Anitesh Barua* Deepa Mani** Andrew B. Whinston* *McCombs School of Business. The University of Texas at Austin. Austin, TX 78712

Transcription

1 Deconstructing or Destroying the Value Chain? An Empirical Assessment of the Long Term Market Value of Information Technology and Business Process Outsourcing Anitesh Barua* Deepa Mani** Andrew B. Whinston* *McCombs School of Business The University of Texas at Austin Austin, TX **Indian School of Business Hyderabad, India 1

2 Revised: January 2009 This research was supported in part by the McCombs Research Excellence Grant and the Research Excellence Grant from the Office of the Vice President of Research at the University of Texas at Austin. The authors thank Bin Gu, Prabhudev Konana, Cynthia Beath, faculty in the Finance department at the University of Texas at Austin, and seminar participants at Harvard Business School, New York University, University of California at Irvine, University of Maryland at College Park and the Indian School of Business for helpful comments on earlier versions of this manuscript. We also acknowledge the helpful comments provided by Saumya Mohan at Credit Suisse First Boston. Daniel Kung, Shivram Venkatasubramaniam and Jaya Das provided valuable research assistance. Any errors remain the responsibility of the authors. Abstract As the focus of Information Technology outsourcing (ITO) and business process outsourcing (BPO) evolves from pure cost savings to diverse strategic objectives, the impact of externalizing these activities on the long term value of the firm surfaces as a key issue for researchers and practitioners. Principles of managing simple outsourcing initiatives may not be effective for complex relationships, and there is empirical evidence that firms may not make suitable managerial choices, especially in strategic outsourcing decisions. Capital markets may not be privy to such information when an outsourcing decision is announced, and hence respond with a delay, after the consequences of the initial choices become public knowledge. Thus, there may be long term abnormal returns from such outsourcing decisions. Based on theories of contracts and procedural coordination, we argue that simple (complex) 2

3 outsourcing initiatives will experience positive (negative) long term abnormal returns. Further, we find prior experience with outsourcing induces insider buying in the case of simple outsourcing tasks. Data on 100 largest ITO and BPO decisions between 1996 and 2005 support our hypotheses. Keywords: IT outsourcing, Business Process Outsourcing, coordination, uncertainty, abnormal returns 1. Introduction Outsourcing of value chain activities is considered a strategic necessity for competitiveness and profitability today (Gottfredson et al., 2005). Evolving from its early focus on cost savings, IT services outsourcing (ITO) and business process outsourcing (BPO) today have embraced diverse strategic objectives, ranging from faster time to market to organizational transformation (Linder, 2004). Activities, which were considered poor candidates for outsourcing just a few years ago, are now being scrutinized for externalization. What started as a trickle of simple outsourcing engagements such as and web hosting and payroll processing has culminated into an avalanche of outsourcing deals spanning IT infrastructure, application services, and a myriad of strategic business processes. In 2006, Gartner emphasized this trend toward the decoupling of value chain activities (Figure 1), whereby even core business activities have a moderate chance of being outsourced in the future (Gartner, 2006). Indeed, even complex activities that comprise supply chain management are being outsourced today to service providers like United Parcel Service, DHL and FedEx Corp. For instance, supply chain services constituted 17 percent of revenues earned by United Parcel Service in 2007, which is a key driver of its revenue growth (Reuters, 2007). Insert Figure 1 here However, the challenges associated with the management of complex outsourcing initiatives like supply chain services may be quite different from those of managing simple engagements like 3

4 payroll processing, benefits management or web hosting services, where cost savings is the primary objective. Simple outsourcing relationships may involve specifying well defined performance metrics and a contract that provides the right incentives for the service provider to meet the client s expectations (Lee et al., 2004; Dyer and Singh, 1998). Further, an arms length relationship may be sufficient to manage such an outsourcing deal (Mani et al., 2006). For example, web hosting services are outsourced based on service level agreements (SLA) involving response time, availability, redundancy, and other attributes, and the even the monitoring of the SLAs are automated, minimizing the need for frequent interaction between the client and the provider. However, complex outsourcing relationships, which often involve strategic goals such as capabilities acquisition or the penetration of new markets, may necessitate a substantially different management approach. For instance, outsourcing customer relationship management (CRM) services may require intense interactions between the client and provider organizations, not only in the early phases of the engagement to customize and integrate the service with the client s internal applications and work routines, but also throughout the life of the contract to incorporate changes demanded by dynamics of the client s business environment (Susarla, Barua and Whinston, 2008). Along similar lines, outsourcing a business process such as new product development may require extensive communication, coordination and coordination with various groups such as R&D, production, marketing and finance within the client organization throughout the life of the contract (Mani, Barua and Whinston, 2008). In light of the above trend toward externalizing strategic elements of the value chain and the differences between managing simple versus complex outsourcing initiatives, it may not be surprising that outsourcing failures are a commonplace occurrence 1. Such failures may include the cancellation of 1 70% of the respondents in a 2005 survey by Deloitte Consulting (Deloitte Consulting, 2005) expressed significant dissatisfaction with their outsourcing projects. Similarly, a survey conducted by Bain Consulting 4

5 outsourcing contracts and/or costly renegotiations and legal action, widespread dissatisfaction within the client organization, and the loss of productivity and profitability (Rouse and Corbitt, 2006). While any of these undesirable outcomes of outsourcing is unfortunate from the client s standpoint, it has been widely argued that the primary objective of a publicly traded firm is to maximize its shareholder value (e.g., Rappaport, 1986; Sundaram and Inkpen, 2004). Thus, while there is much discussion regarding the impact of outsourcing on the bottom line (cost savings) and profitability of the firm, the crux of the issue involves the impact of outsourcing decisions on the long term market value of the firm. When large outsourcing decisions are announced by client firms, capital markets may not be privy to the specific nature of the outsourcing contract and other management choices and capabilities. Further, investors may not even incorporate all the available information in their immediate trading decisions. Hence, there may not be a significant impact of outsourcing on the market value of the firm in the short run. However, research on outsourcing (see Dibbern et al., 2004, for a review of the literature) has shown that management choices regarding contract and relationship management can make a significant difference in the level of success (e.g., user satisfaction, delays, cost overruns, and operational efficiency) of the outsourcing initiative. These outcomes emerge over time after the implementation of the outsourcing contract. Even though the market may not have initially responded to the outsourcing decision, it may, based on these observed outcomes, respond positively or negatively to the outsourcing decision with a delay, resulting in abnormal returns. Thus the efficient markets hypothesis (Fama, 1970) may not hold due to the lack of detailed information on various aspects of the outsourcing decision and/or a lack of understanding of how different outsourcing parameters affect the chances of its success or failure. found that although 82% of large firms in North America engage in BPO, almost half of the respondents say their outsourcing programs fall short of expectations. 5

6 In this study, we analyze the impact of ITO and BPO initiatives on the long term market value of the firm. Specifically, we investigate the following research questions: (i) Do simple (complex) outsourcing initiatives characterized by low (high) business uncertainty and low (high) complexity of coordination requirements experience different long term abnormal returns, if any? (ii) (iii) If yes, what are the differences in abnormal returns? What can explain such differences? Does outsourcing experience of the client firm affect long term abnormal returns? If yes, what are the implications for management action? Based on theories of contracts and procedural coordination, we argue that there may be a misalignment between the nature of the outsourced activities and the contractual and procedural coordination mechanisms chosen to manage the relationship. Such misalignment may not be obvious to investors when outsourcing decisions are announced, but can play a vital role in hastening the failure of the engagement. Thus, there may be a lagged market response to the outsourcing announcement. We hypothesize that simple outsourcing initiatives characterized by low complexity of coordination requirements and uncertainty in the firm s business environment experience positive long term abnormal returns, while complex projects with high coordination complexity and business uncertainty are associated with negative long term abnormal returns. We also posit that experience with outsourcing enhances the chance of success, and is therefore associated with positive long term abnormal returns. Our empirical analysis on data from the largest 100 ITO and BPO initiatives between 1996 and 2005 strongly support the above hypotheses. This study contributes to both theory and practice in Information Systems. Academic research on the value of outsourcing has generally focused on outcomes such as client satisfaction (e.g., Susarla et al. 2003), cost savings and announcement period returns. However, we demonstrate that not all 6

7 outsourcing engagements help firms maximize long term shareholder value, which is well accepted in the finance and strategy literature as the key objective of a publicly traded firm. We theorize why complex outsourcing engagements may involve misaligned choices of mechanisms to manage the engagement, and empirically establish a large difference in long term returns from simple versus complex outsourcing. From a practitioner s viewpoint, our study underscores the caution that firms must exercise before they undertake the outsourcing of complex ITO and BPO. The negative returns problem may be exacerbated by the lack of outsourcing experience, implying that firms with little experience should initially restrict themselves to projects with low complexity and business uncertainty. The balance of the paper is organized as follows. Section 2 presents the theoretical foundations of the study involving contract and procedural coordination theories, and provides the logic behind the hypotheses of positive and negative abnormal returns from simple and complex outsourcing activities respectively. Section 3 describes the operationalization of the constructs, while Section 4 outlines details of the data used in the study. Section 5 presents the methodology and empirical analysis. Discussion of the results as well as concluding remarks are provided in Section Theoretical Foundations and Hypotheses Development According to a survey by the Outsourcing Center (Goolsby, 2004), failures in outsourcing can be attributed to a myriad of causes, including unclear expectations at the beginning of the project, misalignment of interests over time, poor governance of the relationship, inequity of benefits, and poor communication (Figure 2). We show that many of these problems and challenges may be attributed to the incorrect choice of two factors that govern an outsourcing relationship: Contractual and procedural coordination. We then derive our hypotheses based on the characteristics of outsourcing initiatives for 7

8 which firms are likely to make misaligned choices in contractual and/or procedural coordination mechanisms. Insert Figure 2 here 2.1 Contractual coordination Contractual coordination specifies the mutual exchange of rights between the client and the service provider (Sobrero and Schrader, 1998). Poppo and Zenger (2002) note that a contract seeks to align incentives and interests between the client and the provider firms, and specifies ex ante promises or obligations to perform certain actions in the future. The choice of a contractual coordination mechanism is based on Transaction Cost Economics (TCE) (Williamson, 1985), which argues that a client firm should choose a contract that minimizes transaction costs and exchange hazards in the relationship. Exchange hazards are risks that arise from uncertainty perceived by the client firm about its relationship with the service provider. TCE posits that as relational uncertainty increases, so must contractual safeguards or the level of hierarchical control. In risky exchange settings, contractual safeguards enhance exchange performance (Masten, 2002; Poppo and Zenger, 2002) and allow for efficient decision making, since they make the information exchange process between partners more predictable and allow joint decisions to be made more by rules than by exception (Gulati and Singh, 1998). Two common contractual forms are fixed price (where the service provider is paid a fixed sum) and time and material (where the provider is compensated for its cost and also paid a markup). A fixed price contract provides a high powered incentive for the provider to minimize cost, since the provider is the residual claimant of its effort (Williamson, 1985), and also minimizes monitoring costs for the client. However, for outsourcing projects where it is difficult to predict the requirements to be fulfilled by the 8

9 provider, a fixed price contract may lead to inflexibility on part of the service provider (Bajari and Tadelis, 2001; Williamson, 1985). A time and materials contract may provide a safeguard against such maladaptation problems. However, with its low powered incentives, the downside of a time and materials contract is that the provider may not try to minimize cost for the client (Klein, 1980). Let us consider some examples of inappropriate choice of contractual coordination. Choosing a fixed price contract for a project with a high degree of initial uncertainty regarding client requirements may result in ex post inflexibility, whereby the provider refuses to tailor a stream of services that were not initially foreseen, or engages in a costly bargaining exercise with the client. As a second illustration, consider a complex outsourced task that has multiple dimensions, all of which are important to the client; however, suppose the provider s effort on some of these dimensions are difficult to verify. For instance, the CRM application outsourcing mentioned in the Introduction may have two distinct but complementary dimensions involving automation and business analytics (Susarla et al., 2008). Automation tasks may include automated response, campaign management, and lead generation; business analytics, however, may require an in-depth understanding of the client s business setting, and integration with internal applications and processes. The automation type tasks can be measured through SLAs on verifiable dimensions of effort, including network availability and application response (ITAA, 2003; Recktenwald, 2000). Susarla et al. (2008) show that in such a setting, choosing a fixed price contract will result in the service provider allocating its effort to the automation dimension (which is easily verifiable) to the detriment of the analytics dimension (which is difficult to verify), thereby lowering the value delivered to the client (Susarla et al., 2008). Why would client firms make an inappropriate choice of contractual coordination? Both the business press and academic literature (e.g., Lacity and Willcocks, 1998) have recommended iron clad 9

10 contracts to protect against opportunistic behavior by service providers. Typically such contracts involve fixed prices, with a high degree of hierarchical control and arms length relationships, which, we argued above, are not suited for complex outsourcing activities. Efficient contract design has long been considered central to the success of outsourcing relationships (e.g., Gopal et al., 2003), and empirical evidence regarding a misfit between the characteristics of the outsourced task and contractual choice (e.g., Mani et al., 2006; Susarla et al., 2008) underscore the likelihood of failure in complex outsourcing arrangements. 2.2 Choice of procedural coordination mechanisms Choosing the right contractual arrangement is a necessary but not sufficient condition for success in outsourcing (Mani, Barua and Whinston, 2005). Even when incentives are aligned and relational uncertainty managed through appropriate contractual form, it may still be challenging to achieve coordinated a action across the client and provider firms due to cognitive limitations that make it difficult for individuals or groups in interdependent settings to comprehend how their actions will affect others or vice versa (Gulati et al., 2005). Mani et al. (2006) describe procedural coordination in outsourcing relationships as the information exchange norms and processes that address such cognitive limitations of participant firms to promote a shared understanding of the task environment and mutual adjustment in behavior. They note that strategic outsourcing initiatives may need high levels of information exchange and adaptation on an ongoing basis to effectively cope with dynamic task environments. Organizational theories based on the structural contingency framework (March and Simon, 1958; Thompson, 1967; Galbraith, 1973) posit that the nature of information exchange amongst organizational actors is contingent on task uncertainty. Extending this viewpoint to the outsourcing 10

11 context, Mani et al. (2006) suggest that procedural coordination between the user firm and the service provider is dependent on the level of uncertainty in the client firm s business environment. Task allocation and coordination is transacted and renegotiated frequently in uncertain task environments. Also, contingent situations that arise on account of uncertainty must be solved using judgment and experience rather than rules or computational routines and necessitate a broader scope of information sharing (Perrow, 1967). Therefore, an increase in uncertainty in the business environment increases the levels of procedural coordination in outsourcing. Mani et al. (2006) provide empirical evidence that client firms may choose lower than appropriate levels of communication, coordination processes such as joint action and planning, and investments in inter organizational technologies for complex and strategic outsourcing, which may result in severe misalignment between the outsourced task and its governance, leading to loss of satisfaction and operational efficiency. 2.3 Learning effects The externalization of the critical activities within the value chain is a relatively new phenomenon for many firms that have primarily engaged in outsourcing with cost savings as the sole objective. As noted earlier, such simple initiatives can be managed with arms length contractual relationships with minimal need for procedural coordination. It may be natural for inexperienced client firms to apply similar approaches to the outsourcing of complex activities. However, Lacity and Willcocks (1998) find that firms accumulate experience with their outsourcing deals that is fed back into further outsourcing. Experience in dealing with complex outsourcing relationships may enable firms to choose suitable contractual and coordination mechanisms. Another reason to consider experience is that as firms gain mutual experience, concerns of opportunism may be somewhat mitigated, and hence the importance of contractual safeguards may be lessened (Santoro and McGill, 2005). 11

12 2.4 Long term abnormal returns from outsourcing decisions We discussed above why a firm s choice of contractual and procedural coordination may affect the likelihood of success or failure of an outsourcing project. When a firm announces an outsourcing decision, details of the contract and coordination mechanisms are rarely made public. In fact, we also argued that the firm itself may not realize the need to implement potentially costly coordination mechanisms for complex engagements. Thus, the market as a whole does not receive information on key parameters of the outsourcing decision, and may not be able to evaluate available information due to cognitive limitations. Moreover, potential outcomes of outsourcing arrangements may represent intangible information regarding future cash flows (Daniel and Titman, 2003), and thus result in misreaction and long term abnormal stock returns. The above logic leads to the following hypotheses: H1. Announcement period returns from outsourcing will be insignificant for both simple and complex initiatives, as well as for the outsourcing experience of the client firm. H2. Outsourcing simple projects characterized by low (high) uncertainty in the business environment and low (high) coordination complexity will lead to significant positive (negative) long term abnormal returns. H3. Prior experience with outsourcing is associated with positive long term abnormal returns. 12

13 2.5 Control variables Since the focus of this study is on the impact of business uncertainty and coordination requirements in outsourcing initiatives on abnormal returns, we control for factors that may potentially influence abnormal returns. Banerjee and Dulfo (2000) suggest that norms prevailing between a client and its service provider may improve outsourcing outcomes, which may be difficult to achieve solely through contractual means. Hence we control for trust between the client and the provider in our model. Given that performance improvements after the implementation of the outsourcing contract can be attributed to many other factors not related to outsourcing, we include income efficiency in the post outsourcing period as a control variable in our analysis. It is possible that when the outcomes of outsourcing become noticeable to capital markets, a comparison is made with the operational and financial performance prior to the implementation of the initiative. Hence we control for prior operational and financial performance of the client firm. Given that the type of activities outsourced (e.g., IT infrastructure, software outsourcing, business process) may have different likelihood of success, we control for outsourcing type. Further, the length of the outsourcing contract may affect outcomes to the extent that too long a contract may lock a client firm out of new opportunities brought about by new technologies and competition, while too short a duration may offer insufficient incentives to the provider to invest in client specific technologies, processes and routines. We also control for the strategic importance of an outsourcing deal, since engagements with high strategic importance are likely to receive significant attention and resources from senior 13

14 management, which may increase the chances of success. Furthermore, the payoffs associated with such projects may be significantly higher than those with only a tactical or operational focus. 3. Measures Coordination complexity of the outsourcing engagement is adapted from Gulati and Singh's (1998) operationalization of anticipated interdependence in strategic alliances. They argue that the objectives of an alliance suggest a distinct logic for value creation that is associated with a specific level of interdependence necessary for accomplishing the objective. The outsourcing literature points to eight rationales that cover the spectrum of outsourcing logics in increasing order of interdependence: Reduce costs, improve management focus on core competences, gain access to competitive capabilities not available in house, pursue growth strategy, increase speed to market, obtain access to new markets, increase proximity to customers, and achieve business transformation. The rationales are assessed from International Data Corporation s (IDC) description of the outsourcing initiative and the public announcement of the initiative. The greater the interdependence between the client and provider firms, the greater the complexity of coordination. If two or more objectives are pursued, the objective with the higher level of interdependence is recorded. We use variance in the outsourcing firm's return on assets over three years prior to the contract s effective year as a measure of uncertainty in its business environment. Given that the outsourcing projects in the sample are large scale initiatives (over 10 percent of the firm's operating expenses in the year of implementation of the contract) that span multiple departments in the organization (end to end business processes, organizational IT, etc.), it is reasonable to assume that the outsourced function responds and adapts to changes in the client s business environment. 14

15 Strategic importance of the outsourcing decision is measured as the ratio of contract value to operating expenses, where operating expenses is defined as the sum of cost of goods sold, sales and administrative expenses, and depreciation and amortization expenses. Prior operational performance is measured by operating income as a percentage of total assets as of the year prior to the implementation of the outsourcing contract. Buy and hold returns for three years preceding the contract implementation is used as a proxy for prior financial performance. 4. Data We analyze the 100 largest outsourcing initiatives implemented between 1996 and Such large outsourcing contracts have important advantages over a similar random sample. First, larger contracts are more likely to have a more significant economic impact on the firm. Second, while the sample consists of a small fraction of the total number of outsourcing initiatives in the sample period, the aggregate contract value of $83 billion is a significant 18 percent of the total outsourcing contract value for the period. The average contract value in our sample is $922 million and represents an average of 10.2 percent of operating expenses of the firms involved. Finally, our inclusion of large deals reduces the probability of confounding events since firms are less likely to sign equally large contracts in the same time period. The data set draws on multiple sources. Information on the 100 largest outsourcing initiatives and their governing contracts is obtained from IDC s services contracts database. IDC tracks outsourcing contracts worldwide with the database comprising more than 14,000 service contracts. As outsourcing began to gain momentum and contract value began to increase, IDC began to offer a detailed look at the top 100 outsourcing contracts each year, ranked by total contract value. This data on the top

16 outsourcing deals dates back to 1996, and is the primary input to this study. IDC data on the top 100 outsourcing contracts signed each year includes contract value, length, announcement and signing date, geography, industry, outsourcing type, and a detailed description of the service provided. We also use Lexis Nexis and the Dow Jones News Retrieval Service to verify and supplement IDC information on announcement and signing dates. We use the Center for Research on Security Prices (CRSP) files to compute abnormal stock returns, and the Compustat Basic and Research files to assess firm characteristics and develop operating performance measures. Our sample outsourcing contracts satisfy two requirements. First, the firm is publicly traded on at least one of the major United States stock exchanges. Second, information on the contract used to govern the outsourcing initiative is available. IDC classifies outsourcing contracts as one of fixed price, time and materials or transactional, combination, or incentive. Our final sample of 100 firm year observations consists of 66 firms. We circumvent problems inherent to event time measures such as potential bias in cross sectional standard errors due to overlapping data through computation of all results in calendar time as well. Fixed price contracts constitute 30 percent of our sample. The average contract value of the fixed price contracts is $826 million while that of variable price contracts is $834 million. The outsourcing initiatives in our sample are classified as Information Systems (IS) Outsourcing, Business Process Outsourcing (BPO) and Processing Services, and Application, Network and Desktop Management. IS outsourcing services involve a long term, contractual arrangement in which the service provider takes ownership of and responsibility for managing all or large part of a client s IS infrastructure and operations, often involving customized, one to one engagements. If only the network and desktop environment are outsourced, IDC captures the spending in the network management services and desktop management services category. Likewise, if only the application environment is outsourced, IDC 16

17 captures the spending in the applications outsourcing category. Applications outsourcing is a service wherein responsibility for the deployment, management, and enhancement of a packaged or customized software application is externalized to the service provider. Applications outsourcers also include application service providers (ASPs). ASPs deploy, host, manage, and rent access to an application from a centrally managed facility. Network management services involve the outsourcing of the operations of a specific segment or entire network communication system of a company. The network operations provided as part of a larger IS outsourcing contract are not captured in this category. Desktop management captures contracts for which several desktop services are outsourced to the same supplier. Processing services involve outsourcing business activities with performance metrics tied to the efficiency of high volume service capabilities. The client retains control over key decisions, and the vendor generally has a lower level of strategic involvement. BPO involves outsourcing business processes or functional areas (such as logistics or HR), with performance metrics tied to the strategic business value of services provided and to customer satisfaction. Business value is recognized through results such as new business opportunities, revenue generation and business transformation. The client and service provider share a tight partnership, with services often customized to fit the client s particular needs. IS outsourcing contracts constitute 53 percent of the sample, and on average, are valued at $1.1 billion. BPO and processing services comprise 27 percent, and on average, are valued at $703 million. Application, network and desktop management contracts comprise the remainder 20 percent of the sample, and on average, are valued at $747 million. The relatively higher number of IS outsourcing contracts is consistent with the greater maturity of this segment of the outsourcing market. Given the clustering by outsourcing type, we control for the impact of type of outsourcing transaction in our analyses. 17

18 5. Methodology and Empirical Analysis We calculate abnormal returns over a three year period following the implementation of the outsourcing contract using the matching firm method in finance, and then regress on abnormal returns with coordination complexity, uncertainty in business environment, and outsourcing experience as explanatory variables, and with type, income efficiency, prior operational performance, prior financial performance and strategic importance as control variables. To further understand the impact of coordination complexity, uncertainty and experience, we divide the dataset at the median, lowest and highest quartile points of these variables, and analyze the difference in abnormal returns. 5.1 Measuring abnormal stock returns While there are multiple ways to measure long term abnormal stock returns, the buy and hold abnormal returns (BHAR) relative to a matched portfolio has been suggested as a desirable approach (Barber and Lyon, 1997; Lyon, Barber and Tsai, 1999). Therefore we choose BHAR to estimate long term impacts of an outsourcing decision on firm value. For a client firm that announces an outsourcing engagement, BHAR is the return for that firm during a pre specified period following the implementation of the contract minus the return for a control firm during the same period. The control firm has similar characteristics as the sample firm such as industry, size and book to market, but which chose not to outsource. Thus the control firm acts as the proxy for the normal return for the sample firm. 18

19 Barber and Lyon (1997) recommend using an average BHAR because it better measures the investor experience" over the time period of interest. Thus, we calculate BHAR as the compound return on a sample firm less the compound return on an appropriately selected control firm. The calculations involve the month after the contract is effective through the earlier of the firm s delisting date, December 31, 2006, or end of the three year period following the contract effective date. Thus, the percentage buy and hold return (BHR) for firm i over the holding period T, beginning time a through time b is: b i, T t= a BHR = [ (1 + r ) 1], it where r it is the return for firm i in month t, period a is the month after the contract effective month, and period b is the earlier of the firm s delisting date or the end of the three year period following the contract effective date. Following Barber and Lyon (1997), we consider an industry, size and book tomarket matched sample as a benchmark of performance post implementation of the outsourcing contract. Therefore, we begin with a group of firms in the same two digit SIC code as the sample that do not engage in an outsourcing initiative of significant strategic importance as of the beginning of the contract effective year. The firms may outsource an organizational function but such an outsourcing initiative cannot be economically significant at the time of the matching. We determine economic significance of the outsourcing initiative by absolute contract value (> $100 million) and the percent of operating expenses (> 1%) that it constitutes. From this initial screen, a matched firm is defined as the firm that has the lowest absolute value of the joint difference in size (equity capitalization) and book tomarket ratio (equity capitalization divided by the book value of equity). Thus, the buy and hold abnormal return (BHAR) for stock i over holding period T is defined as: BHAR i, T BHRi, T BHRm, T = (2) 19

20 where BHR i,t is the buy and hold return of the sample firm, and BHR m,t is the buy and hold return of the matching control firm over the same period. The average buy and hold abnormal return is: 1 BHARi, T = ( ) n n i= 1 BHAR i, T where n is the number of firms in the sample. As in Barber and Lyon (1997), we report results of a crosssectional t test. However, this may be inappropriate since post contract implementation period returns overlap across firms, thereby, skewing the distribution of buy and hold returns (Hertzel et al., 2002). Thus, we use a bootstrapping procedure (Kothari and Warner, 1997; Hertzel et al., 2002) to assess the statistical significance of the calculated abnormal returns. 5.2 Analysis and results We computed the mean two day ( 1, 0) outsourcing announcement period return, which is an insignificant 0.11 percent. This result is consistent with prior studies, which find no significant value changes around outsourcing announcement dates. We also computed the ( 10, 0) and ( 1, 0) returns for lowest and highest quartiles of business uncertainty, coordination complexity and outsourcing experience (Table 1), and find the differences to be statistically insignificant. These observations provide support for hypothesis H1. Insert Table 1 here Next we calculate the 3 year BHAR for the entire sample. This return is a statistically insignificant 6.15 percent, which implies that overall the announcement of the outsourcing decision did not have a substantial impact on long term firm value. However, to test hypotheses H2 and H3, we regress the 3 year BHAR on the outsourcing characteristics (coordination complexity, uncertainty in business 20

21 environment, and outsourcing experience) and control variables outlined in Section 2. The results of the regression are shown in Table 2. Insert Table 2 here Uncertainty in the business environment and the complexity of coordination requirements show a significant negative impact on abnormal returns. Hypotheses H2 is therefore verified. Outsourcing experience is significantly associated with long term positive abnormal returns, thereby providing support for hypothesis H3. Among the control variables, change in income efficiency and strategic importance show a positive impact on 3 year BHAR. To investigate the impacts of task and firm characteristics on BHAR more closely, we divide the sample by the median values of uncertainty, coordination requirements, and outsourcing experience, and test the difference in BHAR across the two groups. The results are shown in Table 3, which provide further support for the regression results. Insert Table 3 here Table 4 shows the difference in BHAR across the lowest and highest quartiles of the explanatory variables. The differences are very large and significant. For example, the firms in the lowest and highest quartiles of business uncertainty and coordination complexity had a difference in 3 year BHAR of 113 and 99.3 percent respectively. Firms outsourcing tasks in the lowest quartile of coordination complexity enjoyed a 38.8 percent 3 year BHAR, while those outsourcing complex tasks that rank in the highest quartile of coordination complexity suffered a negative return of 64.2 percent (Table 4). Insert Table 4 here 21

22 6. Discussions and Conclusion The empirical results suggest that capital markets initially underreact to outsourcing decisions, and that firms manage simple outsourcing projects with stable business environments and low coordination requirements quite efficiently, which result in significant positive abnormal returns relative to similar firms that chose not to outsource. Thus, not outsourcing such projects would incur substantial opportunity costs in terms of long term shareholder value. It should be noted that the firms in our sample belong to the Fortune 500 list, and that they are expected to exhibit many of the best management practices. Therefore, it may not be surprising that the outcomes of outsourcing simple activities are positive for these firms, leading to positive abnormal returns. While information on many parameters of the initiative may not be publicly available, it appears that the market as a whole does not make an effort to collect and evaluate additional information to predict the success or failure of the outsourcing decision. Given that large scale externalization of the value chain is a relatively new practice, there may be a learning period for investors before such information gets incorporated in the value of the firm at the outset of the outsourcing project. However, our results also suggest that even Fortune 500 firms may not yet be managing complex projects efficiently, and are actually incurring large losses in financial value from their outsourcing decisions. That is, by externalizing activities in the value chain that are complex in nature, firms are actually destroying long term shareholder value. The finding that there are no significant abnormal returns for the entire sample suggests that the mere announcement of an outsourcing initiative may not automatically create (or destroy) value for the firm or its shareholders. Value realization calls for effective management of the outsourcing relationship, and that many firms may be unprepared to handle complex arrangements. Hypothesis H1 indicates that there are opportunities for firms to create value, while H2 cautions about the perils of 22

23 outsourcing activities that are performed in uncertain business environments, and where there may be significant interdependence between the client and the provider organizations. What can be responsible for the poor management of complex outsourcing projects? Given that outsourcing end to end IT and business processes is a relatively new phenomenon for many firms, it is feasible that the same management practices that have worked for simple outsourcing projects are also being deployed to manage complex relationships. For example, a fixed price contract may have been chosen for engagements with unclear objectives or specifications, forcing the provider to forego the level of effort it takes to cater satisfactorily to dynamic client needs. Similarly, choosing a fixed price for activities with high volatility in business requirements is also likely to run into renegotiation problems during the life of the engagement. Complex outsourcing arrangements also necessitate new investments in information technology applications and coordination processes. Further, both the client and the provider have to invest in these capabilities. Given the exclusive focus on cost savings in the early days of outsourcing, these additional investments may be seen as lowering the net benefits of externalization. Along similar lines, new coordination processes require organizational change that may be met with resistance in either or both organizations. An encouraging result is that outsourcing experience helps organizations increase financial returns from outsourcing. With experience, firms are likely to realize that complex relationships cannot be successfully managed with arms length approaches and SLA based automated monitoring of provider performance. Further, the positive impact of the strategic importance of the project suggests that projects that receive the attention of senior management are likely to pay rich dividends. This study is an early attempt to understand the impact of externalizing the value chain of a firm on its long term market value. Historically the value chain has been managed internally, and best 23

24 practices have evolved around this mode of governance. Research has focused on the linkage between internal best practices and business processes on firm value. The externalization of value chain is a paradigm shift for most organizations, and management approaches that have been effective for an internal value chain may not be applicable to inter organizational relationships with divergence in incentives and information. Our theoretical discussions suggest how outsourcing projects may differ widely in their complexity and the business environments they serve, and hence must be managed in different ways. Future research should focus on explicit linkage between governance choices and performance outcomes, and those between such outcomes and the long term value of the firm. 24

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29 Non-core yet Critical Accounting Supply Chain Management HR Administration Claims Administration Likelihood to Outsource: Moderate Today Future ++++ Core Business Managing Market Image/Trademarks Caring for Patients Managing Customers Financial Portfolio Manufacture Products Likelihood to Outsource: Low Today Future ++ Noncore/Noncritical Physical security Cafeteria Laundry Likelihood to Outsource: High Today Figure 1: Likelihood of outsourcing value chain activities (Source: Gartner, 2006) 29