Offshore Outsourcing of IT and Business Process Services

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1 Offshore Outsourcing of IT and Business Process Services Hofland, Hilde Student ID#68537 Submitted to Aarhus School of Business Aarhus, Denmark September 2010 Supervisor: Philipp Schröder Abstract: As ICT has made trade in services easier, firms are locating services abroad in order to seek efficiency gains and attain competitive advantage. The thesis identifies trends in the development of IT services and business process services by looking at transaction cost economics and at how global value chain structures are governed and change. The trend seems to be a move towards standardisation of services making it easier for companies to outsource and offshore. Technology is improving rapidly in this sector, and companies need to actively follow the development in the market in order to take advantage of the benefits of offshore outsourcing.

2 Table of Contents PART I: INTRODUCTION Methodology and Delimitations Outline of the thesis... 5 PART II: TERMINOLOGY AND DEFINITIONS Vertical disintegration versus unbundling of corporate functions Outsourcing Offshoring Services Information Technology - and Business Process Services Method of delivery Intermediate summary PART III: THEORY Transaction cost theory TCE and Governance Structures Governance Structures Governance structure classifications Markets Modular value Chains Relational value chains Captive value chains Hierarchy Intermediate Summary PART IV: ANALYSIS The make or buy decision Frequency Asset specificity Uncertainty Legal issues Capabilities in the supply base India China Russia Latvia Romania Offshoring versus nearshoring Governance Structures PART V: CONCLUSION References:

3 PART I: INTRODUCTION The fragmentation of the production process is a major theme in international economics. Fragmentation of the production process has given rise to the restructuring of the firm to include locating activities outside the boundary of the firm and locating parts of the production process abroad. As such, production processes are becoming increasingly more geographically dispersed. Research on this area is however largely restricted to manufacturing and the underlying aspect of globalisation (Defever, 2006). Cross-border trade in services is however increasing rapidly much due to Information and Communication Technology (ICT) which has changed the way we trade in services. As ICT has made trade in services easier, firms are locating services abroad in order to seek efficiency gains and attain competitive advantage. Locating services abroad has been termed offshoring. A company may choose to offshore services that are kept in-house or outside the boundaries of the firm. The latter is termed outsourcing. Moreover, a company may choose to outsource and offshore a service which constitutes part of the production process of a final good or service, or outsource and offshore a business functions. The thesis aim to identify trends in the development IT services and Business Process services offshore outsourcing. Offshore outsourcing will be examined from a transaction cost economics (TCE) perspective. From this perspective, the choice of whether to locate services within or outside the boundaries of the firm will be made with the aim of minimizing transaction costs. As opposed to classical economics which view the marketplace as the most efficient means of exchange, TCE takes into account costs incurred when making a transaction. Taking transaction costs into account it may be cheaper to make than to buy. The make-or-buy decision can be viewed as a choice of mode of governance. That is, a buyerseller relationship may be mediated by an interfirm ( make ) or intrafirm ( buy ) contract. The first corresponds to using the hierarchy of the firm, whereas the latter corresponds to using the market. There exist a variety of hybrid governance structures within the span of hierarchy and market. The efficient governance of a contractual relation will vary with 3

4 the attributes of the transaction and move from simple market exchange to hierarchy as bilateral dependency builds up (Williamson, 2008). The thesis will thus go on to explain different modes of governance. IT- and Business Process services will be analysed in light of TCE. Possible governance structures will be proposed depending on determinants like complexity, ability to codify information and supplier skill base. There exists a number of IT and Business Process services which vary greatly with respect to complexity and codifiability. If a service is complex higher skilled workers will be required. Choosing the right service provider is thus vital to a company seeking to outsource and offshore. Countries differ greatly with respect to availability of high skilled labour and type of services offered. Transaction costs may however serve as an impediment to trade with some of these countries, making it cheaper to locate services at home or closer to home. From a European organisation s perspective locating service activities within the EU could for instance prove less costly then locating in Asia due to transaction costs. The topic will be discussed from European organisations perspective in order to capture the choice between nearshoring and offshoring. Hence, it will offer a comparative analysis between likely offshoring destinations within and outside the EU. Outside the EU, the main focus will be on Asian countries and India in particular. Nearshoring is likely to offer advantages regarding language, and geographical and cultural proximity. There also exist laws and regulation that might prevent European firms from offshoring to countries outside the EU Methodology and Delimitations The topic will be discussed and analysed based on applicable theory and desk research. As previously stated, during recent years ICT has changed the way we trade in services. This change complicates defining the term services precisely. Moreover, a lack of proper classifications as well as the nature of the way trade in services takes place makes it difficult to find adequate data capturing the extent of exports of intermediate services or business functions from affiliated and unaffiliated companies. 4

5 Nevertheless, the topic is widely discussed although debates on the topic largely concern the relocation of jobs and wages across national boundaries. This topic is often referred to as international sourcing relocation or delocalisation (in French) and has long been an issue in manufacturing. International sourcing implies some substitution of activities at home by production abroad, and the effect of exports of manufacturers from developing countries on jobs and wages in the home country is thus a hot political issue. Offshoring generally refer to low-cost nations, and most trade in services that involves developing countries takes place within IT- and business process outsourcing services (Matto & Wunch, 2004). Through offshoring of services, the fear of losing low-skilled jobs in manufacturing to developing countries has thus extended to include high-skilled service jobs (OECD a, 2007; Krugman, Cooper, and Srinivasan, 1995). As such labour movements are also a major theme within offshoring. These topics will however not be covered. At a national level the development of IT- and business process service outsourcing will have implications for how nations can anticipate future competitive factors in order to invest effectively in these areas and attract investment. Asian countries and India in particular has had major success in attracting offshoring investments from abroad. Transactions costs may however incur by locating outside the EU which could lead to trade diversion. A lack of adequate data does however make it difficult to give any empirical evidence of trade diversion, and will thus not be the main theme of the thesis Outline of the thesis The thesis is divided into five sections. The first part of the thesis consists of the introduction, methodology and limitations, and outline. The second part of the thesis will focus on the terminology; defining and exemplifying the concepts used. Firstly, the difference between vertical disintegration and corporate function unbundling will be explained. Vertical disintegration is well known from manufacturing and enabled through fragmentation and slicing up of the value chain. Vertical disintegration is increasingly witnessed in services as well, but in addition, corporate functions are outsourced. 5

6 Next, outsourcing and offshoring will be defined. Outsourcing is the make-or-buy decision, and will be defined as a choice of mode. Offshoring is the decision on where to locate. As illustrated in the below table (table 1) offshore outsourcing fit into the bottom right corner (marked grey), where companies choose to buy abroad. It is worth noting that outsourcing implies more than just a pure vendor relationship, and that there exist a variety of hybrid modes of governance structure within the span of make and buy. Home Location Abroad Mode Make Domestic in-house sourcing Offshore in-house sourcing Buy Outsourced to domestic suppliers Outsourced to foreign suppliers Table 1 Subsequently services will be defined. Due to the intangible nature of services, they are difficult to record and to define precisely. Moreover, ICT has led to increased trade in services and also changed the way we trade in services which further complicates defining and classifying the term properly. IT services and Business Processes is also hard to define due to the same reasons. In addition, these types of services span from simple call centres to more advanced finance and accounting services. The types of services will be categorised and exemplified as in the table below (table 2), where business process services are divided into three subcategories: 1. Information Technology Services Table 2 2. Business Process Services - Customer Interaction Services - Back-office operations - Other Professional Services 6

7 Part three of the thesis introduces the theory that will form the basis for the analysis. The concept of transaction cost economics and governance structures. Transaction costs will be divided into three main categories: The frequency of the transaction The uncertainty of the transaction The asset specificity of the transaction In addition, mode of governance will be explained taking into account the following determinants: complexity of transactions ability to codify transactions capabilities in the supply-base Part four of the thesis will analyse the IT-and Business Process services in light of the before mentioned theories. Different countries within and outside the EU will be presented in order to give an overview of the services offered, and in order to capture the possible advantages of nearshoring. Subsequently, the last part of the thesis will conclude. PART II: TERMINOLOGY AND DEFINITIONS 2.1. Vertical disintegration versus unbundling of corporate functions Outsourcing and Offshoring of Information Technology Services and Business Processes are not new phenomenon but similar to what has been witnessed before in manufacturing when sourcing intermediate goods from abroad. Fragmentation or slicing up of the value chain lets firms produce a good in a number of stages in a number of locations, adding a bit of value at each stage. Intermediate products might be produced in disperse locations, and assembled from subcomponents from yet other countries which can greatly increase the volume of international trade (Krugman et al., 1995). This is referred to as vertical disintegration. 7

8 The difference between vertical disintegration and unbundling of corporate functions is depicted in the table below (table 3). The two differs with respect to type of delivery as well as supplier upgrading opportunities and possible market consequences. Vertical Disintegration Description Suppliers provide inputs which is part of a final good or service Supplier s upgrading Moving up the value opportunity chain. The supplier end up competing in the same industry as the client firm Consequences Bilateral monopoly is a possibility with suppliers engaging in hold-up and buyers exercising monopsonistic power Table 3 Source; Sako 2006, pp 507 Unbundling of corporate functions Suppliers provide a services in corporate functions such as HR, IT etc. Deepen functional expertise, the supplier operates in a different market than the client firm Client firms are in a weak position with no monopsonistic power visà-vis suppliers Vertical disintegration thus refers to the slicing up the value chain to find niches for labour intensive production when producing goods that traditionally has been viewed as skill-, capital, or technology- intensive goods. Labour intensive parts of the production process can then be located in low-wage countries. A high-technology product like a notebook computer is assembled from intermediate products of which some are high-tech and some are low-tech. The high-tech parts are produced in America and Japan, while the plastic that surrounds it and the wiring that connects the high-tech parts are produced in low-wage countries. As such, the notebook computer assembly is a Newly Industrialised Countries (NIE s) industry (Krugman et.al., 1995). As services are becoming more easily tradable, fragmentation not only enables firms to outsource or offshore intermediate goods but also intermediate services. A company may for instance outsource application development as an IT service to a company in a low-cost 8

9 nation. The development of the application will then be a service performed as part of the final good produced. The way services have changed however also enables companies to outsource part or all of a business process as a service. This is termed corporate function unbundling. Sako (2006) views this as a novel way of restructuring corporations in which the make-or-buy decision no longer only concerns intermediate products but also business processes which reside in corporate-function unbundling. Corporate function unbundling provides a different base for the supplier to enhance value-adding activities from vertical disintegration (Sako, 2006) Outsourcing The choice of deciding what activities to buy and what to keep inside or internal to the firm s ownership structure is amongst others analysed in the literature on internalisation of which early analysis include Dunning (1977) (Markusen, 2005). Outsourcing can be viewed as the opposite of internalisation. Outsourcing is more precisely defined as the acquisition of an input or service from an unaffiliated company. This is according to Helpman (2006) the standard terminology used in industrial organisation. Buying services from a provider is not necessarily outsourcing. Outsourcing entails more than just purchasing a service from an outside supplier, which is just a pure vendor relationship. Outsourcing involves a considerable degree of two way information exchange, coordination and trust. Moreover, it implies that the supplier undertakes relationship-specific investments so that it becomes able to produce a good or service that fit the firm s particular needs (Erber, Sayer-Ahmed, 2005; Grossman and Helpman, 2002). Bhagwati, Pangariya, and Srinivasan (2004) make a noteworthy narrow definition of outsourcing as the offshore trade in arm s length services, excluding purchasing and FDI. That is, they take outsourcing to mean sourcing from not only outside the firm but also outside the borders of the home country. Moreover, they exclude trade in goods from the definition. 9

10 Bhagwati et.al derive their definition from the World Trade Organisation s (WTO) General Agreement on Trade in Services (GATS) which categorises trade in services into four different modes. Mode 1 involves the arm s length trade in services where supplier and buyer remain in their respective locations. Mode 2 involves moving the service recipient to the location of the provider. Mode 3 involves the service provider establishing a commercial presence in another country, requiring an element of foreign direct investment (FDI). The direct investment involved is however assumed to be miniscule. Mode 4 involves the service seller moving to the location of the service buyer. Hence, Bhagwati et. al (2004) does not distinguish between the sourcing decision and the decision of whether to locate at home or abroad. Markusen (2005) however warns against this narrow definition and emphasises the importance of keeping the outsourcing and offshoring terms apart, as the first is a mode choice and the second a location decision Offshoring In addition to the choice of internalising or outsourcing an organisation s activities, the choice can be made of whether to locate at home or abroad. Offshoring refers to the shifting of tasks to a location outside the home country borders. Moreover, it implies that the offshored tasks previously carried out at home will now be imported back into the country from the offshore location (OECD b, 2007). Hence, the offshore location will function as an export platform. How and where a firm choose to locate their activities globally can be an ownership specific advantage, and increase a firm s globally competitive position. A firm may widen or deepen their global value chain across or within nations taking advantage of countries comparative advantages. Offshore can refer to any destination outside the home country but is generally understood in the business jargon to mean low-cost nations. Thus, a software division in the US would typically not be termed an offshore destination. Low-cost nations would include emerging/transition and developing nations (Carmel & Tjia, 2005). 10

11 The term offshore has spawned a list of related terms. The opposite of offshoring is onshore services, which refers to the services provided by foreign firms onsite. Thus the term onshore is equivalent to Mode 4 trade in services of the GATS. Nearshoring refers to sourcing of services from a location close to the home country (Carmel & Tjia, 2005). The type of good or service sourced may determine the type of governance structure, and put requirements on the buyer-supplier relationship such as frequent face-to-face meeting that might favour the nearshoring option. Legal issues, and cultural proximity amongst others might also make nearshoring favourable. There are three different paths towards offshoring. A firm may simultaneously make the decision to outsource and offshore their activities, they may shift outsourcing activities from a local to a foreign supplier, or they may decide to offshore their activities to an overseas subsidiary. It is also possible for a firm to switch source from an internal subsidiary to an outside supplier (Sako, 2006). The latter is essentially a choice of mode of governance structure. Home Abroad Make Domestic in-house sourcing Offshore in-house sourcing Buy Outsourced to domestic suppliers Outsourced to foreign suppliers Table 4 The red arrows in the above table illustrate moving either in-house, outsourced activities from at home to abroad Services Here, a service will be defined as an intangible good. An economy may be divided into the goods-producing and service-producing sector where services traditionally has been defined as intangible, non-storable and non-transportable (Rugman, 1987). For a customer, the value of a service is not in receiving a tangible object but in the function performed by the seller. 11

12 Hence, the service is co-produced with the customer. This requirement has in the past made it difficult to transport services cross-borders. Information and Communication Technology (ICT) has however changed this and made geographical distance less of a barrier to the simultaneous production and consumption of services (Sako, 2006). Call centres are examples of this. ICT also enables standardisation and storage of services as for instance with medical diagnosis (Sako, 2006). Hence, services acts more like products and are more easily tradable now than they used to be. Consequently, the traditional distinction between services and goods are no longer viable. Moreover a firm is likely to have a combination between products and service activities that make it hard to differentiate between the two. Sako (2006) calls this the productising of services and serviceising of products. Products are becoming more like services in that software firms for instance are turning to services when their core product markets become saturated, and may offer maintenance, customisation and upgrading services. Hence, offering complementary services to the products sold is a way to seek growth (Sako, 2006). The productising of services on the other hand enables a larger degree of standardisation and the role of human skills is minimised. As the traditional distinction between goods and services are becoming blurred, Blinder (2006) suggests it more useful to separate services into personal and impersonal ones. Personal services are those that cannot be delivered electronically, or those who are notably inferior when delivered in that manner. Personal services require face-to-face contact such as going to the hairdresser or a check up at the doctor. Impersonal services do not require faceto-face contact in the same way, and it does not matter where the person performing the service is located (Blinder, 2006). Impersonal services have more in common with manufactured goods than with personal services. According to Blinder (2006) however, the dividing line between personal and impersonal services is not static and personal services might become impersonal as information technology improves. Automation through the use of information technology reduces the need for human intervention. Once a service is standardised and automated, it becomes easier to operate at a distance and services may be offshored (Sako, 2006). Hence, as the dividing line between personal and impersonal services changes, more services might be subject to offshoring. 12

13 Due to the changing nature of services traded today it is not easy linking them to any existing services sector statistical classifications (Mattoo & Wunch, 2004). Moreover, difficulties in defining services makes it hard to quantify the amount of services that cross the border, the very nature of services trade further complicate the situation. There are no tangible products crossing the border Information Technology - and Business Process Services Information Technology (IT) and Business Process Services can be defined as services provided by businesses for businesses, including computer services, professional services, R&D and other services provided by labour placement agencies and call centres (Sako, 2006). Tjia and Carmel (2005) categorise Information Technology and Business Process services by using the terms IT-services and IT-enabled services (ITES). By this definition IT services include any type of software-related activity, whereas ITES typically include call centres, medical transcription, architectural drafting, through to financial securities research. The below table is a non-exclusive listing of information technology and business processes services (Mattoo and Wunsch, 2004). 13

14 1. INFORMATION TECHNOLOGY SERVICES Software development and implementation services, data processing and database services, IT support services, application development and maintenance, business intelligence and data warehousing, content management, e-procurement and B2B marketplaces, enterprise security, package implementation, system integration, SCM, enterprise application integration, total infrastructure outsourcing, Web services (internet content preparation, etc.), Web-hosting and application service providers (ASPs) 2. BUSINESS PROCESS SERVICES Sales support, membership management, claims, reservations for CUSTOMER airlines and hotels, subscription renewal, customer services INTERACTION helpline, handling credit and billing problems, etc. telemarketing SERVICES and marketing research services. Data entry and handling, data processing and database services, medical transcription, payment services, financial processing (financial information and data processing and handling), human BACK-OFFICE resource processing services, payroll services, warehousing, OPERATIONS logistics, inventory, supply chain services, ticketing, insurance claims adjudication, mortgage processing. Human resource services (hiring, benefit planning and payroll, OTHER etc.), finance and accounting services (including auditing, PROFESSIONAL AND bookkeeping, taxation services, etc.), marketing services, product BUSINESS SERVICES design and development. Table 5 Source: Mattoo and Wunsch (2004). p. 4. Gartner defines Business Process Outsourcing (BPO) as the delegation of an IT-enabled business process to a third party that owns, administers and manages the process according to a defined set of metrics. That is, BPO is typically corporate function unbundling. Moreover, Gartner differentiate between Business Processes that are tailored to specific industries, and those that can be leveraged across specific industries (Singh et al., 2009). Examples are listed in the below table: 14

15 Horizontal offerings: Benefits administration Accounts payable Indirect procurement Contact centre operations More-holistic horizontal offerings, including HR-related functions Table 6. Source: Singh et al. (2009) Vertical-specific offerings: Revenue cycle management for the healthcare industry Mortgage origination for the banking industry Policy administration for insurance companies This is a useful distinction and shows how business process services may be customised not only to a specific firm but to industries as a whole. Service suppliers may specialise in providing services that fit for instance insurance companies or may provide more generic services. What Gartner defines as horizontal offerings fit more than one industry, but might also be customised to a particular company or standardised to fit more than one company Method of delivery IT- and business process services can be traded using various methods of delivery, location of delivery and methods of purchasing (Caminos et al., 2008). Depending on the type of service, and depending on among others the degree of automation and standardisation, IT- and business process services supplier-vendor relationship take different forms. Cloud computing is a delivery method for Information Technology Services in which internet is used as the platform for service delivery (Singh et al., 2009). Cloud computing came about as companies like Amazon, Google and Salesforce.com appeared in the consumer market and then spread into business organisations. This development is termed consumerization. By concentrating on rationalising and increasing standardisation of service offerings, service suppliers are able to deliver with greater predictability and cost savings (Caminos et al., 2008). Cloud computing is a suited delivery method for such standardised service offerings, 15

16 and may be used for services like or application services. Application Service Providers may thus use the internet to provide their services. Cloud computing is on the rise as an IT service delivery method and is equivalent to using the arms length market as opposed to hierarchy at the other end of the spectrum. Another method of delivery which is on the rise is 24/7 availability of IT support. A company may for instance set up several help desks in remote locations in order to limit the number of contacts hitting one help desk. By setting up global delivery networks based on the same homogenous processes and methodologies, the end user will experience the same service regardless of location. By taking advantage of different time zones, a company may ensure 24/7 seamless IT support. 24/7 seamless IT support would be the ultimate aim for providers, however still a work in progress for many (van der Heiden, 2009). Business processes may, in the same way as IT services, take different forms and may be delivered to the buyer using different delivery methods depending on the type of service provided. Gartner has defined the following four major categories of service delivery for business processes (Caminos et al., 2008): Discrete-process BPO Comprehensive BPO Multi-domain BPO Business Process Utility (BPU) The bulk of the BPO market falls into the first of the categories and constitute outsourcing of single sub processes such as benefits administration and accounts payable. This is what Mattoo & Wunch (2004) defines as back-office operations. This differs from Mattoo & Wunch s (2004) other professional and business services category which equals Gartner s Comprehensive BPO. Comprehensive BPO are characterised by support for multiple business processes within on area or business function, such as payroll, benefits administration etc. Multi-domain BPO support several functions across multiple process domains such as pieces of HR, F&A, procurement and customer service. These types of contracts are not common (Caminos et al., 2008). 16

17 Similar to how standard IT services are moving to the cloud, automated and standardised business processes may move towards utility like offerings. This is termed business process utility (BPU) and forms the last of the four delivery methods defined by Gartner. The term utility is used as a metaphor to illustrate how standardised business processes may be provided much in the same way as utilities like power and electricity. The business process service recipient will pay for the functionality but not own, build or develop the service provided itself (Young et al., 2010). This provides the user of BPU with flexibility, reduce cost, and speed to access among others. Thus, for some services Companies may gain from taking advantage of standardised offerings that are prebuilt and not prebuilt specifically to fit their particular organisation. BPU will be offered as a standardised process as a one-to-many technology platform (Caminos et al., 2008) Intermediate summary It is possible to make the distinction between vertical disintegration and corporate function unbundling. The first is known from manufacturing and enables outsourcing of intermediate goods or services, whereas the latter lets Companies outsource part of a business function like human resource functions (HR). IT- services may constitute part of a final good or service whereas corporate function unbundling enables outsourcing of Business Process services. Vertical disintegration and corporate function unbundling also differs in that suppliers of an intermediate service or good may end up competing in the same market as the client firm, as opposed to business function service suppliers. Suppliers of a business process compete in a different market then the client firm. A Company face the decision to either make-or-buy. As a simplification, outsourcing can be said to equal the latter. However, outsourcing is more than just a pure vendor relationship and involves relationship-specific investments that fit a Company s specific needs. IT services and Business Processes services differ with respect to the amount of customisation. Standardising and automation has been termed the productising of services (Sako, 2006), and impersonal services (Blinder, 2006). As information technology improves services may increasingly be automated and standardised. Services that are highly standardised and automated are moving to the cloud and utility-like offerings. The cloud type of service delivery method is closer to purely utilising the arm s length market, then outsourcing. Service providers of BPU, 17

18 providing services from a one-to-many technology platform also lack extensive relationshipspecific investments. Companies seeking to outsource also face the location decision. If a Company choose to outsource abroad, this is termed offshoring. Nearshoring refers to sourcing of services from a location close to the home country. Highly automated and standardised IT and Business Process services may be offered over the internet. As stated above, outsourcing entails a larger degree of bilateral dependency between buyer and supplier than just a simple vendor relationship. Hence, as these types of services fit in the buy part of the spectrum, it is not considered outsourcing by the definition in this thesis. Home Location Abroad Mode Make Domestic in-house sourcing Offshore in-house sourcing Buy Outsourced to domestic suppliers Outsourced to foreign suppliers (GATS mode 1) Table 7 Countries may specialise in different types of services. The choice of where to locate depends among others on the type of service outsourced, who can provide the service, and the cost associated with the transaction. Next, the theory forming the background of the analysis will be presented. PART III: THEORY Transaction cost economics explains the rationale of the so called make-or-buy decision. That is, the choice of either keeping the activity in-house or letting someone else produce the good or service outside the boundaries of the firm. The choice to buy would in this respect correspond to outsourcing. As stated above, outsourcing entails more than merely a vendor relationship. Depending on the type of transaction taking place, the buyer-supplier 18

19 relationship can take several forms within the range of either make or buy. TCE is operationalised by naming the key attributes to which transactions differ (Williamson, 2008). Drawing on the literature on TCE, production networks, and technological capability and firm-level learning Gereffi, Humphrey and Sturgeon (2005) similarly identifies three key variables describing governance structures. These three variables include the complexity of transactions, the ability to codify transactions, and the capabilities in the supply-base. TCE and governance structures will be explained and defined in the following section Transaction cost theory Classical economics based on the theory of efficient markets imply that it should always be cheaper to buy on the market rather than internalise. Classical economics does however not explain how large vertically integrated companies producing nearly everything in-house can be successful. The theory of transaction costs explains this by taking into consideration costs incurred when going out to the marketplace. These costs may be thought of externalities or transaction costs. Examples of transaction costs may include identifying suppliers, negotiation and contracting costs as well as follow-up of suppliers to make sure they deliver at the correct quality at the correct time (Rugman, 1987). These costs may be avoided by keeping activities within the firm, and hence explain how vertically integrated firms may be successful. According to transaction cost theory a firm should keep activities internal to the firm unless: Production cost savings > Sum of all Transaction Costs Transaction cost theory identifies three main factors which impact on whether a company should make or buy (Rugman 1987). These are; The frequency of the transaction The uncertainty of the transaction The asset specificity of the transaction Frequency of the transaction refers to whether a product is acquired frequently or not. If a product is acquired infrequently it is common to use the market. This is due to factors such as 19

20 setup costs and scale economics. As the cost of producing a good tends to fall as a firm produces at a higher scale of production, it might be too costly to internalise intermediate goods acquired infrequently. As Multinational Enterprises (MNE s) can draw advantage of scale benefits, these are this more likely to produce in-house than the average small firm. If economies of scale exist and there is sufficient demand, specialised service firms will develop. If services required are fairly standardised it could thus be attractive for companies to contract out as it is likely that specialised service firm will be able to deliver at lower cost. There is however difficulty in adapting to changes in customer tastes and the risk that a company offering the service might fail to adjust over time (Rugman, 1987). The uncertainty of the transaction relates to enforcement costs associated with the transaction (Rungman, 1987). This would include for instance policing the supplier to make sure that he delivers on time. Transactions may be subject to both market and technology uncertainty. Market uncertainty develops due to factors like bounded rationality, and self-interest seeking. Bounded rationality is the notion that rationality of individuals is limited to the information they have. Self-interest seeking behaviour is also described as opportunism, moral hazard and agency. This behaviour might lead to market participants taking advantage of measurement difficulties and underperform and/or overprice. The greater the uncertainty the greater the need will be for policing. Asset specificity refers to whether or not an investment is specific to a certain transaction. Standardised products are unspecific and make inter-firm relationships less complex. Moreover it lessens the risk of opportunism. On the other hand, customised products are specific to an investment and raise the risk of opportunism. The fact that a product is customised give rise to bilateral dependency in that the parties have incentives to promote continuity in order to safeguard specific investments (Williamson, 2008). Outsourcing will then be more costly as safeguards need to be put in place. Even without opportunism, transaction costs increase with increased need for coordination. Coordination problems are also reduced and the ease of description makes contract simple to write. Standard products can be made by a variety of suppliers and bought by a variety of customers, thus problems arising from asset specificity are low (Gereffi et.al., 2005) In conclusion, transactions which are frequent, uncertain or asset specific is more likely to be produced in-house. 20

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