The Outsourcing of Primary Activities: Theoretical Analysis and Propositions Roger Strange (University of Sussex) Abstract

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 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 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 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).

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?

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.

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