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Maximizing the Firm Value Impact of Outsourcing Decisions

James R. Kroes, Soumen Ghosh, and Andrew Manikas


The outsourcing of business activities to third parties is now an integral component of many firms' competitive business strategies. Since the 1990s, outsourcing has increasingly resulted in the relocation of business activities to foreign locations. This increased reliance on outsourcing as a business strategy raises a number of challenges and concerns. Most importantly, although the purported goal of outsourcing is usually to derive a competitive advantage in the marketplace, it is not clear if outsourcing has consistently generated value for organizations. In addition, it is not clear if outsourcing decisions made by firms are always strategically aligned with their overall competitive strategy or if outsourcing generates the value firms expect. This chapter presents details of an investigation that was conducted to evaluate the impact that outsourcing decisions have had on the shareholder wealth of U.S. firms, and to identify the strategies used by firms that have had both successful and unsuccessful outsourcing experiences.

The outsourcing of activities to third parties located in other countries, offshore outsourcing, has become a common practice for U.S. firms attempting to increase their competitiveness.1 One study found that 21 percent of firms in the United States outsourced some of their internal business functions to offshore locations,2 and reports estimate that the value of offshore-outsourcing contracts grew approximately 29 percent annually between 2003 and 2008 and is expected to continue to grow by 17 percent annually through 2012.3 With this growth, the types of activities that are outsourced have changed dramatically. In the past, firms typically considered outsourcing only noncore, peripheral activities, but now, many businesses consider outsourcing even strategic activities in an effort to gain a competitive advantage.

Firms that consider offshore outsourcing are conducting a "make or buy" decision. Those that choose to make vertically integrate a function, thus maintaining control over business activities.4 Conversely, firms that choose to buy or outsource activities partner with an external vendor and possibly give up some control over their activities. The dramatic growth of the Internet and broadband technologies throughout the 1990s stimulated the growth of offshore outsourcing by enabling the communication of information and the collaboration of activities across large geographic distances.5 The elimination of these geographic obstacles led many firms to consider offshore outsourcing to take advantage of the perceived lower costs found in many offshore locations.

The main driver of offshore-outsourcing decisions is the desire to reduce costs.6 Cost savings can result from many factors, such as the service provider's ability to perform services at lower cost, the avoidance of fixed costs, being able to maintain a smaller or more efficient labor force, and access to a vendor's highly skilled workforce. The labor savings associated with offshore outsourcing can be significant. A study published by the National Association of Software and Service Companies estimates that U.S. companies saved nearly $8 billion annually in labor costs by outsourcing business functions to firms located in India.7 This is mainly due to lower wage scales in offshore locations; for example, the cost of skilled technology workers in India can be 50 to 60 percent lower than the cost of similar labor in the United States.8 Lower labor costs are not the only workforce-related driver. Many firms outsource to offshore locations to access highly skilled and talented workforce that provide better-quality services and often in a shorter time frame, than can be acquired domestically. As educational systems throughout the world have advanced, the number of offshore workers with advanced degrees has grown substantially. For example, India now produces as many engineering and science masters and doctoral graduates annually as the United States.9 Outsourcing internal business functions may generate value through labor cost savings due to reductions in workforce,10 or through the avoidance of the costs associated with the hiring and training of new workers.11 Offshore outsourcing may also lead to a reduction in material costs by transitioning an operation to a supplier located in a resource-rich location. In addition, a focused and experienced external partner may be able to provide higher-quality services by leveraging capabilities that the outsourcing firm does not possess. Finally, by outsourcing noncore business functions, a firm may be able to refocus its limited internal resources on its core business activities.12 This may in turn allow it to free up cash by avoiding the need for certain capital and overhead expenditures. When activities are outsourced, a firm can avoid investing in equipment and facilities it would otherwise need to complete an activity. Instead, the main costs to the firm are the direct cost of the outsourced product or service and any associated transportation costs.

The outsourcing of activities also creates risks for organizations that must be considered, especially when the activities are moved across national boundaries. Firms that outsource services to offshore locations risk losing a degree of control over their business processes. This loss of control can impact a firm's ability to monitor process quality and the working conditions at the outsourcing partner's facilities. A dramatic example of the consequences of this loss of control occurred in 2007 when Mattel was forced to recall nearly 1,000,000 toys manufactured by a supplier in China that were found to contain lead paint.13 In addition, the loss of control may potentially result in a loss of trade secrets and thus a diminished competitive advantage. Information and intellectual property security issues are difficult to manage when working with offshore firms located thousands of miles from the home country.14 Moreover, many countries do not have rigorous laws or transparent legal systems that can be used to protect a firm's information.15 Offshore outsourcing also lengthens supply chains, which can increase lead times, transportation costs, and magnify the impact of supplier disruptions on the firm's business. From a human resource perspective, outsourcing initiatives that result in a workforce reduction in the home country may also create a morale issue among a firm's remaining workers, as they may feel a reduced sense of loyalty to the organization and a fear that their job will be also be outsourced and eliminated.16

In addition to the risks just discussed, as offshore outsourcing has grown over the past two decades, the practice has been increasingly criticized by industry experts, government officials, and the media, who argue that offshore outsourcing results in lost jobs in the home country, a loss of control of business activities, and lower service quality.17 The movement of jobs from the United States to offshore locations, in particular, has fueled an escalating debate about offshore outsourcing. Studies have estimated that over one million jobs have already moved from the United States and Europe to developing nations, a number that is expected to exceed 2.3 million by 2014. 1 8 Proponents of outsourcing argue that the number of jobs off shored annually equates to only a small fraction of the job market, and that the efficiency improvements offshore outsourcing generates creates additional jobs in the United States.19 Studies that advocate offshore outsourcing also predict that traditional theories related to free trade will hold and that the cost savings generated will translate into lower final goods costs for consumers in the United States.20 However, it is unclear if traditional free trade economics can be applied to offshore outsourcing. Traditional free trade theory states that the loss of jobs in the country moving work offshore will be offset by long-run improvements in the global economy. A country shifting work offshore will thus benefit from lower-cost outsourced goods or services. In contrast to this theory, Nobel laureate economist Paul Samuelson argues that the current wave of offshore outsourcing will not generate the benefits predicted by traditional theory.21 He believes that shifting work offshore will allow foreign firms to develop a comparative advantage that will result in a permanent loss of per capita income in the country moving work offshore.

The debate and negative connotations associated with offshore outsourcing has also led to a political interest in outsourcing.22 Opponents cite the large number of jobs displaced to offshore locations as a justification for laws restricting outsourcing. Over 80 legislative measures have been considered in the United States in an effort to prevent jobs from moving to lower-cost countries.23 The U.S. Congress has repeatedly considered a number of measures, including requiring firms to provide assistance for displaced workers, establishing regulations that force firms to publicly disclose all offshore-outsourcing projects, eliminating federal aid for firms that outsource to offshore locations, and creating tax penalties for offshore outsourcing.24

The remarkable growth of offshore outsourcing may lead one to assume that firms find the practice to add value. Although numerous arguments have been made both for and against offshore outsourcing, most of these arguments have been based on emotion and anecdotal evidence. An alternate way of looking at the ongoing debate is to examine how these initiatives affect shareholder wealth. Offshore outsourcing can impact many aspects of a firm's performance, and the stock market's reaction to offshore outsourcing provides evidence on whether it is perceived as creating or destroying value for the average firm.25 Similarly, it is also not clear if the perceived competitive advantages of offshore outsourcing are still relevant as the practice has become widespread among businesses and target nations have developed. To shed light on these issues, we describe a two-part investigation into the effects of offshore outsourcing on firms. In the first stage of the study, we investigate several aspects of the impact of offshore outsourcing on shareholder wealth. Specifically, we examine the effect of publicly released announcements about outsourcing activity on the shareholder wealth of contract-granting firms, and compare the impact of offshore-outsourcing announcements with the impact of announcements to outsource activities to onshore locations. We also investigate the impact of the growing debate around offshore outsourcing by comparing the stock market reaction to outsourcing before and after the scrutiny into the practice escalated starting in 2001. Based on the results of our investigation, we then develop a strategic framework for successful offshore outsourcing

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