MERIT-Infonomics Researc Memorandum series Organisaional innovaion, informaion ecnology, and ousourcing o business services Werner Hölzl, Andreas Reinsaller & Paul Windrum 2005-030 MERIT Maasric Economic Researc Insiue on Innovaion and Tecnology PO Box 616 6200 MD Maasric Te Neerlands T: +31 43 3883875 F: +31 43 3884905 p://www.meri.unimaas.nl e-mail:secr-meri@meri.unimaas.nl Inernaional Insiue of Infonomics c/o Maasric Universiy PO Box 616 6200 MD Maasric Te Neerlands T: +31 43 388 3875 F: +31 45 388 4905 p://www.infonomics.nl e-mail: secr@infonomics.nl
Organisaional innovaion, informaion ecnology, and ousourcing o business services Werner Hölzl, Andreas Reinsaller and 1,2 (++) Paul Windrum Absrac Tis paper examines e relaionsip beween organisaional innovaion, e inroducion of new inerne-based ICTs, de-vericalisaion, and e rapid grow in business service ousourcing over e las decade. In order o examine is issue, we develop a model of organisaional innovaion. In is model, e goal of managers is o idenify an organisaional design a more effecively inegraes all e adminisraive aciviies of e firm. As par of e process of innovaion, e managers can coose o carry ou an adminisraive aciviy in-ouse, or o ousource a aciviy. A key facor influencing is decision are e relaive informaion coss of organising aciviies inernally and e informaion coss associaed wi seing up and mainaining inerfaces wi exernal suppliers. Te framework as been implemened in a novel model of organisaional innovaion. Simulaions conduced on is model enabled us o consider e sor- and long-run impacs of ousourcing on adminisraion overeads and on long-erm produciviy grow. Te ineresing finding is a managers of a firm can become locked ino a low produciviy grow rajecory, associaed wi e ousourcing of aciviies, if ey are myopic and learn roug eir own acions. Tey perceive ousourcing o cu overead coss in e sor-run (as expeced), and so engage in furer ousourcing ereafer. Tis is o e derimen of long-run produciviy gains (sysem economies) generaed oug organisaional innovaion. Tis occurs because e poenial for organisaional innovaion is reduced wen modular componens are ousourced, placing em beyond e conrol of e firms managemen. Te findings accord well wi e empirical daa, and provide a saluary warning for managers and policy-makers abou e poenial long-erm implicaions of ousourcing forcoming in: L. Rubalcaba and H. Kox (eds), Business services in European economic grow, London: Palgrave MacMillan 2006/2007. Keywords: JEL Codes: Ousourcing, organisaional innovaion, long run produciviy developmen D23, D24, D83, O33 1 Addresses: Werner Hölzl, Öserreicisces Insiu für Wirscafsforscung (WIFO), Posfac 91, A-1103 Vienna, Ausria, e-mail: Werner.Hoelzl@wifo.ac.a Andreas Reinsaller Vienna Universiy of Economics and Business Adminisraion, Deparmen of Economics, Augasse 2-6, 1090 Vienna, Ausria. MERIT, Universiy of Maasric, PO Box 616, 6200 MD Maasric, Te Neerlands. e-mail: Andreas.Reinsaller@wu-wien.ac.a (++) corresponding auor, Paul Windrum, Manceser Meropolian Universiy Business Scool, Ayoun Building, Ayoun Sree, Manceser M1 3GH, Unied Kingdom. MERIT, Universiy of Maasric, PO Box 616, 6200 MD Maasric, Te Neerlands. e-mail: p.windrum@mmu.ac.uk 2 Te auors graefully acknowledge supporive funding roug e PUBLIN Projec, European Commission s Framework 5 Programme. 1
1. Inroducion Tis caper examines e relaionsip beween organisaional innovaion, e inroducion of new inerne-based ICTs, de-vericalisaion, and e rapid grow in business service ousourcing over e las decade. We presen daa on e range of aciviies a are being ousourced, and discuss a se of poenial advanages associaed wi ousourcing aciviies o knowledge-inensive service providers (KIBS). We also examine e laes empirical sudies wic row up a se of poenial disadvanages associaed wi ousourcing. Tese sugges a ousourcing may ave advanages in e sor-run bu ave negaive long-run implicaions for compeiive performance. In order o examine is issue, we develop a model of organisaional innovaion. In is model, e goal of managers is o idenify an organisaional design a more effecively inegraes all e adminisraive aciviies of e firm. As par of e process of innovaion, e managers can coose o carry ou an adminisraive aciviy in-ouse, or o ousource a aciviy. A key facor influencing is decision are e relaive informaion coss of organising aciviies inernally, and e informaion coss associaed wi seing up and mainaining inerfaces wi exernal suppliers. Herein lies e imporance of new ICT. Te inroducion of new ICTs can aler e relaive coss on inernal and exernal adminisraion. Tis capures a key sylised fac abou knowledge-inensive business services (KIBS), suc as business consulans, financial services, and ICT services: e rapid expansion of KIBS over e las decade is srongly conneced e inroducion and diffusion of inerne-based neworking ICTs. Te caper is organised as follows. Secion 2 inroduces e key conceps of organisaional design and organisaional innovaion. I en oulines e core eoreical approac a is used o concepualise organisaional innovaion. Tis is based on a modular eory of e firm, wic is founded on e win principles of increasing specialisaion and e modularisaion of complex organisaional srucures. Increasing e modulariy of e organisaional srucure no only leads o improvemens in efficiency roug specialisaion, bu enables a firm o realise sysems economies, ereby pusing aead e produciviy fronier. A e core of e eoreical framework is a ransmission mecanism beween ICT adopion, organisaional innovaion and ousourcing. Tis ransmission mecanism enables one o analyse e condiions under e adopion of new ICTs leads o organisaional innovaion, de-vericalisaion, and ousourcing. Using is eoreical framework we are able o criically discuss e long-run implicaions of ousourcing on produciviy. Secion 3 reviews recen empirical sudies in order o idenify a se of poenial benefis and poenial disadvanages associaed wi e ousourcing of aciviies o business services. Te mos recen empirical lieraure igligs differences in sor and long-run benefis and coss. In e sor-run, ousourcing firms are able o reduce coss because e number of personnel are reduced (i.e. e wage bill is cu) and savings are made because ese aciviies no longer need o be adminisered inernally. However, ere are long-erm coss. Increased coss of logisics, in order o inegrae e business service provider effecively wi e remaining inernal aciviies of e firm, mean managemen and adminisraive funcions are no reduced overall. More imporanly, ere is new empirical evidence o sugges a ousourcing can be derimenal o e innovaive capaciy of e firms and, ence, ave a negaive impac on is long-run produciviy grow. Secion 4 describes e simulaion model a is used o invesigae is long-run penomenon. Te secion specifies e alernaive sraegies for organisaional innovaion available o e firm, e way in wic learning is modelled, and e decision rules for adoping new ICTs and ousourcing aciviies. Secion 5 discusses e oupus generaed by e simulaion model. Te resuls make clear e manner in wic e ousourcing of aciviies resrics e long-erm opporuniies for organisaional innovaion, leading o lower produciviy grow. Secion 6 pulls ogeer e overall findings of e caper and poins o ineresing direcions for furer researc. 2
2. Organisaional innovaion Te goal of organisaional cange is e idenificaion of an organisaional design a more effecively inegraes all e adminisraive aciviies of e firm. An organisaional design is a ierarcial srucure a solves wo key problems faced by managers. Te firs is e fundamenal coordinaion problem, namely, ow o mos effecively organise e value-adding aciviies and informaion flows of e firm in order o maximise profi. In addiion, managers need o resolve e agency problem : o realise and enforce coordinaion and conrol in producion, bo inernally and across e boundary of e firm. Organisaional innovaion involves e searc for new organisaional designs a aler e inernal organisaional srucure of e firm, and cange e boundary beween e firm and markes (vericalisaion / de-vericalisaion). As jus described, i is a searc process a is conduced wiin a complex searc space conaining many dimensions, and in wic e dimensions are relaed o one anoer in igly non-linear ways. Dealing wi is organisaional complexiy requires managers o engage in ongoing sraegic experimenaion and learning. I is is ongoing problem-solving aciviy a drives organisaional cange and innovaion over ime. Our analysis is based on a modular eory of e firm, developed in recen work by Langlois and Roberson (1995), Baldwin and Clark (1997), Langlois (2002, 2003), and Marengo and Dosi (2005). Te eory brings ogeer Adam Smi s principles of specialisaion and e division of labour (Smi, 1776), and Herber Simon s discussion of complexiy and e near-decomposabiliy of complex problems (Simon, 1996; 2002), and provides a useful means of discussing organisaional cange and innovaion. We will use is eory o idenify e se of condiions under wic modularisaion is associaed wi ousourcing o specialis KIBS, and o consider e impac of new ICTs on e decision o ousource. Simon (1996, 2002) provides an imporan insig ino problem-solving aciviy in general. He provides us wi an idea of ow problem-solving aciviy occurs in complex sysems. Simon suggesed a complex problems can be made more manageable by breaking em down ino a se of consiuen pars, or modular componens. In is way, e number of disinc elemens in a sysem is reduced by grouping em ino a smaller number of sub-sysems. Te grea advanage of modularisaion is a improvemens can be made o one sub-componen of e sysem wiou e need o cange all oer pars of e sysem (as would be e case if ere were no modularisaion). Tere is a cos, owever. Tese are associaed wi e esablismen and mainenance of organisaional inerfaces beween sub-componens. Tese inerfaces enable a sub-componen o funcion compaibly wi all sub-componens. Tis ensures e organisaional srucure as a wole funcions in an inegraed way, wile mainaining a ig degree of independence for eac subcomponen. Smi s principle of specialisaion roug e division of labour is a way of dealing wi is problem-solving aciviy. Smi s classic example is e pin facory. A range of complex valueadding processes are broken down and divide up ino a finer se of specialised funcions. Tis specialisaion raises e efficiency of producion. Aloug Smi s example is of specialisaion in e organisaion of producion, e principle olds equally specialisaion in e organisaion of adminisraion (our curren focus). Firms engage in coninual, ongoing experimenaion in all aspecs of e organisaion, no jus producion. Tis includes decisions abou wa o produce, e inpus a are required, wa sould be produced in-ouse or boug in markes, e geograpical locaion of producion, sales ec., e appropriae organisaion srucure of e firm, and e informaion and communicaion requiremens of e organisaion. Placing Smi s discussion wiin Simon s framework of decomposable complex problems, e issue facing firms is a process of problem decomposiion of decomposing a sysem ino subsysems. Te ask becomes one of idenifying subsysems, esablising linkages beween disinc subsysems, and undersanding, managing and codifying eir ineracions. Te problem en facing managers of e firm is, firs, ow o 3
decompose is value-adding aciviies and, second, ow o coordinae e subsysems. Troug successful modularisaion, a complex sysem is en ransformed ino a nearly decomposable one. To is eory we add e concep of sysem economies inroduced by Nigingale e al. (2003). Our inerpreaion of sysem economies are mosly due o improvemen in e conrol of a given se of producive aciviies and, ence, operae a e mea level. Managers of e firm seek o improve produciviy reorganising way in wic ese value-adding aciviies inerac. Tis produciviy improvemen is gained roug e design of a more effecive organisaional design. Organisaional innovaion, e process roug wic new designs are arrived a, involves eier spliing e adminisraive asks ino more organisaional modules or, alernaively, e inegraing of organisaional modules o increase conrol of e modular elemens and eir ineracion. A superior organisaional design improves e coordinaion and conrol of goods, raffic, maerials, funds, services, and informaion a flows roug e complex supply, producion and disribuion aciviies of e firm. In is way, beer organisaional designs (i.e. more effecive modularisaion scemas) increase e producive uilisaion of e firm s insalled producive capaciy. Innovaion beges furer innovaion over ime. Troug organisaional innovaion, managers gain a more specific view of e differen aciviies of e firm, and see e poenial creaive opporuniies a arise roug breaking down deparmenal silos and creaing novel synergies aciviies (i.e. new organisaional combinaions). For example, creaing sronger ineracions beween e sales and producion deparmens can lead o new produc opporuniies being realised. Tese in urn may lead o economies of scope and, if able o develop new markes, economies of scale. Tis picks up on e pin made by Baldwin and Clark (1997), a e more modular e organisaional design, e greaer e likeliood of simulaing new invenions, i.e. innovaion in producs/services, disribuion, and e oer key value adding aciviies of e firm. We sugges a e exen of organisaion specialisaion ulimaely depends on a number of demand and supply side facors. On e demand side, i will depend on e exen of e marke (i.e. increases in populaion and income), and e degree of compeiion (e elasiciy of demand) (Young, 1928). On e supply side, i is affeced by e availabiliy of ICTs a enable aciviies o be subdivided and coordinaed, and wic enable managers o deal wi e agency problem. To do is, managers mus be able o generae informaion on e pars of e organisaion for wic ey are direcly responsible, and o excange beween em informaion abou differen pars of e organisaion. Togeer, e demand and supply side facors deermine e exen o wic aciviies can be effecively modularised and ecnical ierarcies esablised. A number of issues can be discussed wiin is eoreical framework. To sar wi, e framework clarifies e relaionsip beween new ICTs and more effecive adminisraive conrol leading o sysem economies. Te applicaion of new, improved ICTs enable furer modularisaion of e organisaion o occur by lowering e cos of managing and conrolling informaion, leading o increased sysem economies 3. I was Candler (1962, 1977) wo firs claimed a ecnology direcly affecs organisaional srucure. His observaion goes o e ear of our discussion. New ICTs aler e se of feasible ecnological opporuniies in producion and e division of labour (e fundamenal coordinaion problem), and e opporuniies for effecive coordinaion and conrol wiin and across e boundary of e firm (e agency problem). Tese aler e relaive efficacy of olding aciviies in-ouse and ousourcing. Depending on e paricular vinage of ICTs, ecnological opporuniies and cos reducions may simulae vericalisaion or de- vericalisaion. Inerne-based ICTs enable e exernal coordinaion coss of e firm o be significanly reduced. Tis opens up new opporuniies ousourcing wiin new, for experimenal organisaional designs. Over e las decade, a new generaion of neworking ICTs (buil on open web and inerne 3 Brynolfsson and Hi (2000) sudied e impac of large ICT invesmens over e las decades on produciviy. Tey find a, on eir own, cosly invesmens ave lile impac on produciviy. Tey do, owever, ave very significan impacs on produciviy wen ey are maced wi complemenary canges in e orgnaisaional design. 4
proocols) ave provided e means by wic firms can radically reorganise bo ineracions wi firms along e supply cain. I as opened up previously inconceivable levels of ineracion beween companies. Tis includes new opporuniies for ousourcing o specialis KIBS providers. Te neworked corporaion as emerged as a consequence of iner-firm neworking aciviies along e supply cain. Tere is a flaening of e ierarcy of e firm, a endency owards verical disinegraion, and for individual business unis o become smaller in size. I is imporan o noe a e relaionsip beween new ICTs and ousourcing is no simple. Cerain ypes of new ICTs may decrease e coss of inernal as well as exernal coss of communicaion. Inerne ecnologies, for example, lower e cos of inernal adminisraion (roug applicaions suc as inranes) as well as reducing e adminisraion cos of exernal ineracion. Oers reduce inernal coss only. As discussed by Reinsaller and Hölzl (2004), ICTs a were limied in eir applicaion o inernal adminisraive aciviies (suc as calculaors, ypewriers, Holleri elecric abulaing macines, and book-keeping macines) played an imporan role in e developmen of u- form and m-form ierarcies. Candler (1977) and Yaes (2000) ave discussed e way in wic ese ecnologies were essenial for e emergence of e modern ierarcial organisaion in e period beween e 1850s and e 1930s. Large corporaions were e key purcasers of ese new ICT1 ecnologies, and ese ecnologies in urn furer enanced eir abiliy o grow in size, wi a endency owards verical inegraion and e greaer cenralisaion of aciviies by bringing aciviies in-ouse, increasing e ierarcy wiin e firm. A second issue a is of cenral in is caper is e long-run implicaions of ousourcing for firm performance. On e one and, as discussed, inerne-based ecnologies reduce e cos of seing up organisaional and informaion ineracions wi KIBS. Tis makes possible e ousourcing of aciviies a can be delivered more ceaply by e exernal supplier. A e same ime, ousourcing reduces e inernal adminisraion overead of e firm. However, ere are limis o e benefis of modularisaion. To sar wi, wile inernal adminisraion overeads are reduced, exernal adminisraion overeads rise because an effecive inerface wi e exernal provider needs o be se-up and mainained. Te ne benefi, in erms of adminisraive overeads, depends on weer e cos of e exernal inerface is greaer or less an e cos of e inernal inerface. Tis is e non-separabiliy effec discussed by Seinmueller (2003), and Miozzo and Grimsaw (2005). Tey sugges a e governance srucures a oversee e inerface ineracions beween clien and supplier represen large, sunk invesmens. Consequenly, suppliers are no easily subsiued. A more imporan poenial downside is e impac of ousourcing on e clien s long-run poenial for organisaion innovaion and, ence, on is long-run produciviy grow. To undersand is, le us apply e ransmission mecanism jus discussed. If new, inerne-based ICTs significanly reduce exernal adminisraion coss compared o inernal adminisraion coss, ere is a simulus for ousourcing. However, by ousourcing, e se of inernal aciviies under e direc managemen of e firm is reduced. Tis reduces e se of modular elemens wi wic managers can experimen and innovae o creae new, more efficien organisaional designs. In e long-run is can lead o a lower produciviy grow of e clien firm. Prencipe (1997) and Brusoni e al. (2001) sress e need o reain conrol over R&D, no jus for e aciviy iself, bu because i is imporan o mainain conrol of e coordinaion of R&D, design and manufacuring aciviies. 3. Poenial advanages and poenial coss of ousourcing Te 1990s saw a dramaic rise in e number of specialised business service firms. Te seer range of aciviies a are being ousourced is igliged by McCary s 2002 sudy of ousourcing by US firms. Tese aciviies no only include basic back-office aciviies suc as payrolls, ey also include advanced, back-office aciviies suc as legal services, and clien-facing fron-office aciviies in sales and markeing. Te sare of aciviies being ousourced by e firms in is sudy is presened in Figure 1. 5
1% 2% 11% 26% 4% 3% 53% Office Compuer Business Sales Arciecure Legal Ar Design Figure 1. Variey of aciviies being ousourced Source: McCary, 2002 Te purcase of e business services from exernal providers raised e performance of clien firms in bo services and manufacuring. Wile acknowledgemen of e role played by business services in economic developmen is no new (see, for example, Greenfield, 1966), empirical sudies of eir impac are new. For example, Windrum and Tomlinson (1999) esed e conribuion o services and manufacuring secors of knowledge-inensive business services (KIBS) suc as business consulans, financial services, and ICT services. Using inpu-oupu daa from 1970 o 1990, ey examined Germany, Japan, e Neerlands, and e UK. KIBS were found o ave a posiive impac on bo service and manufacuring secors in all four counries over e weny-year period. Similar findings ave been idenified in sudies by Drejer (2001), Peneder e al. (2003) and Tomlinson (2003). So, wile e use of business services as grown rapidly, eir use is no new. A number of sudies ave soug o idenify e key drivers for ousourcing. One of e bes known is in e Morgan Cambers sudy of FTSE 100 firms (Morgan Cambers, 2001). In addiion, ere is Te Ousourcing Insiue s sudy of ousourcing in Japan (Ousourcing Insiue, 2005). Taken ogeer, ese sudies presen a remarkably consisen picure. Tese are presened in Table 1 below. We see a e op ree ranked drivers are e same in eac sudy. Tese are, in order, e reducion of operaing coss, improving e focus of e business roug a reorganisaion of e aciviies a are conduced in-ouse and ose a are exernally sourced, and access o skills and ecnologies a are no eld in-ouse. In bo surveys, ese ree drivers ogeer accouned for more an 60% of all responses. Morgan Cambers sudy Cos saving Focus on core business Access o skills and ecnology Risk managemen Qualiy service improvemen Cange enabler Business developmen Oer Ousourcing Insiue sudy Reduce and conrol operaing coss Improve company focus Gain access o world-class capabiliies Free inernal resources for oer purposes Resources are no available inernally Accelerae reengineering benefis Funcion is difficul o manage/ ou of conrol Make capial funds available Sare risks Cas infusion Table 1. Drivers of ousourcing, by rank Tese ree key drivers ave also been igliged in e lieraure on knowledge-inensive business services (KIBS). KIBS provide eir cliens wi ig qualiy informaion on new business opporuniies, new rends in e marke place, and e business poenial of new ecnologies, suc as new ICTs. Troug e ousourcing of specific inpus o KIBS, cliens can improve produciviy and 6
compeiive performance as exising in-ouse inpus are subsiued for iger-qualiy, exernally sourced inpus. Tird, KIBS are exemplars of novel business models. Tey provide a concree illusraion of new business models and, roug eir ongoing relaionsip, inroduce cliens o ese new ways of working and new ecnologies. Anonelli (1998), for example, as igliged e role of KIBS on e diffusion of new ICTs. KIBS are leading advocaes of new, inerne-based ecnologies because ese ecnologies enable em o more effecively inerface wi cliens and, as a consequence, o more effecively inermediae experience, informaion and knowledge beween cliens. In is way, KIBS ave become key inermediaries, improving e efficiency and speed of learning wiin innovaion neworks. As noed in secion 2, ere exis a se of poenial disadvanages associaed wi ousourcing. Tese can ave negaive long-run implicaions for organisaion innovaion and, ence, long-run produciviy grow. Le us discuss ese in deail. An empirical sudy based on a large scale survey of medium and large size Swedis manufacuring and service firms 4 as been conduced by Bengsson and von Harman (2005). Tey found a companies evaluaions of e direc effecs of ousourcing, e.g. cos reducion roug e reducion of direc personnel, were fulfilled. However, managemen and adminisraive funcions were no reduced. Indeed e firms repor a srongly negaive impac of ousourcing on logisics e.g. manufacuring lead imes, delivery imes and accuracy. Tey also repor negaive impacs on qualiy and adapaion o cusomer demands. Tese key findings indicae a ousourcing is accompanied by more complex logisics, increasing e inernal adminisraive overead. Bengsson and von Harman repor a ese logisics problems were more common among amongs companies a ousource o low-cos counries. Tese findings are suppored by researc conduced by oers auors. Firs, i is observed a e conrac needs o be moniored and measured carefully. Tis can prove expensive, and increasingly expensive if skills in e clien firm are los over ime (Domberger, 1998). Second, governance inseparabiliy beween clien and supplier means considerable invesmen in inerpersonal and adminisraive relaions beween e firms is necessary in order o suppor e new division of labour (Seinmueller, 2003; Miozzo and Grimsaw, 2005). Tird, poorly delivered services will negaively affec e clien s producion or, were end-user services are delivered, e clien s brand and repuaion (Hinks and Hanson, 2001). Four, e securiy of sensiive informaion needs o be considered, wi an increased risk of exposure of e cliens sensiive inernal informaion (Mylo III, 1995). Fif, ere are well documened cases of knowledge and informaion, acquired by e service provider, being sared wi e cliens compeior firms. Cliens believed a services and informaion would be proprieary, wile e service providers saw e ransacions as e basis for furer business wiin e clien s indusry. Of course, i is no jus low-skilled aciviies a are being ousourced. Complex producion and advanced R&D are also being ousourced. Te inseparabiliy of ICT from producion means suppliers are no urn-key, i.e. ey canno be easily subsiued (Miozzo and Grimsaw, 2005). Prencipe (1997) igligs e dangers of ousourcing aciviies based on simple noions of core and non-core compeences. Te ousourcing of wa oday appear o be non-core compeences can seriously impair e developmen of new (core) ecnological compeences in e fuure. Separaion of developmen and producion ampers innovaion. Brusoni e al. (2001) empasise e imporance of reaining conrol over R&D, and e abiliy o coordinae e R&D, design and manufacuring aciviies of suppliers. To summarise, a growing body of empirical researc exiss wic suggess a e sor-run gains of ousourcing may be more an offse in e longer erm, leading o lower long-run produciviy grow. We ave formulaed a eoreical framework for undersanding ese dangers; one a links organisaional innovaion wi e adopion of new ICTs and wi ousourcing opporuniies. Te framework enables us o idenify a specific ransmission mecanism beween ICT adopion, 4 Te analysis is based on a se of compleed wrien quesionnaires from 267 firms. All firms ave more an 50 employees and are drawn from e ISIC secors 28-35: meal goods, macinery, office equipmen and compuers, oer elecronics, elecoms, insrumenaion, and auomoive indusry. 7
organisaional innovaion and ousourcing. Furer, e framework explains wy ousourcing can negaively impac organisaional innovaion and produciviy in e long-run. Specifically, e ousourcing of aciviies reduces e oal se of modular elemens a can be experimened wi in e fuure. Wi less componens under eir conrol, managers are unable o experimen wi all possible organisaional combinaions. Te danger is a is pus ou-of-reac e discovery of more efficien organisaional designs. Hence, e firm can become locked in o a subopimal design space. If is is e case, en e ousourcing firm will suffer lower grow in produciviy an if i ad no ousourced (and e enire space of organisaional designs could ave be explored). 4. Te model: ierarcy, profiabiliy and informaion ecnologies In is secion we develop a simulaion model a capures some of e core ideas of modulariy in organisaions presened in e previous secions, and sudy ow ICTs and ousourcing of business services may affec e long-run performance of a firm. For is purpose we define e organisaion as a complex sysem. Te managemen seeks o improve is sysem by searcing for beer organisaional designs. As firms are boundedly raional is appens roug learning from pas experiences in organisaional resrucuring. Adminisraion Figure 2 sows ow we concepualise an organisaional design. We assume e adminisraion of a firm delivers services o producive aciviies a evenually generae e value added generaed of e firm. Te qualiy of ese services, θ 1 o θ 4 in Figure 2, as an impac on e performance of producive aciviies. Tese services are produced by organisaional aciviies m 1 and m 2 (see Figure 2a) wic produce a subse of all services. More generally, e organisaion of a firm consiss of a se of n organisaional modules or aciviies m i grouped ino an organisaional design d =<m 1, m 2,,m n > a delivers a vecor θ of k services o producive aciviies in e firm. Te array d D corresponds o one organisaional design, wic is drawn from of a finie space D of organisaional designs, wic e managemen explores over ime. λi Eac of e aciviies presen in a design consiss of λi sub-aciviies or m i =< x k > =1. Te number of sub-aciviies λ i in eac of ese modules may vary, bu we assume a eac affecs exacly one of e k oupu caracerisics. Eac larger aciviy in urn affecs some subse of e services o e producive aciviies. Togeer ese oupu caracerisics mee well defined cusomer needs in e marke were e firm operaes. In our model e organisaion of a firm is erefore defined roug e caracerisics of an organisaional design d given by n organisaional modules m i and k service caracerisics. Te number of modules n is a measure of e degree of decomposiion of organisaional aciviies. Figure 2. Inerdependence and modulariy in organizaional designs 8
Te sub-aciviies x in eac module m i are srongly relaed o one anoer, i.e. e performance of eac sub-aciviy φ ( x k ) a ime sep affecs e performance of all oer sub-aciviies in e module and is performance is in urn influenced by all oer sub-aciviies in e module. Tis implies a e oal performance of a module φ ( m i ) canges if φ ( x k ) canges. Te modules m i emselves are linked roug organisaional and ecnical inerfaces a neuralise e srong complemenariies a persis beween e sub-aciviies wiin eac module. Tese inerdependencies reflec a siuaion a is ypical in eam producion, were e skills and aciviies of e members in a eam are closely complemenary and inegraed. So, if one member performs under par, e work efficiency of all oer members is affeced. Tis is sown in Figure 2. If e managemen wans o improve service θ 3 produced in organisaional module m 2 en canging e work profile of e relaed aciviy x will acually imply e performance of e sub-aciviy producing service θ 4 is also affeced. In e simulaions we will deermine φ ( m i ) by drawing λ i values from a uniform disribuion wi φ( x k ) Uniform[0,1 ] and calculaing e average over e λ i subaciviies. Te impac of all n service producing adminisraive aciviies on firm performance is en 1 n given by, Φ = φ( m ). 5 n i= 1 i In Figure 2b e problem of srong complemenariy is resolved by spliing module m 2 ino wo disinc sub-aciviies were eac is focused on producing exacly one service. Te coordinaion problem beween e wo sub-aciviies is solved by inroducing a coordinaion mecanism beween e wo. Terefore e ierarcy increases and e co-ordinaion overead increases. Tis capures Simon s (1996) idea of realising near-decomposable designs in order o conrol complex problems beer. In is process economies of sysem are realised. Organisaional learning: exploiaion vs. exploraion Te managemen of e firm is assumed o use a se of sraegies S o explore e space of organisaional designs D. Te sraegy space S = ( s1, s2, s3) consiss of ree sraegies, eac of wic is used wi probabiliy μ j a eac ime sep. Te firm pursues em o improve adminisraive services a ave an impac on e performance of producive aciviies. Te firs sraegy s 1 corresponds o learning by doing. In is case all values for φ ( x k ) + 1 are redrawn, and if e average over e λ i sub-aciviies increases is will correspond o a performance improvemen. Te second and e ird innovaion sraegies involve canging e organisaional design of e firm. Tis is illusraed in Figure 3. Te firm may engage in idenifying and neuralising some of e complemenariies a bind sub-aciviies ino a module. Tis may enable i o spli a more complex aciviy ino a number of less complex aciviies and redesign is organisaion accordingly. Tis decomposiion sraegy s 2 is called spliing. I corresponds o e developmen of a neardecomposable design of adminisraive aciviies. Finally, i may pay e firm o redesign is producion and organisaion by organising smaller aciviies ino larger and more complex modules. I is e reverse sraegy of decomposiion. I involves e selecive acquisiion of complemenariy relaionsips beween previously unrelaed aciviies, say by supporing e developmen of synergies. Tis inegraion sraegy s 3 we call job-enricmen. In bo s 2 and s 3 e organisaional design is canged, wi poorly performing aciviies replaced by beer performing ones 6. In is case all 5 Tis represenaion of organisaional designs and eir impac on e performance of producive aciviies corresponds o a generalised NK model (see Alenberg,1995). 6 Decomposiion and inegraion ave been discussed as possible evoluionary mecanisms of cange in e realm of geneics by Wagner and Alenberg (1996). 9
performance values φ ( x k ) + 1 for e elemens in e new module(s) are redrawn and if eir join average increases is will again correspond o a performance improvemen. Figure 3. Spliing and enricmen as sraegies in organizaional re-design Tese sraegies are assumed o affec e performance Φ of producive aciviies roug economies of sysem, i.e. by allowing for beer conrol of producive aciviies and erefore pusing produciviy for a given ecnology owards is limi. As discussed earlier, e lieraure on modulariy advances e argumen a an increase of e modulariy of a sysem leads also o an improvemen in e innovaion rae. Te basic idea beind is is a modulariy allows a beer undersanding of e workings of a sysem and erefore increases e cance a beer ways of doing ings are discovered. In our case we will assume a, depending on e degree of decomposiion of e adminisraion of e firm given by e number of aciviies n, e likeliood a beer ways of organising e producion process are discovered increases if e firm invess ino is process of exploraion. Tis will pus aead e performance Φ of producive aciviies by a facor (1 + ε ), were ε+ 1 = ε(1 + τ). In e simulaion, parameer τ as a small posiive value as does ε a =0. Te probabiliy of e firm making an innovaion ε is deermined by a Poisson process wi an arrival rae α. Following Silverberg and Verspagen (1994), we assume e firm s invesmens ave firs increasing and en decreasing reurns, wic are refleced in a logisic represenaion of e arrival rae given by α = α α min max + 1 ( r* n ) αmin + ( αmax αmin ). Here α min represens a small auonomous probabiliy of making a foruious innovaion wiou invesing in is ype of innovaion, and α max corresponds o an asympoic sauraion level of e arrival rae. As can be seen, is process depends on e propensiy o inves (r) and on e degree of decomposiion, wic essenially capures e innovaion poenial. 10
Te beaviour of e firm is given by e probabiliy disribuion over is ree acions. Te innovaion policy mix s = [ μ1, s1 μ2, s2 μ3, s3], wi μ1, + μ2, + μ3, = 1, a maximises profis Π d( s), evolves roug reinforcemen learning given some iniial probabiliies μ j,= 0. Tis sould no be inerpreed as conscious randomisaion, raer i indicaes (from e perspecive of e ouside observer) ow likely i is a e decision maker will coose eac of ese ree acions. Te reinforcemen learning dynamics we apply is idenical o e one explored by Arur (1993), were eac of e sraegies is allocaed a sreng according o is pas conribuion o e performance of e firm μ ΔΠ( sj) μ j, ΔΠ( sj) j = μ +, ΔΠ( s ) j,+ 1 j, j j (1) were ΔΠ ( sj ) = Π( sj) Π ( sj) indicaes e cange in e performance improvemen beween 1 wo ime seps and 1 were sraegy s j was used. Equaion (1) reinforces e sraegies a performed bes in e pas, i.e. ose wic previously maximised profis. Coss of producion for a given organisaional design We assume a wie collar aciviies are no producive in emselves, bu a ey improve e uilisaion and e developmen of e firm s producive resources. More precisely, we assume a e services produced by an adminisraive aciviy m i ave an impac on e performance of producive aciviies, φ ( m i ). As menioned previously, e impac on e uni coss of producive aciviies by all n modules is given by Φ. Te uni coss of producive aciviies are en given by vc (1 + ε) Φ d, = wpl pe, were w p is e average wage bill per uni of oupu paid for producive aciviies, and l p is e uni labour requiremen. In e adminisraion of a firm ere are wo ypes of aciviies. Te firs se of aciviies produces services for producive aciviies. Te second se of aciviies coordinae e ineracion beween ese services. Only service producing adminisraive aciviies are ousourced as coordinaion aciviies ypically reflec criical managemen skills. We also assume a e number of services a module produces is proporional o is skill inensiy, i.e. e more services an aciviy produces, e iger are e skills required o carry em ou. Tis in urn implies a e average wage paid o ese aciviies is iger an o aciviies were only a few services are produced. For simpliciy we assume a e uni wage cos of producing one service o producive aciviies and a of carrying ou one coordinaion ask are e same. Informaion ecnologies affec coordinaion coss. We disinguis beween e cos of inernal coordinaion and e cos of exernal coordinaion. Toal adminisraive overead coss are en defined by oc d, zl a w λ + (1 z ) 11 θ in θ ex ( ν e + ν ) = p + l c w in ex e were l a and l c are e uni labour requiremens for service and coordinaion aciviies, w is e going wage rae paid per skill uni, λ is e average number of services produced in eac adminisraive aciviy, p are e prices paid for ousourced aciviies, ν in and ν ex are e number of inernal and
exernal coordinaion aciviies, and θ in and θ ex reflec e impac of e use of ICTs on inernal and exernal coordinaion coss respecively. Variable z, 0 z 1, weigs e uni coss of producion of adminisraive services produced in-ouse and ose produced ououse by eir respecive sare in e oal number services produced. We assume a subconracor ypically as a cos advanage in producing a paricular service. If a specific service producing adminisraive module m i is ousourced e uni cos of producion of is services by e service firm is en given by cs = l wλ γ + l w e a, i, c, θ in θ ex ( ν in, e + ν ex, ), were γ now reflecs e comparaive cos advanage service firm as in producing e services of 2 adminisraive aciviy m i. In e simulaions we will assume a γ N(1, σ ), i.e. e cos advanage is normally disribued around a mean of 1 (meaning a a-priori ere mig be no cos advanage) wi some variance σ 2. Variables l a, and l c, reflec e relaive uni labour requiremens for service producing and coordinaion aciviies and ν in, and ν ex, give e number of inernal and exernal coordinaion aciviies e service supplier as o manage. Assuming now a e supplier as some marke power suc a e is able o carge a posiive mark-up ξ over coss en e uni price for e services of supplier o e ousourcing firm is given by p ( 1 ξ ) = + cs. Finally, we assume a e firm as a cerain propensiy r o inves par of is revenues ino e exploraion of innovaion poenials due o e modulariy of e adminisraion. Tese coss are en given by rc = rp q, were p and q are e prices carged and e quaniies sold a a ime sep. Profis If e firm acs in an environmen in wic monopolisic compeiion prevails, i will face a downward sloping (inverse) demand given by Is p =, 1/η q were p is e price e firm is able o carge a ime, Is is e amoun of income cusomers spend on e firm s produc, q is e firms oupu and η, η > 1, is e price elasiciy of demand. Following sandard eory, e opimum oupu and price for a given organisaional design d are given by q d, η Is(1 1 η) =, and vcd, + ocd, p * d, η( vcd, + ocd, ) =. η 1 Terefore, for eac organisaional design d e firm ries o maximise profis Π d ( s ) = ( p vc oc ) q rc c, * d, d, * by reducing uni coss of producion. In our model e firm does is by pursuing differen sraegies s of organisaional innovaion a allow improving e performance of e firm s producive 12
aciviies. Te erm c reflecs fixed capial cos. We assume a e firm needs o keep is capialoupu raio consan and erefore invess or disinvess as oupu canges. Te adopion and ousourcing decision Te decision o adop an organisaional innovaion, and e decision o ousource, will depend on e economic profiabiliy of doing so. Terefore e managemen of e firm will calculae e expeced profis E Π ( s ) d a new organisaional design d is likely o generae and compare em wi e profis e curren design yields. Terefore, e decision rule o adop a new organisaional design d is given by e following inequaliies: d( s) E Π Π ( s) rejec innovaion d d( s) E ( s) Π < Π accep innovaion, d Depending on e managemen sraegy, a firm may ave a cerain propensiy o pursue ousourcing as a sraegy, suc a, given sraegy parameer os, 0 os 1, i will calculae e expeced profis of ousourcing ese services o oer firms leading o an organisaional design d wi probabiliy pr os if pr os E ( s) E Π ( ) inouse d Π s d > os. E ( s) E Π ( s) ousource d > Π d Tese are e decision rules e firm follows in order o improve maximise is profis a eac momen in ime. 5. Resuls Using e model, we examined four differen scenarios. Te parameers used o calibrae e model are given in e appendix. Te resuls of e simulaion runs are presened in Figure 4. Te plos in e op quadran of Figure 4 sow e developmen of produciviy in e firm. Te bold line always represens e mean over 50 runs for eac parameer seing, wile e in dased lines represen e 95% confidence inerval of e resuls of e runs. Te plos in e middle of Figure 4 sow e developmen of overead coss over ime and, finally, e plos in e boom quadran sow e dep of ierarcy of e firm s adminisraion srucure. Te firs wo scenarios, presened in e lef par of Figure 4, juxapose e impac of ICTs on performance, and e coss of e firm for a given ig propensiy of managers o coose ousourcing as a sraegy. Te resuls for low inernal bu ig exernal coordinaion coss are represened by das-do-das lines, wile ose for equally efficien inernal and exernal communicaion coss are represened by unbroken lines. 13
Figure 4: Simulaion runs. Lef: scenario wi ig ousourcing propensiy by managemen. Rig: scenario wi low ousourcing propensiy by managemen. Das-do-das lines represen runs wi low inernal communicaion coss only for a given ousourcing propensiy. Unbroken lines represen runs wi low inernal and low exernal communicaion coss for a given ousourcing propensiy. Te bold lines represen means over 50 runs, e in dased lines 95% confidence inervals around ese means. Te findings sugges a a ig ousourcing propensiy, suppored by low exernal coordinaion coss, lead o a paradoxical developmen. Te firm performs worse in e long-run if exernal coordinaion coss fall. Te explanaion for is apparen paradox is as follows. Managers of e firm are myopically learning over ime. Tey do no ave informaion on e payoffs of all possible coices, and are unable o observe e pay-offs of firms a coose a differen sraegy. Hence, ey are only able o observe e payoffs associaed wi eir own pas coices. In oer words, managers of e firm are engaged in pure learning-by-doing. In pracice, is is reasonable approximaion of e realiy for managers in e vas majoriy of firms. Unlike pysical producs and services, wic can be obained and reverse engineered, managers do no ave ready access o informaion on e oer firms organisaional srucures, adminisraive services, and e performance of ose organisaional srucures. Under ese circumsances, e managers of e firm perceive ere o be cos-cuing poenials if ICTs lead o a fall in exernal coordinaion coss, and proceed o ousource a ig number of service aciviies. As a consequence, e dep of e ierarcy is reduced and in e beginning overead coss drop as well. Produciviy also grows iniially. I grows a a muc slower rae an if e firms ad no ousourced, bu of course e firm will no acually see is in pracice because i as cosen o pursue e alernaive rajecory of ousourcing. Unforunaely, as e firm coninues along is pa, produciviy grow coninues o fall and can even sagnae. Te upso is a managers 14
focused on e sor-run cos cuing effec will succeed in reducing coss, bu unwiingly reduce e long-run innovaion poenial of e firm as well. An alernaive scenario is a e new ICT lowers inernal coordinaion coss. Tis suppors e developmen of increased modulariy in e adminisraion of e firm. As e aciviies become more specialised, i is easier o improve e qualiy of eir service o e producive aciviies. A e same ime, e long run poenial for radical organisaional innovaions is exploied successfully. Te longrun produciviy of e firm under is scenario ouperforms alernaive scenarios were exernal coordinaion coss are lowed by new ICTs and firms engage in ousourcing. Tese resuls lend suppor o e esis a e quick-fix sraegy, o ousource in order o reduce coss, endangers e long-run performance and survival of firms. On e rig and side of Figure 4 we presen e resuls for e scenarios were ousourcing propensiies are low. Again, we consider wa appens if ICT reduces exernal coordinaion coss and wa appens if ICTs reduce inernal exernal coordinaion coss. Once again, e finding is a ICTs wic simulae inernal organisaional innovaion ouperform e scenario were ICTs simulae ousourcing. As before, e reason is a e long-run produciviy poenial of e firm depends on e degree of decomposiion of adminisraive aciviies. Terefore firms always fare beer in e long-run if ey keep e service aciviies in-ouse and reap all e benefis of e process of organisaional innovaion. Once aciviies are ousourced, suppliers in our model carge a consan price and no longer improve e qualiy of e services ey deliver. As a consequence, producing services in-ouse is e dominan sraegy in is simulaion. Te resuls seem o mirror e observaions of e empirical sudies discussed in secion 3. However, i is imporan o observe a long-run produciviy of e runs wi low exernal coordinaion cos comes close o e long-run produciviy levels were exernal coordinaion coss are ig in e upper end of e confidence inerval. Tis oucome depends on e propensiy of e firm o inves in radical organisaional innovaion. I suggess a, if a firm cooses o (moderaely) ousource and is inclined o do so by low exernal coordinaion coss, i sould scale up is invesmen in radical organisaional innovaions, wic will beer exploi e innovaion poenials. 6. Conclusions and direcions for furer researc Te caper as invesigaed e esis a ousourcing aciviies o business services (KIBS) can cu cerain ypes of adminisraive coss bu a ey may reduce produciviy grow in e long-run. Tis is e sriking esis a is emerging from e laes empirical researc on e long-erm impacs of ousourcing on e innovaive capabiliies and produciviy grow of clien firms. Te caper summarised e sor- and long-erm coss and benefis of ousourcing, and proceeded o place em a more analyical fooing roug e developmen of a framework of organisaional innovaion a inegraes decisions o ousource wi e inroducion of cos saving new ICTs. Te framework specified a ransmission mecanism a explains e links beween e adopion of new ICTs, alernaive sraegies for organisaional resrucuring, sysem economies and e decision o ousource. Te framework as been implemened in a novel model of organisaional innovaion. Simulaions conduced on is model enabled us o consider e sor- and long-run impacs of ousourcing on adminisraion overeads and on long-erm produciviy grow. Te ineresing finding is a managers of a firm can become locked ino a low produciviy grow rajecory, associaed wi e ousourcing of aciviies, if ey are myopic and learn roug eir own acions. Tey perceive ousourcing o cu overead coss in e sor-run (as expeced), and so engage in furer ousourcing ereafer. Tis is o e derimen of long-run produciviy gains (sysem economies) generaed oug organisaional innovaion. Tis occurs because e poenial for organisaional innovaion is reduced wen modular componens are ousourced, placing em beyond e conrol of e firms managemen. Te findings accord well wi e empirical daa, and provide a saluary warning for managers and policy-makers abou e poenial long-erm implicaions of ousourcing. 15
Looking forward, ere are clearly a number of limiaions in e curren model and a need for exensions o be made in e fuure. Te resuls inge upon a number of simplificaions. In our model, ousourcing is a purely cos driven process and imporan poenial ineracions beween suppliers and service firms, as well as e excange of compeencies, are negleced. Terefore e model presens a perspecive were service suppliers jus offer a cos cuing poenial once, bu aferwards do no longer inerac wi eir cusomer on service improvemens. Tis is no always e case wi KIBS, even oug some of e empirical lieraure we ave discussed suggess a is problem does exis. In fuure researc we will explore e alernaive case, were e ineracion beween service suppliers and firms sreces o e process of organisaional innovaion. Anoer limiaion of e curren version of e model is a i ignores poenial conflics and organisaional resisance o cange. Tese may play an imporan role in managemen decisions, and are also likely o ave an impac on e long-run produciviy of firms. In is model, e developmen of a neardecomposable adminisraive ierarcy is a fricionless process wi perfecly flexible labour markes. Furer researc needs o address is se of quesions as well. References ALTENBERG L., 1995, Genome grow and e evoluion of e genoype-penoype map, in: W. Banzaf and F.H. Eckman (eds.), Evoluion and Biocompuaion, Berlin & Heidelberg: Springer-Verlag, 205-259. ANTONELLI C., 1998, Localized ecnological cange, new informaion ecnology and e knowledge-based economy: e European evidence, Journal of Evoluionary Economics, 8 (2), 177-198. BALDWIN C.Y. AND K.B. CLARK, 1997, Managing in an age of modulariy, Harvard Business Review, 75 (5), 84-94. BENGTSSON, L. AND L. VON HARTMAN, 2005, Ousourcing manufacuring and is effec on firm performance, Paper presened a CINe, Brigon 4-6 Sepember 2005. BRUSONI S., PRENCIPE A. AND K. PAVITT, 2001, Knowledge specialisaion, organisaional coupling, and e boundaries of e firm: wy do firms know more an ey make?, Adminisraive Science Quarerly, 46, 597-621. BRYNOLFSSON, E. AND L.M. HITT, 2000, Beyond compuaion: informaion ecnology, organisaional ransformaion, and business performance, Journal of Economic Perspecives, 117, 339-376. CHANDLER A.D., 1962, Sraegy and Srucure, Cambridge, Mass.: MIT Press. CHANDLER A.D., 1977, Te Visible Hand: Te Managerial Revoluion in American Business. Cambridge, Mass.: Belknap Harvard Universiy Press. DOMBERGER S., 1998, Te Conracing Organizaion: A Sraegic Guide o Ousourcing, Oxford: Oxford Universiy Press. DREJER I., 2001, Business services as a producion facor, CEBR Working Paper 2001-7, Copenagen: CEBR. GREENFIELD H.I., 1966, Manpower and e Grow of Producer Services, Columbia, New York: Columbia Universiy Press. HINKS J. AND H. HANSON, 2001, 'In-ouse or ousourced? Making e decision', in J. Hinks, and J. Reuvid (eds), Sraegies for Ousourcing and Faciliies Managemen: Managing Business Suppor Service, London: Kogan Page. 41-49. LANGLOIS R.N., 2002, Modulariy in ecnology and organizaion, Journal of Economic Beaviour & Organizaion, 49, 19-37. LANGLOIS R.N., 2003, Te vanising and: e canging dynamics of indusrial capialism, Indusrial and Corporae Cange, 12 (2), 351-385. LANGLOIS R.N. AND P. L. ROBERTSON, 1995, Firms, Markes and Economic Cange. London: Rouledge. 16
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Appendix Variable Efficiency of inernal and exernal coordinaion aciviies{ θ, θ } in ex Ousourcing propensiy os os = 0.2, os = 0.9 Toal number of services F F=100 Wage bill w w=1 range/value Scenario wi exernal coordinaion cos ig {10,0.1} Scenario wi exernal coordinaion cos same as inernal {10,10} Performance improvemenτ N(0.01,0.0025) Supplier cos advanage γ N(1,0.0625) Invesmen propensiy r N(0.02,0.0025) αmin, α max α min = 0.01 α max = 1 l p 0.8 l a F la = (1 l p ) F + υ + ν l c z l a, l c, Toal consumer income allocaed o e firm in eac period Is Elasiciy of demand η Iniial degree of decomposiion of e ecno-organisaional design n 0 l = ν in + ν ex (1 in ex c l p F + ν in + ν ex F Nos z = F Nos = number of ousourced services; λ = i, Nos λi, l a, = λi, + ν in, + ν ex, ν in, + ν ex, l c, = λi, + ν in, + ν ex, Is = 100 η=1.5 n 0 =5 Average supplier mark-up ξ =.05 μ i,0, i = 1,2,3; μ1 = μ2 = μ3 = 0.3, a = 0 Table A1: Parameer values used o calibrae e model ) 18