OUTSOURCING STRATEGY: A RECENT LITERATURE REVIEW AND MODEL
UPDATE
By
LINA FERIA
BUAD 591
CALIFORNIA STATE UNIVERSITY, FULLERTON
Abstract
The importance of including an outsourcing strategy in the overall firms operations has
become increasingly important over the last decade. Companies in the U.S. pay about $68
billion every year to other companies for outsourced services and although a major part of
these contracts succeed, there is an increasing concern due to recent broken deals. A recent
study shows that 80% of companies that outsource their customer based functions are
failing to meet their cost savings targets. Usually companies fail to budget hidden
outsourcing costs such as customer dissatisfaction that can eventually jeopardize the future
of the firm. In this paper I reviewed the most current literature on outsourcing and built a
model that includes the principal four factors influencing the success of outsourcing
strategies: the firms Comparative Advantage, Employees, Suppliers and Customers.
Outsourcing Strategy: A Recent Literature Review and Model Update
Introduction
Every year in the United States, companies pay about $68 billion to other companies for
key services or products that help them focus on their core business and delegate other
functions (Thurm, 2007). The value of IT Outsourcing contracts worldwide was $119
billion in 2004 (Pai, 2007). Without a doubt, outsourcing is a major part of the business
strategy that drives organizations to success. Whether at its simplest version of buying raw
materials from a large supplier to its most complex variation of offshoring services,
outsourcing is present in all business strategies.
However, outsourcing strategies are not always successful; therefore it is crucial to
understand the factors that influence a firms outsourcing strategy. In 2004, J.P Morgan
Chase & Co. took its main technology functions to be in-house again abandoning a $5
billion agreement and Electronic Data Systems Inc. backed down from a $1 billion deal
(Thurm, 2007). Although a few years ago outsourcing was used by some manages as
another mean to cut costs, the main reasons for outsourcing have evolved to become more
strategy oriented (Pai, 2007).
The basis of outsourcing is the same one as the trade theory where two or more parties
benefit from the exchange of goods or services. Outsourcing and trade are beneficial for
many reasons including cost savings and increase in wealth, but the main reason
companies incorporate outsourcing into their business strategy can be explained in terms
of comparative advantage.
The purpose of this paper is to review the most relevant recent literature in outsourcing and
to identify the key elements that connect to a proposed model of outsourcing that
complements the outsourcing decision framework Figure 1 (Kremic and Tukel, 2003). A
revised version of this model follows.
Strategic Outsourcing Model
This research paper differs from Kremics in that it incorporates the comparative advantage
concept as the main driver of outsourcing and it also includes other triggering factors such
as the industry clockspeed and the entrance of new technology into the industry. The main
contribution of this article is to gather the most important factors of outsourcing into a
model. In the current literature, the risks of outsourcing are mentioned very scattered. In
this paper I provide a ranking of the most important risk factors mentioned in the reviewed
literature.
There are three types of functions a business can be divided into: core functions, tactical
non-core functions and strategic non-core functions (Pai, 2007). Core functions are the
ones that dictate the comparative advantage of the firm; they are the specialized task that
makes the business unique and successful. Tactical non-core functions are most commonly
outsourced. They are the functions that are necessary components of the core business but
do not have a direct impact on the core functions. These are functions like payroll,
accounts receivable, accounting, call centers and recruitment.
The first part of the model includes two external forces that trigger the need to outsource.
The first one is the industry and the second one is the new technologies that become an
important part of the core business of the firm. Following the external forces are the
internal reasons that push a firm to outsource. Although many have been identified in the
literature, the most relevant refer to reduction of costs, focus on the core business, avoid
the investment in specific assets and increase in efficiency and performance. A ranking of
these reasons is presented in Figure 2 (Pai, 2007).
The proposed model highlights the four most important forces of strategic outsourcing:
Suppliers, Customers, Employees, and the firms comparative advantage.
Comparative and Competitive Advantage
It is important to understand the implications of comparative and competitive advantage in
outsourcing. Comparative advantage theory explains that it may be beneficial for two
parties (countries, regions, individuals and so on) to trade if one has a lower relative cost
of producing some good. It takes into account the opportunity cost instead of the absolute
cost of production of one good to evaluate the sourcing strategies that are beneficial for
both parties.
The gains from outsourcing are well explained by this trade theory. In a simplified world
with only two firms that produce two goods, trade will allow each firm to specialize in
their production in a way that allocates resources to their most productive uses. If Firm A
specializes in the production of software and Firm B specializes in human resources
management, the trade theory demonstrates us that both firms wealth will be maximized if
Firm A produces software and sells it to Firm B in relative terms and Firm B, in exchange
for software, administrates the human resources department of Firm A. Firm A then, holds
