Outsourcing helps or hurts businesses, depending on how they're used

Feb. 2, 2006 -- Outsourcing has a bad reputation that may be unwarranted. According to new research from a professor in the Olin School of Business at Washington University in St. Louis, firms can gain a lot from outsourcing — under the right conditions.

Some think that outsourcing is just a way for firms to save a buck. That may be true, but outsourcing has risks. When firms outsource IT projects or share resources with a supplier, they might be creating competitors who could steal customers or profit making ideas, says Olin School of Business professor of strategy Jackson Nickerson. Only under the right conditions do the benefits of outsourcing outweigh these risks. The trick is in knowing the right circumstances.

The risks for outsourcing IT projects include losing money to pay for higher performance costs, contracting difficulties or expropriation of ideas.

"Using contractors for high-tech projects brings problems when it comes to oversight and governance," Nickerson says. "Firms may need contractors because of gaps in their own internal skill base or lack of resources. Contractors do have an incentive to perform well, but they're outside the direct control of managers. Even if contractors do a good job, the costs for having to coordinate changes are much higher than if the job were performed internally."

With his co-author Kyle Mayer from the Marshall School of Business at the University of Southern California, Nickerson examined 190 IT service projects in a large Silicon Valley firm. The researchers found that if a firm decides to keep a project in-house when it should outsource, then the project becomes slightly unprofitable. When a firm outsources when "insourcing" should have occurred, the detriment is even more extreme as the project loses a substantially larger amount of money.

Nickerson says the penalty for making the wrong choice varies depending on the potential problem the firm faces. For example, the loss of profit that could result from expropriation of intellectual property is significantly greater than the loss of profit if the company kept that same project in-house.

"The presence of expropriation concerns means that firms should heavily favor employees," Nickerson says. "We believe that the significant penalty for outsourcing in the presence of proprietary technology is consistent with the importance of protecting the proprietary technology in this industry.

Jackson Nickerson

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Low-tech industries also take risks when they turn to outsourcing. Nickerson studied the tendency of trucking companies to team-up with competitors for some hauls, while relying on their own company drivers for other transporting jobs.

"It's counter-intuitive. Why would you want to give your competitor business when it could result in your losing your customer?" Nickerson asks.

Jackson found that companies can gain by collaborating with other firms — as long as the circumstances are correct. Evidence of competing firms working together is seen in many industries including airlines, hotels, finance. Knowing when it's valuable to outsource impacts a broad swath of the economy.

Managers need to assess the benefit of using a competitor that has a cost advantage for some tasks. They also need to consider the risk of losing possible sources of future revenue to their collaborators, and they need to understand when outsourcing will actually increase competition for future business.

"When all of these conditions are properly evaluated, knowing when to collaborate and when to compete can be vital to a firm's survival," Nickerson says. "Our theory provides a new lens for thinking through such collaboration decisions."