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An Evolutionary Perspective on Outsourcing (Mahoney, 2001) This paper is concerned with the process, context and strategic impact of vertical dish- integration – letting suppliers take-over activities previously performed in-house. It develops propositions regarding scope, speed, and switching costs in the process of vertical dish-integration based on evolutionary economics.
This paper argues that an evolutionary perspective on firm boundaries with Its strong focus on knowledge, as well as processes of search, learning and capability development Is particularly useful for developing a theory of firm boundaries that Is close to managerial concerns. Building on insights in evolutionary economics, propositions are developed regarding scope, speed, and switching costs in the process of vertical dish-integration of which outsourcing is a particular instance.
Outsourcing While the question of why firms should outsource certain activities Is an Increasingly relevant question for business practitioners, It Is also a central question In the perhaps dominant theories of the firm: Modern transaction-cost economics and the resource-based view. Transaction-cost economics and vertical ad’s-integration: Transaction-cost theory has emerged as the most often used theory of vertical boundary choice. It Is premised on the Idea that high levels of three transaction attributes – uncertainty, frequency, and especially asset specialty ? are positively related to internal procurement of activities.
ETC suggests that outsourcing entails transaction costs including searching, contracting, controlling, and reconnecting, and that supplier markets do entail some risks for buyers with respect to price, quality, and time. In sum, transaction-cost economics seems to suggest that managers may consider a shift from Internal to external procurement if production cost reductions can be obtained through outsourcing and hold-up risks are low.
ETC has been criticized because it blackballs the historical context, the inter- relationship among transactions, as well as long-term consequences of boundary choices The resource-based view and vertical ad’s-integration: The resource-based view suggests that differential firm-performance is related to differences In a firm’s costs and strategic advantages obtained through building, sing, and defending resource positions.
Factors, which Influence how resource positions are built, used, and maintained, rather than structural industry features alone, determine how firms increase the wedge between the willingness of customers to pay for product/service offerings and the opportunity costs of production and supply. One problem with this approach is that strategic capabilities and resources are often hard to Identify in practice so that at any particular moment and capabilities of critical strategic need. Nonetheless, combining resource based and transaction-cost reasoning, Quinn and
Hillier suggest to simultaneously consider the potential for competitive advantage (resource-based view) and the degree of strategic vulnerability (transaction-cost economics) in making decisions on whether to outsource a particular activity. They recommend that managers answer the following questions: What is the potential for obtaining competitive advantage in this activity, taking into account transaction costs? What is the potential vulnerability that could arise from market failure if the activity is outsourced?
What can we do to alleviate our vulnerability through structuring arrangements with suppliers to afford appropriate controls, yet provide for necessary flexibility in demand? While these are important questions that may contribute to guiding a firm’s outsourcing decision, they do little to help managers understand switching costs during the process of vertical dish-integration, fail to relate the process of outsourcing to competitive dynamics, and downplay long-term consequences on maintaining and developing the dynamic capabilities of the firm.
An Evolutionary Perspective on Vertical Ad’s-Aggregation Unlike transaction-cost theory and the resource-based view, evolutionary theory revises the core of a process theory of economic organization. Although, evolutionary theory has not focused directly on the question of vertical dish- integration, it yields important insights relevant to the process of outsourcing.
In particular, evolutionary theorists assume three central elements of evolutionary explanations: Bounded rational actors are assumed The central units of analysis are search processes, problem-solving procedures and path-dependent learning in organizations Sensitivity to the contextual embeddings of organizational capability maintenance and development is emphasized
Switching costs during governance change Even if a company could reliably identify why certain activities should be outsourced, an evolutionary perspective on governance change suggests that there are at least two process complications that give cause to switching costs: Governance inseparability and complementarily of capabilities.
The switching costs associated with these problems are neglected in conventional theories of the firm, but they become obvious in an evolutionary process perspective. Governance inseparability: In essence, the authors assert that there are exit barriers n a governance level because a firm’s past governance choices significantly influence the range and types of governance mechanisms that it can adopt in future periods.
Complementary capabilities: Complementarily of capabilities is the technical corollary of governance inseparability. It is an essential insight in the evolutionary literature that capabilities develop in a context-dependent and path-dependent In sum, switching costs exist when there are costs in breaking prior commitment and separating capabilities through interfaces that are tacit, causally ambiguous, socially employ or taken for granted.
Specifying interfaces, knowledge articulation, and codification: The scope of activities that a firm can outsource at any point in time depends on prior contractual commitments and the consequences of breaking them, required articulation and codification of interface specification between activities that are intended to be transferred from internal to external procurement, as well as the capabilities and motivation of participants in the process of vertical dish- integration.
Additionally, however, an evolutionary perspective on the process of vertical dish-integration insiders that outsourcing processes take place in a particular, competitive context. Vertical ad’s-integration and competitive dynamics Firms are not isolated entities; they are embedded in exchange and production relations. There might be external factors within the competitive environment of the firm that limit or facilitate varying degrees of vertical ad’s-integration, including the extent of the market, the nature of innovation regimes, as well as imitation dynamics.
The extent of the market: Whether or not capabilities can be successfully deployed, forever, depends on how easy they can be imitated, protected, challenged by competitors, or, alternatively supported by complementary. In other words, they depend on the capability configuration of the competitive and institutional environment in which the local firm operates; to which it responds; which it may try to shape, and on which it draws. Imitation dynamics: Firms engaged in outsourcing face a critical concern: successful outsourcing often requires putting valuable knowledge-assets at risk.
While vertical ad’s-integration may help companies to access abilities that they cannot build in a reasonable time frame themselves, outsourcing also gives vendors a window to valuable knowledge that they may leak to other clients, including competitors. Innovation regime: Outsourcing innovative activities can be complicated to the extent that one innovative activity depends on simultaneous development of another. While autonomous innovation can be pursued independently from other innovations, the benefits of systemic innovation can be realized only in conjunction with related, complementary innovations.
If innovations re of the systemic type in the sense that simultaneous innovation in a related technology is required, then coordinated-adjustment and information flows between development efforts are required. Vertical Dish-Aggregation and Dynamic Capabilities This section argued that vertical dish-integration can contribute to a firm’s dynamic capability through focused learning in the outsourcing firm, overcoming competence traps, and by limiting the risk of experimentation in the exploration of new competence.
Outsourcing can also raise incentives to learn through the re-drawing of ointments to high-powered incentives. On the other hand, outsourcing can have a negative impact on dynamic capabilities by undermining absorptive capacity, hollowing-out current capability endowments, and increasing search costs in vendor selection. Conclusions This paper has argued that an evolutionary-process perspective on firm boundaries with its strong focus on knowledge, as well as processes of search, learning and capability development is instrumental in developing a theory of firm boundaries that is close to managerial concerns.
Building on insights in evolutionary economics, beatable propositions have been developed regarding scope, speed, and switching costs in the process of vertical dish-integration, of which outsourcing is a particular instance. This paper has argued that the scope of vertical dish-integration will be lower if firms operate in constrained labor markets; in technological regimes; with higher degrees of unionization; and when they are engaged in the development of systemic innovations. These propositions are not obvious in current theories addressing firm boundaries. Nonetheless, they are of crucial managerial concern.