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Outsourcing refers to the fundamental decision to contract out specific activities that previously were undertaken internally. In other words, outsourcing involves the decision to reject the internalization of an activity and can be viewed as vertical disintegration. As it means to obtain by contract from an outside supplier, it is also called contracting out or subcontracting.
Outsourcing is not new. Contractual relationships dominated the economic organization of production prior to and during the Industrial Revolution. However, from the mid-nineteenth century until the 1980s, the internalization of transactions within organizations became the dominant trend. From the 1880s, there was a shift from a regime of laissez-faire production consisting of many small firms to a regime based on large, vertically integrated corporations, or what is called a shift from markets to hierarchies, which culminated in the large-scale public and private sector bureaucracies of the post-war era. Two reinforcing tendencies played an important part in this trend: the growth of direct government involvement in economic activity and the development of production technologies that favored large, vertically integrated organizations. Those same factors forced the retreat from outsourcing in the 1980s and 1990s. In the first years of this outsourcing trend, mainly non-core and less strategically important activities were subcontracted, such as cleaning, catering, and maintenance, also called blue-collar activities. Increasingly, however, organizations began to outsource white-collar, business services, which many might claim are strategic, such as IT and telecommunications. The offshore contracting out of manufacturing and especially of service activities to developing countries is the reason for a growing skepticism toward outsourcing in the developed countries.
A large number of studies are primarily engaged with the empirical proof of the existence of cost efficiencies from outsourcing. As a leading figure in this research, Domberger (1998) undertook several empirical studies of outsourcing in the UK and Australian public and private sector, reporting that, on the average, organizations realized 20 percent increases in efficiency and decreases in cost through outsourcing. These cost efficiencies result, for example, from the reduced capital intensity and lower fixed costs for the outsourcing companies and in the reduced costs of the outsourced activity due to the supplier’s economies of scale and scope. Additionally, other positive effects have been proposed, such as higher flexibility through the choice between different suppliers and the easy switch between technologies, quick response to changes in the environment, increased managerial attention and resource allocation to tasks where the organization has its core competences, and increased quality and innovativeness of the purchased products or services due to specialization of the supplier and spreading of risk.
Despite the arguments that outsourcing firms often achieve better performance than vertically integrated firms, there is a lack of consistency as to the extent to which outsourcing improves the performance and the competitive situation of organizations. Several studies show that efficiency gains are often much smaller than claimed, or even that costs increased after services are contracted out. Additionally, it has been argued that using outsourcing merely as a defensive technique can cause long-term negative effects. Because of outsourcing, there is the danger for firms to enter the so-called ”spiral of decline” (also called hollowing out of organizations): after contracting out, companies need to shift overhead allocation to those products and services that remain in-house. As a result, the remaining products and services become more expensive and less competitive, which raises their vulnerability to subsequent outsourcing. This process can lead to the loss of important knowledge and capabilities and, as a result, can threaten the long-term survival of organizations.
Some other important disadvantages that may result from outsourcing are a negative impact upon employees that remain in the company (e.g., lower employee commitment, drop in promotional opportunities, drop in job satisfaction, and changes in duties), declining innovation by the outsourcer, dependence on the supplier, and the provider’s lack of necessary capabilities. Especially the social cost associated with loss of employment in the outsourcing organizations has been strongly criticized by opponents of outsourcing.
- Domberger, S. (1998) The Contracting Organization: A Strategic Guide to Outsourcing. Oxford University Press, Oxford.