rare or imitable, and that could be used for achievement of the same strategy. If resources are rare and inimitable but substitutable then competing firms can implement same strategies by using substitutable resources. The condition of absence of strategically equivalent resources must be fulfilled for the realization of a sustainable competitive advantage (Barney 1991, p. 111).

The resource-based theory is linked to other theories of organizational economics. Value and inimitability of a resource is secured among other factors through property rights. Consequently, property rights theory is linked to the resource-based view. Similarly, agency cost is a relevant variable for resource deployment and connects agency theory and resource- based view. Likewise, resource combinations are influenced by transaction cost economizing and thus resource-based theory is linked to transaction cost theory (Mahoney/Pandian 1992, p. 370).

The resource-based view fosters understanding of the conditions that make competitive advantage sustainable, the nature of rents and origins of heterogeneity (Peteraf 1993, p. 179). This theory is applied in the explanation of sourcing decisions and is important for understanding of outsourcing and offshoring. When applied to outsourcing or offshoring, it highlights that internal resources should guide firm’s strategy. Namely, outsourcing and offshoring allows firms to strategically exploit resources without expanding their boundaries (Thakur 2010, p. 19). The theory also infers that firms do not have to depend on internal resources, but can acquire resources from outside and thus overcome resource scarcity and sustain competitive advantage (Thakur 2010, p. 19). The stipulations of the resource based view have, in general, been supported by empirical studies. However, there is no unified understanding of firm resources and different researchers have proposed a variety of different conditions which are deemed necessary as to make a resource a source of competitive edge (Wade/Hulland 2004, p. 107).

The knowledge-based view is an outgrowth of the resource-based view because it identifies knowledge as the most important of the firm’s strategic resources (Grant 1996, p. 110). Knowledge has the potential to be source of sustainable competitive advantage and to generate economic rents. That is why the key task of management is to accumulate and protect valuable knowledge (Nickerson/Zenger 2004, p. 617). Knowledge can be classified into two categories: tacit knowledge and explicit knowledge. Knowledge transferability is very important, especially within firms. Absorptive capacity identifies boundaries of knowledge transfer (Grant 1996, p. 111). The knowledge-based view considers, just like resource-based view, dynamism. It also states that boundaries of the firm can shift in response to changes in problems and environment (Nickerson/Zenger 2004, p. 629). Some experts argued that firms exist because of asymmetry in the economics of knowledge (Grant 1996, p. 112). Similar to the resource-based view, knowledge-based view is linked to transaction cost theory because it focuses on a specific type of costs, which are related to knowledge (Grant 1996, p. 113). Transaction cost theory, which will be discussed in the following passage, complements theories presented above in understanding of the sourcing decision.

2.2 Transaction cost theory

From the perspective of the transaction cost theory firms exist because they are able to avoid costs associated with market transactions. The roots of this theory can be traced back to the Ronald Coase's article "The Nature of the Firm". In this famous article, Coase views markets and hierarchies as alternative governance structures (Coase 1937, p. 395), whereas the properties of transactions determine which one is the most efficient governance structure in a given case (Mclvor 2009, p. 47). Bounded rationality, uncertainty, small numbers, informational impactedness and opportunism are listed as the primary factors which cause transactional difficulties and contribute to the failure of markets (Williamson 1973, pp. 317­318). Bounded rationality refers to the cognitive limitations of participants to fully receive and understand relevant information in a transaction. Apart from bounded rationality, uncertainty also may complicate the process of decision making. Similarly, the factor of small numbers is relevant in bargaining and describes the degree to which a buyer can satisfy his requirements while having alternative sources of supply. Furthermore, information impactedness refers to information asymmetries between buyer and supplier in a transaction, whereas opportunism describes behavior which aims to realize individual gains through dishonesty in a transaction. Market governance will not be able to restrain opportunistic exploitation, which is why, according to the transaction cost theory, vertical integration is to be chosen (Geyskens et al. 2006, p. 520).

Oliver Williamson also contributed significantly to the research of transaction costs. He solved the operationalization problem of transaction costs by identifying observable dimensions of transactions (Geyskens et al. 2006, p. 519). The identified critical dimensions which characterize transactions are asset specificity, uncertainty and frequency (Williamson 1979, p. 239). Asset specificity describes the level of customization, whereby tailored assets have low or no value outside the transaction. There are several facets of asset specificity. Physical asset specificity refers to the material customization of the product and human asset specificity is in place if specialized knowledge is involved in the transaction. Also, if a special location is transaction specific then the asset exhibits in addition site specificity (Mclvor 2009, p. 47). Similarly, uncertainty can be divided into two categories: environmental and behavioral uncertainty. Unpredictability in the environment in which an exchange takes place raises transaction costs. Contracts help to resolve the uncertainty to some degree, they are however costly and incomplete. At this point, organization theory extensively overlaps with the contract law. Williamson (1979, pp. 248-260) discusses in more detail the different governance structures and contract types, while taking into consideration transaction characteristics. There is no clear opinion in the literature whether market or hierarchy is the best response to the environmental uncertainty. Moreover, behavioral uncertainty refers to the problem of ex-post evaluation and performance appraisal. General response to behavioral uncertainty is vertical integration. This is so due to the assumption made that the hierarchies embody higher degree of control and evaluation capabilities (Geyskens et al. 2006, p. 521).

The third identified critical dimension - the transaction frequency - describes the recurrence of transactions. In the case of recurring transactions, hierarchical governance is the better choice since the overhead costs of recurrent transactions can be recovered faster. However, this characteristic of transactions is not frequently discussed in the literature (Geyskens et al. 2006, p. 521).

Asset specificity has been identified in the literature as the most relevant variable for the choice of governance system. Hierarchical governance is likely to be chosen if asset specificity is high, since these assets can hardly be redeployed in alternative uses (Williamson 1981, p. 1548). Furthermore, the firm has several general advantages which enable it to be a better transaction cost economizer. Writing of a contract is less costly in an internal organization, since it can better control opportunism of its members. Also, the problem of information impactedness and uncertainty is reduced (Dugger 1983, p. 99). However, superiority of hierarchies to markets may be not only because of reduction in transaction costs, but also because of productivity enhancing factors such as skills and knowledge (Geyskens et al. 2006, p. 534).

Central application of transaction cost theory is the analysis of sourcing decisions. If costs of market governance are higher than benefits, then internalization must be chosen. Similar cost considerations also apply to the offshoring decision (Thakur 2010, p. 18). Transaction cost theory supports the outsourcing decision by analyzing the conditions for outsourcing. If asset specificity and uncertainty are low then outsourcing is in general possible. Transaction costs of different governance structures have to be analyzed in order to come up with the sourcing strategy of the firm. Furthermore, transaction cost theory enables a better understanding of the role of switching costs in the choice between backsourcing and switching vendors (Whitten et al. 2010, p. 168). However, it is essential to be aware of limitations of the transaction cost theory. The first limitation would be its strong focus on efficiency considerations and negligence of other important factors such as financing issues and strategic flexibility. The second limitation would be the assumed opportunism, which may not necessarily be present in reality due to long interorganizational relations. Final limitation arises from the fact that the theory focuses solely on two governance structures - markets and hierarchies - neglecting thereby alternative governance structures (Kim/Chung 2003, p. 82).

2.3 The relationship between two theories

The resource based view stresses the avoidance of opportunism by choosing hierarchy instead of markets. Namely, from the resource based perspective, the reason for existence of firms lies not in the avoidance of negative consequences of alternative governance structure, but rather in the existence of valuable bundle of strategic resources. Some researchers argue that hierarchy can be more appropriate even if there is no opportunism (Mclvor 2009, p. 48).

In recent discussions, a relational view has evolved. Its evolution was motivated by the limitations of the transaction cost theory and the extensions of the resource based view. According to this view, collaboration should be employed to minimize the cost of governing an activity. Externalities and resource constraints may suggest collaboration in situations where collaboration is not a best response to changing conditions (Mclvor 2009, p. 48).

These theoretical concepts are highly relevant when examining sourcing decisions. They help to identify core competencies and choose most effective governance structure. In recent years many companies outsourced some parts of their value chain. The outsourcing decision can be explained through the theories presented above but some scholars argue that both theories are complementary and that each theory alone is not able to fully explain the outsourcing decision (Mclvor 2009, p. 48). In some situations both theories come to the same conclusion and are complementary in nature. For instance, if a company has a rare and non-imitable resource and the potential for opportunism is high, then the best response from the perspective of both theories is to internalize the activity. The complementary nature results from the assumption that specific assets have distinctive characteristics which are difficult to imitate. Transaction cost theory aims to find efficient governance structure, whereas resource based view aims to find and preserve competitive advantage. As a result, the transaction cost theory focuses on governance skills and the resource based view focuses on production skills. To conclude, transaction cost theory answers the question of why firms exist and the resource based view why do they differ in performance, thus both theories are required to understand the complexities of outsourcing decision (Mclvor 2009, p. 59).

3. Outsourcing

Today’s constantly evolving global economy, characterized by merciless forces of competition, compels many companies to seek increasingly aggressive ways of accommodating the demands of their stake- and shareholders. Such globalized world economy, along with the current knowledge and service-based market orientation, offers numerous opportunities for companies to “disaggregate their value chain into discrete pieces” (Contractor et al.; 2010, pg. 1417), disseminate them to a larger or lesser extent around the globe and accordingly take advantage, both locally and internationally, of the external contractors’ competence and expertise. As a result of such value chain reconfiguration, the boundaries of many firms have simultaneously shrunk organizationally and expanded geographically (Contractor et al.; 2010, pg. 1418).

The so far presented line of reasoning brings us into the domain of strategic sourcing. While making sourcing decisions, companies are faced with the choice between four different modes of sourcing: in-house, fully owned foreign affiliates (also known as captive offshoring), domestic outsourcing and offshore outsourcing (Thakur; 2010, p. 3). These sourcing alternatives can be categorized along two dimensions: organizational (in-house vs. externally) and geographical (domestic vs. offshoring) dimension (Contractor et. al.; 2010, pg. 1418). Since this paper seeks to address the complexities of the outsourcing and consequently backsourcing phenomena in globalized context, both of these dimensions in the following will be examined.

3.1 Outsourcing Definition and Typology

3.1.1 Outsourcing Definition

Academic literature supplies a myriad of diverse outsourcing definitions. A typical textbook definition denotes outsourcing as a “purchase of a value-creating activity from an external supplier” (Irland et. al.; 2011, pg. 81). Such definitions spell out the most basic intuition of outsourcing, being simply farming out of services to external third parties. Gilley and Rasheed, however, do not agree with such a broad and all-encompassing definition. They argue that outsourcing activities is much more than a simple procurement decision, since all firms procure some or even a majority of the elements of their business operations in one form or another. In particular, they view outsourcing as a “highly strategic decision” with potential to exert influence throughout the whole organization, and, as such, it represents a “fundamental decision to reject the internalization of an activity” (Gilley, Rasheed; 2000, pg.764). In effect, Gilley and Rasheed condition the granting of outsourcing label on the fulfillment of the following stipulation: company needs to itself dispose of all the necessary managerial and/or financial capabilities for producing the good or service by itself (Gilley, Rasheed; 2000, pg.765). If the company is not able to produce internally goods or services in question - meaning that the rejection of a certain activity’s internalization was never a choice in the first place - such sourcing scenario represents nothing more than a simple procurement exercise. Hence, they differentiate outsourcing from discrete exchange which refers to a relatively short-term relationship between highly autonomous and sometimes also anonymous counterparties (Kim et. al.; 2003, pg.82).

3.1.2 Outsourcing Typology

The extensive research on outsourcing typology has produced just as many classifications as there are definitions of outsourcing. The most prevailing of those in academia are the ones that differentiate outsourcing strategies along the ways outsourcing may arise, the types of relationship with the vendor and the evolutional shifts in the nature of outsourcing (Thakur, 2010, pg.16).

Regarding the first mentioned dimension of classification, outsourcing literature identifies two ways in which outsourcing arises, by means of substitution and absenteeism (Gilley, Rasheed, 2000, pg. 764). The former represents the substitution of externally procured activities for internal ones, resulting in an annulment of internal production and its transfer to external vendor. The latter denotes the outsourcing of newly introduced activities which have not yet been procured internally.

The second classification focuses on the relationship with the vendor, differentiating between strategic and arms-length outsourcing (Thakur, 2010, pg. 16). Strategic outsourcing is concerned with long-term outsourcing relationship with the vendor, whereas arms-length outsourcing is more short-term oriented, featuring more superficial and formal relationship between the parties involved.

Ian Hunter has offered another classification partially relating to the previous dimension, in which he distinguishes between tactical, strategic and transformational outsourcing (Hunter, 2006, pg. 10). Tactical outsourcing focuses on achieving operational efficiencies by inducing competition tensions between existing internally operated activities and the corresponding externally sourced alternatives.

38 of 38 pages


Empirical Analysis of Backsourcing Rationale, Risks and Trends
University of Mannheim
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empirical, analysis, backsourcing, rationale, risks, trends
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Diana Kovacic (Author)Semen Zaltsman (Author), 2012, Empirical Analysis of Backsourcing Rationale, Risks and Trends, Munich, GRIN Verlag, https://www.grin.com/document/192343


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