Theory and Practice of Outsourcing

Outsourcing is the practice of charging external service providers with the task of performing in-house activities. Outsourcing has drawn attention with regard to its role in achieving effective logistics integration by which inter- and intrafirm activities are integrated to enhance customer satisfaction and competitive advantage (Bolumole, Frankel, and Naslund 35). By understanding the theoretical perspectives attributed to outsourcing, managers can identify and evaluate strategic reasons specific to their company, and analyze the cost and benefits (if any) to outsource.

The evolution of outsourcing can benefit from understanding how it exists in direct correlation, and/or in opposition, to established social science theory. Several theories are particularly relevant to logistics outsourcing practices and decision strategies: (1) Transaction-Costs Analysis (TCA) and Agency Theory; (2) Resource-Based Theory (RBT); and (3) Network Theory (NT) and General Systems Theory.

Transaction costs refer to the costs of physical and human resources incurred in order to complete an exchange of goods and services between parties. Factors that contribute to these costs include opportunistic behavior, the search for the "true" price at which purchases ought to take place, and the need to discover the "true'' quality of a good/service. In transaction cost economics, a firm's ownership decisions focus on minimizing the sum of its transaction and production costs (Mikherji and Ramachandran 213). Excessive costs may cause transactions to be transferred to other institutions. Transaction cost analysis (TCA) proposes that firms exist in order to maximize profits by reducing transaction costs through three different forms of governance structures: market (arms-length, one-off transactions for standard investments); hierarchical (vertical integration through direct ownership); and hybrid structures (combining elements of the market and hierarchical mechanisms). The transaction costs reduced by outsourcing logistics include, for example, decentralized order processing, assets, working capital, and overhead (Bolumole, Frankel, and Naslund 40).

An alternative explanation for outsourcing recognizes that in addition to costs, resource and competence based considerations are increasingly important in today's business environment. The resource- based theory (RBT) of the firm views the firm as a bundle of resources (Mikherji and Ramachandran 211). According to its principles, an organization must secure an efficient bundle and flow of the right type of resources from its environment in order to survive and improve its operational performance (Bolumole, Frankel, and Naslund 40). It regards firms as collections of heterogeneous resources and capabilities, and examines why they exist and what determines their scale and scope, and has since advanced as an important perspective for understanding how firms compete through their resources and capabilities. Emphasizing the value-maximizing feature of resource-based theory, competitive advantage is defined within this perspective as the ability to implement a value-creating strategy not simultaneously implemented by any current or potential competitors (Bolumole, Frankel, and Naslund 41). Sustaining this advantage depends primarily on the firm's ability to acquire, combine, and deploy resources in such a way that yields a long-lasting productivity and/or value advantage. Within this perspective, the rationale for organizations--in determining whether or not to outsource--is to maximize value through access to external resources. Accordingly, a resource-based view is particularly appropriate for examining logistics outsourcing because firms essentially use outsourcing as a strategy for gaining access to other firms' valuable resources (Mikherji and Ramachandran 211).

Systems theory focuses on organization and interdependence of relationships. This systems theory concept is used to explain how materials-flow, related activities, and information within and outside firms are so complex that they can be considered only in the context of their interaction. This school of thought regards outsourcing in structural terms with a view that the performance of organizations is no longer wholly dependent on what they do internally, but is largely affected by the collective performance of firms connected through business processes and relationships. In the network theory perspective, logistics outsourcing enables the firm to manage its supply chain as a single entity through the application of relational contracting and network coordination (Bolumole, Frankel, and Naslund 41). In the network theory, forms of collaboration are based on the key concepts of economic motivations, power, and trust. Network theory acknowledges that firms sometimes depend on resources controlled by other firms. Access to these resources can be achieved only by interacting with these firms, forming relationships, and, subsequently, networks across the value pipeline. This implies that different organizational boundaries overlap in the process of bringing finished products to the end consumer. From this perspective, logistics outsourcing is viewed as a strategy of using third parties to enable the logistics integration and interdependence of cross-functional and cross-organizational business processes. Network theory represents an attempt to develop an opportunism-independent theory of the firm while broadening the focus from cost minimization to incorporate the management of multiple firms' resource base (Bolumole, Frankel, and Naslund 42). This perspective is useful to managers seeking to understand, preserve, and extend their competitive advantage through their firm's specific network relationship endowment.

In developing a theoretical framework for logistics outsourcing, we take a combined view simultaneously. The elements of the three theoretical perspectives discussed to this point and beyond can be combined to create a strategic perspective to evaluate the impact of outsourcing. Managers need to know why the market can conduct an activity more efficiently and when the organization is better suited to carry out the activity in-house. Thus, focusing on the following strategic areas can help answer their why: (1) cost minimization (2) resource access (3) resource leverage and (4) risk diversification.

The most common motivation behind outsourcing decisions is cost minimization. The underlying assumption here is the greater ability of markets to reduce fixed costs derived from economies of scale. Therefore, in a market where there are a large number of buyers and suppliers, buying from the market is likely to be more cost efficient than in-house production, if the production process involves significant fixed costs. In a globalized world it is increasingly becoming easier