For outsourcing to be effective, an organization must not rely solely upon contracts but should also establish an informal supplier-buyer relationship, says a business professor at Kansas State.

"So many people are looking at whether to do outsourcing or not: is it a good decision or a poor one? Not too many have actually studied how to do it effectively, though. That question of 'how' is really key," said Chwen Sheu, Paul Edgerley Chair in Business Management, professor and interim head of the department of marketing at Kansas State's College of Business Administration.

Sheu studied how nearly 1,000 companies worldwide manage outsourcing for a paper, "What makes outsourcing effective -- a transaction cost analysis." He investigated how firms should structure and govern outsourcing transactions in order to achieve a competitive edge in the market.

The paper, co-authored by John Wacker from Arizona State University and C.L. Yang from Chung Hau University, Taiwan,  received a Best Paper Award at a joint conference between the Asia Pacific Decision Science Institute and the International Conference
on Operations and Supply Chain Management.

For their research, data was collected and analyzed from 970 manufacturing firms in 17 countries. The researchers evaluated the information using the transaction cost theory.
"The theory tries to explain why organizations exist and why they outsource," Sheu said.

In short, a company weighs the costs of outsourcing goods against the bureaucratic costs of producing them in-house, he said. This theory was first proposed by economist Ronald Coase, the 1991 Nobel laureate, and later extended by economist Oliver Williamson, 2009 Nobel laureate.

The researchers found that of the sampled firms, most depend on both legal contracts and an informal supplier-buyer relationship. Sheu said both mechanisms are effective, but the latter deserves more management attention since in outsourcing it's impossible to cover every risk and outcome contractually.

"When something unexpected happens, and the contract doesn't specify how to deal with it, you must be able to sit down and resolve the issues with your suppliers," Sheu said. "It's about trust and information sharing with each other so both parties can deal with unforeseen risks and uncertainties more effectively."

For a company to have the best outsourcing strategy, both forms of governance are needed as varying situations call for different responses, Sheu said. "First we wanted to look at the overall data between different countries to see if outsourcing really does help to compete in the markets. We found that yes, it does help," Sheu said. "Our primary purpose then was to identify the governance mechanisms of how to make existing outsourcing transactions effective. And that's by legal and relational governance."

Sheu plans to reexamine the data and determine which countries are the using outsourcing most effectively, and how national culture may affect the utilization of legal versus relational governance. Those findings would improve the understanding of outsourcing practices in different countries. Such understanding should provide U.S. companies with valuable guidelines for their outsourcing decisions, Sheu said.

Source: Kansas State College of Business Administration