PDF Ebook Does Outsourcing Increase Profitability?
Both the popular press and academic literature have recently covered the growth of outsourcing or contracting out, of business activities and its economic implications. While Heshmati (2003) in his recent survey points out that there is no general definition or measurement of outsourcing, he broadly describes it as “different kinds of corporate action related to all subcontracting relationships between firms and the hiring of workers in non-traditional jobs” (p. 99). Outsourcing may provide a viable strategy if firms aim to save on labour costs (Abraham and Taylor, 1996), exploit production differentials both within the services sector and between services and manufacturing (Fixler and Siegel, 1999), or take advantage of globalisation (Feenstra and Hanson, 1999). According to an article in the Financial Times ‘Subcontracting as many non-core activities as possible is a central element of the new economy’.
A fundamental question to ask is whether outsourcing is value enhancing and, in particular, whether the firm that undertakes outsourcing shows higher profitability as a result. Essentially this question renders down to the transactions cost question regularly posed to university undergraduates: should a firm manufacture its own inputs by some form of vertical merger or should it seek to obtain possibly more competitively priced inputs on the open market? While the viability of vertical mergers as a determinant of profitability is comparatively well researched, less work has been undertaken on the viability of pursuing a less integrated strategy, namely of outsourcing inputs.
Recent evidence from practitioners casts some doubt on the benefits to outsourcing. A UK survey by Manpower focussing on the benefits accruing to firms from offshoring services, found that 68 percent of firms outsource at least some services, the main motivation being cost reduction. However, in a recent survey, 56 percent of IT specialists claimed that outsourced IT work was at least inferior to that produced in-house. More worryingly, 11 percent reported that the outsourced work actually induced a setback to the firm’s production. Accordingly, in the popular press one appears to have arrived at a point where experts begin to question the validity of outsourcing as a long-term strategy or even short term as a cost reduction exercise.
To the best of our knowledge, there is only a very limited number of more rigorous statistical or econometric studies looking at this issue. The evidence that has been produced in such papers, however, suggests that the value-enhancing link between outsourcing and profitability is not clearly established. Specifically, Kimura (2002) does not find any evidence that subcontracting leads to higher profits in Japanese manufacturing firms. Differentiating between outsourcing of services and non-services inputs, Görzig and Stephan (2002) find that outsourcing of materials is positively correlated with profits, while there is a negative relationship between profitability and outsourced services for a sample of German manufacturing firms.
Motivated by the benefits to outsourcing claimed by some practitioners and the corresponding lack of any direct evidence as to the truth behind these assertions, we aim to establish whether outsourcing does indeed raise profitability. We use unique plant level panel data for the electronics sector in the Republic of Ireland. Ireland represents an interesting case study for outsourcing as noted by Ruane and Görg (2001), who document the increasing growth in outsourcing in the electronics sector for the Irish economy. The novelty of our data stems from the fact that we can distinguish 12 electronics sub-sectors which cover both manufacturing and services activities. Also, we have detailed information on outsourcing activities at the plant level. Furthermore, in comparison to the study by Görzig and Stephan (2002) which is the one most closely related to ours, we pay particular attention to the possible endogeneity of outsourcing and profitability. We attempt to circumvent this problem by using an instrumental variable approach, implemented using a General Method of Moments (GMM) estimator.
The remainder of the paper is structured as follows. The following section briefly discusses recent literature on firms’ decisions to outsource, in order to provide the context for our subsequent empirical analysis. The data are described in Section 3. Section 4 outlines the econometric methodology and discusses the results. Finally, Section 5 presents some conclusions.
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