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The impact of outsourcing on the transaction costs and boundaries of manufacturing

The impact of outsourcing on the transaction costs and boundaries of manufacturing



This paper discusses the concept of outsourcing, along with an account of the economic benefits that are achieved by reconfiguring the organization and reducing the transaction costs of providing ...

This paper discusses the concept of outsourcing, along with an account of the economic benefits that are achieved by reconfiguring the organization and reducing the transaction costs of providing products and services. With the practice of outsourcing experiencing exceptional growth, this paper examines the corresponding change (decline) in UK manufacturing as an economic activity, and considers how the economic benefits of outsourcing alter the contribution that an organization makes to a sector’s gross domestic product. To assess this issue, an input–output methodology for measuring economic restructuring in UK manufacturing is presented.



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    The impact of outsourcing on the transaction costs and boundaries of manufacturing The impact of outsourcing on the transaction costs and boundaries of manufacturing Document Transcript

    • ARTICLE IN PRESS Int. J. Production Economics 88 (2004) 61–71 The impact of outsourcing on the transaction costs and boundaries of manufacturing Ian McCarthya,*, Angela Anagnostoub a SFU Business, Management of Technology, Simon Fraser University, 515 West Hastings Street, Vancouver, BC V6B 5K3, Canada b Brasenose College, University of Oxford, Oxford, UK Received 15 April 2003; accepted 16 May 2003Abstract This paper discusses the concept of outsourcing, along with an account of the economic benefits that are achieved byreconfiguring the organization and reducing the transaction costs of providing products and services. With the practiceof outsourcing experiencing exceptional growth, this paper examines the corresponding change (decline) in UKmanufacturing as an economic activity, and considers how the economic benefits of outsourcing alter the contributionthat an organization makes to a sector’s gross domestic product. To assess this issue, an input–output methodology formeasuring economic restructuring in UK manufacturing is presented.r 2003 Elsevier B.V. All rights reserved.Keywords: Outsourcing; Input–output methodology; Manufacturing; Boundary; Configuration1. Introduction of information processing (design, marketing, R&D, customer service, etc.) geography proces- All businesses exist because they perform value- sing (distribution and logistics) and availabilityadding processes that consist of transformation (retail outlets).functions. Service, transportation and retail orga- Pioneered in the 1930s by organizations such asnizations perform processes that focus on infor- the Ford Motor Company, which was ferventmation, geographical distance and availability, about control, rationalization and the eliminationrespectively. Manufacturing organizations focus, of uncertainty, many corporations since then haveby definition, on processing raw material, but since sought growth and power by conglomeration, andthe industrial revolution they have evolved into vertical and horizontal integration. The Fordbusinesses that also deal with significant amounts Motor Company altered the boundary of its organization by acquiring and integrating busi- nesses that were parts of its supply chain. These *Corresponding author. SFU Business, Simon Fraser Uni-versity, 515 West Hastings Street, Vancouver, BC V6B 5K3, included mining companies, shipping companies,Canada. Tel.: +1-604-291-5298; fax: +1-604-291-5153. railway companies and rubber plantations. This E-mail address: imccarth@sfu.ca (I. McCarthy). strategy, not only provided ownership and0925-5273/03/$ - see front matter r 2003 Elsevier B.V. All rights reserved.doi:10.1016/S0925-5273(03)00183-X
    • ARTICLE IN PRESS62 I. McCarthy, A. Anagnostou / Int. J. Production Economics 88 (2004) 61–71enhanced control of the supply chain and market, to outsource, with durable goods manufacturersbut as reported by Lonsdale and Cox (2000) it accounting for 39% of all activity and non-durableoffered organizations the potential for economies goods manufacturers accounting for 25% (Zhuof scale and the opportunity to exercise greater et al., 2001). In addition, with a global outsourcingmarket power. market estimated at d188 billion in 1998, and Manufacturing organizations are complex sys- with annual growth rates of 15% (Coombs &tems that consciously evolve in response to market Battaglia, 1998), the distinction between eco-needs, competition and innovation. Directing this nomic activities in different sectors has becomeevolution is a key management responsibility that blurred.involves making decisions about the configuration With the practice of outsourcing experiencingand boundary of an organization, to ensure exceptional growth, this paper examines a possiblecompetitiveness relative to market demands and corresponding and related change, a decline instability. This concept is central to the transaction manufacturing as an economic activity, andcost perspective (see Section 2.2), which asserts considers how outsourcing alters the perceivedthat organizations seek to reduce costs (direct contribution that an organization makes to acosts and associated support costs) by forming country’s GDP. The conclusion is that thealliances or selecting structures and practices that boundaries of manufacturing activity have altered,lead to efficiency improvements. This cost mini- changing the ownership of certain aspects of themization hypothesis has underpinned the purchas- economic activity. Thus, to properly understanding function and is a key issue in both defining an and measure the economic value of manufacturingorganization’s boundary and understanding the requires an approach that recognizes the highlybenefits of outsourcing. For instance, in the early integrated and codependent set of activities that1990s, many manufacturing organizations had constitute the modern economic system of manu-evolved into businesses that were no longer just facturing.concerned with material processing and assembly. To review and assess this notion, this paperThey had extended their boundaries and remit to will proceed as follows. Section 2 reviews thefocus on converting an idea or need into a economic benefits and drivers that motivatemarketable product, along with the provision of manufacturing organizations to outsource. Sectionappropriate product support and service. The 3 provides an introductory account of the macro-conglomeration and vertical integration activities economic decline that has occurred in UKof the previous 60 years had helped manufacturing manufacturing and asserts that the decline hasorganizations achieve this change in focus, but at been influenced by the practice of outsourcing,the expense of burdening the organization with which has shifted activities and employment fromexcess and inefficient processes and services, and manufacturing to services. Section 4 examines thisuncompetitive transaction costs. claim by using an input–output methodology and With this development in organizational focus, more specifically the decomposition approachthe need and trend for outsourcing emerged. (Dietrich, 1999) to investigate the impact thatIt was based on the assumption that a competitive outsourcing has had on the boundaries andadvantage would be gained if external suppliers outputs of the manufacturing sector. This methodwere contracted to carry out non-core processes can be used to analyze the flow of goods andmore efficiently and effectively. To achieve services from every sector to every other sector inmore proficient and profitable functions in areas the UK economy at a specific point of time. Thus,such as accounting, logistics, catering, design, flows of goods and services can be traced betweenproduction, IT support and customer service, sectors and their relative contributions to econom-manufacturing organizations began to utilize ic output, value added or productivity can bethe core-competencies of other manufacturing, estimated. The methodology is demonstrated usingservice and transportation organizations. Today, a range of UK input–output data. Section 5manufacturing is the industry sector most likely provides a conclusion.
    • ARTICLE IN PRESS I. McCarthy, A. Anagnostou / Int. J. Production Economics 88 (2004) 61–71 632. The case for and against outsourcing fied three reasons for outsourcing: (i) savings on wage and benefit payments, (ii) transfer of demand2.1. What is outsourcing? uncertainty to the outside contractor, and (iii) access to specialized skills and inputs that the Outsourcing has become an important business organization cannot itself possess. Kakabadse andapproach, whereby a competitive advantage may Kakabadse (2000) report that the main reasons forbe gained when products or services are produced outsourcing are: (i) economic—greater specializa-more effectively and efficiently by outside suppli- tion in the provision of services, as outsourcingers. It is an agreement in which one company allows economies of scale and the longevity ofcontracts-out a part of their existing internal demand for the activity; (ii) quality—access toactivity to another company. As a management skills, the competency and focus of potentialpractice it has probably been in existence for over suppliers and geographical coverage is increased;200 years, but during the last 15 years, with the and (iii) innovation—improvements in qualitysupport of academics, consultants and industry through innovation, and the development of newforums, it has developed into a popular strategic service products, can lead to new demands.management initiative. During this 15-year period, Bendor-Samuel (1998) also asserts that outsour-the economic value, strategic importance and cing provides certain power that is not availablecomplexity of the outsourced function (when within an organization’s internal departments.considering manufacturing organizations) has in- This power can have many dimensions: economiescreased; evolving from routine and non-value- of scale, process expertise, access to capital, accessadding functions, such as security, cleaning and to expensive technology, etc. The combination ofcatering, to key support and value-adding func- these dimensions creates the cost savings inherenttions, such as information technology, logistics in outsourcing, because the outsourcing supplierand accounting, to core manufacturing-related (the organization specializing in a particularfunctions, such as design and certain production business function) has the economy of scale, theprocesses. expertise and the capital investments in leading Outsourcing not only purchases products or technology to perform the same tasks moreservices from sources that are external to the efficiently and effectively than the internal depart-organization, but also transfers the responsibility ments of the outsourcing ‘buyer’.of the physical business function and often the Another possible benefit is that outsourcingassociated knowledge (tacit and codified) to the provides companies with greater capacity forexternal organization. It is this adaptation, driven flexibility, especially in the purchase of rapidlyby transaction cost rewards, functional competi- developing new technologies, fashion goods, or thetiveness, strategic development and the business myriad components of complex systems (Carlson,pressures of globalization and technological 1989; Harrison, 1994). Companies can buy tech-change, that has altered the configuration (how nology from a supplier that would be toothe organization is designed managed and oper- expensive to replicate internally. A network ofated) and boundary of the modern manufacturing suppliers could provide an organization with theorganization. These changes not only affect an ability to adjust the scale and scope of theirorganization’s performance, but also the perceived production capability upward or downward, at acontribution of an organization and its industrial lower cost, in response to changing demandsector to an economy. conditions and at a rapid rate. As such, out- sourcing claims to provide greater flexibility than2.2. The case for and against outsourcing the vertically integrated organization (Carlson, 1989; Harrison, 1994; Domberger, 1998). Further- There have been several studies that have more, outsourcing can decrease the product/examined the motivations for and benefits of process design cycle time, if the client uses multipleoutsourcing. Abraham and Taylor (1993) identi- best-in-class suppliers, who work simultaneously
    • ARTICLE IN PRESS64 I. McCarthy, A. Anagnostou / Int. J. Production Economics 88 (2004) 61–71on individual components of the process (Quinn between employers and employees, which in turnand Hilmer, 1994). can damage morale, trust and productivity. The case against outsourcing is based on In summary, the rationale for practicingarguments such as loss of management control, outsourcing is to exploit external suppliers’ invest-reduction in flexibility and increased costs. For ments, innovations, and specialized professionalinstance, competitive outsourcing requires a high capabilities. This helps an organization to reducestandard of supplier management to avoid the its operating costs, whilst achieving an increasedpitfalls of transferring critical functionality, or focus on its core competencies. This obvious andbecoming too dependent on a supplier for day-to- important benefit is consistent with transactionday performance of vital business functions. In cost economics, which was largely developedaddition, outsourcing can generate new risks, such by Coase (1937) and Williamson (1975, 1979).as the loss of critical skills, developing the wrong Transaction cost analysis integrates economicskills, the loss of cross-functional skills, and the theory with management practice and organiza-loss of control over suppliers (Domberger, 1998; tion science to study why organizations exist,Quinn and Hilmer, 1994). The possible loss of what are their configurations and what determinesflexibility is connected to the typical long-term their boundaries based on the assumption thatcontractual relationship that is formed as part of transaction costs are minimized. Transaction costsan outsourcing agreement, and that during the are the full cost of providing products or servicescontract term, the customer’s business, the avail- including negotiating, monitoring and enforcingable technology, and the competitive and regula- the contractual agreement. Therefore, regardlesstory environment may change dramatically. Thus, of whether the motivation for outsourcing isthis inflexibility is mostly linked to an unyielding strategic, operational, political, innovative orand inappropriate contract. Although outsourcing structural, transaction cost analysis asserts thatis undertaken by many organizations to control or the properties and economic benefits of businessreduce costs, there is some evidence that it does functions, whether internal or external, influencenot decrease costs as expected, and in some cases, the configuration and boundary of the organiza-costs increase. For instance, when an item is tion. How this effects the economic impact ofoutsourced, the assumption is that the supplier’s outsourcing on structure and perceived size ofcosts and required contribution is less and will industrial sectors is not clear. Yet, outsourcingcontinue to be less than the cost of internal is a management process that alters the boundaryprovision. A survey based on 1000 managers of an organization and therefore changes theworldwide by the PA Consulting Group (PACG) economic contribution that an organizationrevealed that only 5% of organizations gained makes to its industrial sector and thus to the‘‘high’’ levels of economic benefit from outsour- economy.cing (PA Consulting Group (PACG), 1996) andthat 39% of organizations admitted ‘‘mediocre’’economic benefit. Also, as outsourcing leads to a 3. The changing context and boundaries of UKre-definition of organizational boundaries and, by manufacturingimplication, structural adjustments involving hu-man resources, these changes incur social as well Although manufacturing is essential to success-as financial costs. Although the social costs are ful industrialization and has been regarded as onetransitory and can be mitigated by facilitating the of the most important elements of the UKadjustments through the re-training and re- economy up until the late 1960s, it no longerdeployment of staff within the organization, their occupies that status. The period from the earlytransfer to the supplier organization and ensuing 1970s to the early 1990s was one of many changesredundancy payouts can still be considerable with recessions and recoveries. In particular, the(Domberger, 1998; Hall and Domberger, 1995). oil crises of the early 1970s and the recession ofAlso, outsourcing can lead to industrial disputes 1979–1981 had a severe impact on the structure of
    • ARTICLE IN PRESS I. McCarthy, A. Anagnostou / Int. J. Production Economics 88 (2004) 61–71 65the UK industry. The UK economy underwent Table 1a prolonged period of expansion in the 1980s. This Value added (VA) as a percentage of gross value added (GVA) and employment analyzed by industry over the period of 1980–represented recovery from a deep recession 1999and entailed considerable structural change,particularly in manufacturing. Output fell at the GVA Employment (1000s)turn of the decade and only returned to its 1979 1980 1990 1999 1980 1990 1999level in 1987. Much effort in recent years has been Agriculture 2.1 1.9 1.2 654 592 525devoted to comparisons of the UK’s industrial Mining and 4.4 2.7 2.3 361 208 107.8performance with that of other industrialized quarryingcountries. Manufacturing 26.5 23.0 18.8 7081 5398 3936 For a sustained period, UK manufacturing lost Utilities 5.3 2.3 2.3 2343 1820 1886share in world markets and within the domestic Construction 6.1 6.9 5.3 1617 1559 1767 Services 59.9 67.1 70.2 14,937 14,547 20,718economy. Manufacturing gross value added(GVA) as a percentage of total national gross Source: UK National Accounts, 2000; National Statistics:value added fell, from 26.5% in 1980 to 18.8% in Monthly Digest of Statistics, 2000.1999. This was accompanied by significant changesin employment in the manufacturing industry. In Traditional Single Organization Approachthe 1969 manufacturing provided over 8.1 million Flow of marketjobs in the UK (Yearbook of Industrial Statistics, needs or idea Products and services1974) whereas in 1999 it provided four million jobs Primary(Yearbook of Industrial Statistics, 2001). Value Adding Environment This relative reduction in manufacturing, and Flow of resource (PVAE) Wasteparticularly in manufacturing employment, wasaccompanied by substantial changes in the relativesize of other sectors. In essence, there are definablestages of economic development and the final An Extended Enterprise based on a Value Adding Network of Organizationsstages are characterized by a growing and healthytertiary sector (i.e. transport, construction, dis- PVAEtribution and services) with growing preferences Flow of market needs or idea Products and servicesfor service products. In addition, the contribution Sof value added from the services to national gross Svalue added has been rising gradually from 59.9%in 1980 to 70.2% in 1999 (see Table 1), which OEM Tsuggests that the UK appears to be a service-dominated economy. Flow of resource T Waste When considering this competitive and structur- OMal change in UK manufacturing, it is important torecognize that organizations are open systems.They have permeable and changing boundaries OEM =original equipment manufacturerthat reflect the domain of an organization’s S = service organizationactivities and functions. Outsourcing has encour- T = transportation organization OM = other manufactureraged manufacturing organizations to alter theirboundaries and become extended enterprises (see Fig. 1. Traditional and extended enterprise.Fig. 1) by setting up partnerships, and bycollaborating and trading with other manufactur-ing, service and transportation organizations. This nizations creating wealth through the governancehas increasingly resulted in a nebulous manufac- of knowledge and physical production activities.turing sector, with indistinct manufacturing orga- The result is that the conventional boundaries of
    • ARTICLE IN PRESS66 I. McCarthy, A. Anagnostou / Int. J. Production Economics 88 (2004) 61–71Table 2 4. A methodology for measuring economicValue added and gross output (d millions), 1989–1998 restructuring Manufacturinga Tertiary share of share of total totalb Based on the assumption that supply equals demand, the input–output methodology permits1989 Value added 23.8 69.0 study of the structural changes in an economy by Gross outputc 31.8 44.3 separating economic activity into four categories:1992 intermediate deliveries, final demands, primary Value added 20.9 75.9 inputs and final demands of primary inputs. Gross output 27.1 65.6 Basically, supply or sectoral output must equal1997 Value added 20.8 76.5 final demand plus intermediate demand; and on Gross output 26.3 67.5 the production side, intermediate inputs and1998 primary inputs are combined to produce the level Value added 20.0 78.3 of output. Thus, the standard input–output Gross output 25.0 69.4 methodology for input–output data is based onSource: UK National Accounts, 2000. the following identity: a Manufacturing value added divided by total value added. b Tertiary value added divided by total value added. xi ¼ zi1 þ zi2 þ ? þ zij þ ? þ zin þ fi ; ð1Þ c Constant price estimates of gross output by industry. where the total output of any industry can be disaggregated into amount bought by industry from industry j and the output from industry i (zij )manufacturing value are not appropriate. The supplying final demand fi : For all n industries, inmanufacturing sector has been restructured and matrix notation,extended into non-manufacturing sectors, thus x ¼ Z þ f: ð2Þchanging the contribution that this industrialsector makes to a sector’s gross domestic product The intermediate deliveries Z denote transac-(GDP). tions between economic (manufacturing) sectors. The significance of these differences is indicated The manufacturing sectors use commodities ofin Table 2 where manufacturing value added and other sectors as inputs in production of their owngross production are compared with that of a commodity. An element zij of the n  n matrix Zbroadly defined private tertiary sector (transport, denotes the intermediate deliveries from sector i toconstruction, distribution and services). As man- sector j: A large part of the production is usedufacturing has reduced in value added and gross directly for consumption as raw material forproduction (23.8–20% and 31.8–25%, respec- products or as a technology investment. The finaltively), the tertiary sector has increased in terms demand f consists of the output of productionof both value added and gross production over sectors used for consumption, investment, govern-the period 1989–1998 (69–78.3% and 44.3–69.4, ment expenditures, changes in stocks and exports.respectively). An element fig of the matrix f denotes the deliveries Using the input–output methodology and more from sector i to final demand category g: Aspecifically the decomposition approach explained manufacturing sector also requires inputs that arebelow, the next section examines the impact that not produced solely by one of the sectors. Suchoutsourcing has had on the boundaries and output inputs include payments for labor, capital, im-of the manufacturing sector. The UK input– ports, indirect taxes minus subsidies, and profits.output tables between 1984 and 1998 show that Hence, primary inputs consist of value added andthere has been a significant increase in the gross imports, and factor inputs may be used directly forpurchases that UK manufacturing makes from consumption, investment, etc.non-manufacturing sectors (services and transport From the UK input–output tables, severalin particular). relationships and coefficients have been derived.
    • ARTICLE IN PRESS I. McCarthy, A. Anagnostou / Int. J. Production Economics 88 (2004) 61–71 67The matrix with intermediate deliveries can be By rewriting Eq. (7) it is possible to decomposeexpressed as a matrix of input coefficients with the the growth of total output (Dx) in terms of changeselements of the vector of total inputs on its main in the Leontief inverse (DL) and changes in thediagonal: final demand Df: #Z ¼ Ax; ð3Þ Dx ¼ ðLtþ1 À Lt Þf tþ1 þ Lt ðf tþ1 À f t Þwhere which A is defined as ¼ DL f tþ1 þ Lt Df ð9ÞA  ZxÀ1 ; # ð4Þ or#x denotes the digitalized matrix of the vector x. Dx ¼ ðLtþ1 À Lt Þf t þ Ltþ1 ðf tþ1 À f t ÞThe matrix A consists of input coefficients aij as ¼ DL f t þ Ltþ1 Df: ð10Þthe amount of product x required per unit of In both equations, changes are weighted withproduct j: Therefore, the input coefficients are the figures of a different period. This raises a timeelements of the intermediate deliveries part of the inconsistency in the weights of the changes. Toinput–output table divided per column by the total solve this inconsistency the decomposition can beinputs of that sector: rewritten as zijaij ¼ ; ð5Þ Dx ¼ Ltþ1 f tþ1 ðÀLt f t þ Ltþ1 f t Þ À Ltþ1 f t xj þ Lt f tþ1 ðÀLt f tþ1 þ Lt f t Þ À Lt f twhich represents the direct requirements of theoutput of any sector i per unit of any other ¼ DL f t þ Lt Df þ DL Df ð11Þpurchasing sector j ði; j ¼ 1; 2; y; nÞ: From or asEqs. (3) and (2) yields Dx ¼ Ltþ1 f tþ1 ðÀLt f t þ Ltþ1 f t Þ À Ltþ1 f tx ¼ Ax þ f ð6Þ þ Lt f tþ1 ðÀLt f tþ1 þ Ltþ1 f tþ1 Þ À Ltþ1 f tþ1or ¼ DL f tþ1 þ Ltþ1 Df þ DL Df: ð12Þx ¼ ðI À AÞÀ1 f ¼ Lf; ð7Þ Taking the arithmetic average of Eqs. (11) andwhere I is the n  n identity matrix and L is the (12), changes in output can be expressed asLeontief inverse derived from the input coefficient Dx ¼ 1 DLðf t þ f tþ1 Þ þ 1ðLt þ Ltþ1 ÞDf; 2 2 ð13Þmatrix A. Leontief inverse matrix represents thedirect and indirect requirements of sector i per unit which is another possible method of decomposition.of final demand for the output of sector j: The second part of the right-hand side (RHS) of A sufficient condition for the existence of the Eq. (13) captures that part of the change in grossLeontief inverse is that no column sum is larger output which is attributable to the change in thethan 1 while at least one column sum is smaller technical coefficients, keeping final demand at itsthan 1 (Nikaido, 1970; Takayama, 1985). second period level, while the first term captures Changes in the input–output data can be used to the change in final demand, keeping the technicaldescribe the extent to which restructuring, invol- coefficients fixed at the first period level. The firstving outsourcing and related activities such as term on the RHS is the change in technicalcontracting out, and subcontracting has occurred. coefficients evaluated using the first period’s levelSuppose that changes in total output x are of final demand and the second term is the changedecomposed into the contributions of two fac- in final demand evaluated using second periodtors—the Leontief inverse and the final demand technical coefficients.f—and if the value of total output is known at Thus, Eq. (13) separates the total change intimes t and t þ 1; the change in total output Dx is gross output into final demand and inter-industrygiven by effects, i.e. changing demand with given input– output relationships and changing input–outputDx ¼ xtþ1 À xt ¼ Ltþ1 f tþ1 À Lt f t : ð8Þ relationships with given demand.
    • ARTICLE IN PRESS68 I. McCarthy, A. Anagnostou / Int. J. Production Economics 88 (2004) 61–71 For purposes of empirical measurement, we can 4.1. Empirical investigationrewrite Eq. (13) as follows: Input–output tables explicitly account for theDxav ¼ 1ðD1 þ D2Þ þ 1ðS1 þ S2Þ; 2 2 ð14Þ interdependence of different economic activities by incorporating the size and composition of thewhere various industries’ mutual input demands (mea- sured by interdependent coefficients of the Leon-D1 ¼ LtÀ1 f t À LtÀ1 f tÀ1 ¼ LtÀ1 Df t ; tief inverse), this permits analysis of both directD2 ¼ Lt f t À Lt f tÀ1 ¼ Lt Df t ; and indirect interactions. With the practice of outsourcing experiencing significant growth, it isS1 ¼ Lt f t À LtÀ1 f t ¼ DLt f t ; possible to gauge how this management initiativeS2 ¼ Lt f tÀ1 À LtÀ1 f tÀ1 ¼ DLt f tÀ1 : ð15Þ may have altered the contribution that an indus- trial sector makes to GDP; thus, distorting the The first term on the RHS of Eq. (14) is the definition and boundaries of manufacturing sec-average demand-induced change in output. The tor. As the effect of outsourcing is not recognizedsecond term defines the average supply-led change by national economic accounts, input–outputin output. Hence, it is possible to analyze the tables were used to assess if there is a significantsignificance of this compositional effect by exam- increase in the gross purchases that the tradition-ining the relationship between demand changes ally defined manufacturing sector makes fromand the extent to which industries use services non-manufacturing sectors (services transport inactivities. The latter can be measured by the particular). It should be noted that the data wereaverage (input–output) coefficient for each manu- converted to 1995 prices using sector-specific pricefacturing industry’s purchase of services. If this deflators.compositional effect is significant there should be a Annual input–output tables for 1984 and 1989–positive relationship between industry demands 1998 were obtained from the UK Office ofand service coefficients. It is clear from Eqs. (11) National Statistics (ONS). The 1998 tables at theand (12) that if f t > f tÀ1 ; then final demand as a time of writing were the latest available andproportion of gross value is increasing, whereas if provide the most up-to-date information aboutLt > LtÀ1 intermediate use of resources as a the inter-industry relations. Since the aim is toproportion of gross value is expanding, thus study the impact of outsourcing on the boundariesoutsourcing is increasing. of manufacturing, a higher degree of aggregation Based on the definition that outsourcing is an is adopted to focus on the relationship between theagreement in which one company contracts-out a manufacturing sector as a whole and other sectors.part of their existing internal activity to another Thus, the following sectors were considered:company, outsourcing can be quantified for agriculture, energy, manufacturing, construction,measurement purposes as the proportion of distribution, transportation, communication, andbought-in goods and services in gross output, services. This aggregation creates a potentialwhere gross output is calculated as bought-in difficulty, as the supply-side effects may not begoods and services plus value added. This indi- operating at industry level for specific industries.cator can be used for single companies, manufac- Instead, certain industries may make more inten-turing sectors, or the whole economy, depending sive use of bought-in services and these industrieson the level of aggregation and boundary of may have become more important over time byanalysis. In the following section, the input–output growing more rapidly than the average. However,methodology and more specifically the decomposi- it is possible to analyze the significance of thistion approach explained above (Eq. (13)) are used compositional effect by examining the relationshipto examine the impact that outsourcing has had on between demand changes and the extent to whichthe boundaries and outputs of the UK manufac- industries use services activities. The latter can beturing and service sectors. measured by the average (input–output) coefficient
    • ARTICLE IN PRESS I. McCarthy, A. Anagnostou / Int. J. Production Economics 88 (2004) 61–71 69Table 3 Table 4Supply-side and demand-side effects in the manufacturing UK’s domestic manufacturing and total output (d million),sector 1979–1998 Dxda Dxs Dx Manufacturinga Total Share of (d millions) outputa manufacturing1989–1990 — — — (d millions) to total output1990–1991 54,212 À37,747 16,4651991–1992 51,526 À10,990 40,536 1979 136,778 342,688 25.01992–1993 85,081 À34,668 50,413 1984 180,467 547,026 33.01993–1994 78,302 À23,715 54,587 1989 296,776 1,017,919 29.21994–1995 70,741 À25,670 45,071 1990 259,897 894,859 29.01995–1996 50,149 À20,900 29,249 1991 277,506 1,027,824 27.01996–1997 40,973 À25,712 15,261 1992 282,896 1,101,705 25.71997–1998 54,212 À9229 16,465 1993 299,060 1,168,193 25.6 a 1994 326,554 1,271,305 25.7 Dxd ¼ 0:5ðD1 þ D2Þ and Dxs ¼ 0:5ðS1 þ S2Þ as defined in 1995 350,739 1,359,593 25.8Eq. (15). 1996 368,154 1,450,016 25.4 1997 378,851 1,526,371 24.8 1998 376,090 1,601,222 23.5 Source: UK National Accounts, 1980–2000.for each manufacturing industry’s purchase of a Domestic manufacturing and total output of products atservices. If this compositional effect is significant, basic prices, i.e. total supply of products at purchasers’ pricesthere should be a positive relationship between less imports, distributors’ trading margins, less taxes lessindustry demands and service coefficients. subsidies on products. In this section, the use of input–output tables forthe period 1989–1998 is presented to illustrate the Table 5decompositions proposed by Eq. (13). The results UK’s outsourcing in manufacturing (d millions), during 1979–are shown in Table 3. 1998 In Table 3, the decomposition of gross output is Outsourcing Contracting Share ofused to identify what part of the changes in gross (d millions) out plus manufacturingoutput of manufacturing can be attributed to shifts manufacturing and outsourcingin the final demand. In addition, what can be domestic output to total domesticattributed to supply-side changes (i.e. changes in (d millions) outputthe technical coefficients). For any period, the 1979–1984 6930 187,397 34.3change in gross output of the manufacturing sector 1984–1989 6322 303,098 29.8can be attributed to the change in technical 1989–1990 — 259,897 29.2coefficients. Also, for each period, there is a high 1990–1991 37,747 297,644 33.3 1991–1992 10,990 288,496 28.1increase in the demand-side and a significant 1992–1993 34,668 317,564 28.8supply-side effect captured by the change in 1993–1994 23,715 322,775 27.6technical coefficients. For example, during the 1994–1995 25,670 352,224 27.7period 1992–1993, manufacturing could have had 1995–1996 20,900 371,639 27.3recorded d34,668 million more output if the 1996–1997 25,712 393,866 27.2 1997–1998 9229 388,080 25.4supply-side effect had been accounted for. Also,for the period 1997–1998, it appears that manu- Source: Input–Output Tables, 1979–1998; UK National Statis-facturing’s gross output should have been some tics, 1979–2000.d9,229 million higher, suggesting that the totaldomestic output for 1998 from manufacturing, 1990–1991 and 1992–1993. This suggests that theinstead of being the d376,090 million as listed in contribution of manufacturing output in 1993 toTable 4, would have been the d388,080 million as be 28.8% instead of 25.6%, thus 2.2 percentagelisted in Table 5. The largest outsourcing out points higher. In addition, in 1998 it would beperiods between 1984 and 1998 occurred during 25.4% instead of 23.5%, i.e. 1.9 percentage points
    • ARTICLE IN PRESS70 I. McCarthy, A. Anagnostou / Int. J. Production Economics 88 (2004) 61–71higher. These results support the notion that economy, it is necessary to understand andoutsourcing has altered the configuration and measure the significant purchases it makes fromboundary of manufacturing organizations in terms other sectors, using a method such as the input–of value added and that true manufacturing output methodology that analyzes the flow ofoutput is underestimated. goods and services between sectors. The service sector by definition serves other sectors, and initiatives such as outsourcing have helped to5. Conclusions develop and grow this sector. The input–output data shows that manufacturing is a key customer There are several compelling reasons to out- of the service sector, and through its purchasessource, but the underlying rationale is consistent creates a significant and additional contribution towith the principle of transaction cost economics, a nations GDP.i.e. to achieve economic improvement in theperformance of business functions. This involvescontracting out a function to a specialist supplier Referencesin an attempt to reduce costs and to benefit fromcompetitive knowledge and practices. Thus, the Abraham, K.G., Taylor, S.K., 1993. Firms’ use of outsideeconomics of outsourcing alter the configuration contractors: Theory and evidence. NBER Working Paperand boundary of an organization and therefore No. 4468, NBER, Cambridge, MA. Bendor-Samuel, P., 1998. The brave new world of outsourcing.change the economic contribution that an organi- http://www.outsourcing-journal.com/issues/may1998/html/zation makes to its industrial sector and the everest.html.economy. This suggests that even though a Carlson, B., 1989. Flexibility and theory of the organization.reduction in the economic contribution of the International Journal of Industrial Organization 7 (1),UK manufacturing sector has taken place, there 189–203.have been important structural changes in the Coase, R., 1937. The nature of the firm. In: Williamson, O.E., Winther, G. (Eds.), The Nature of the Firm (1991). Oxfordcomposition of UK manufacturing at the enter- University Press, Oxford.prise level which should provide a basis for Coombs, R., Battaglia, P., 1998. Outsourcing of businessstronger performance in the future. This is services and the boundaries of the organization. CRICreflected by the input–output data presented for Working Paper No. 5.1992–1998, that shows a significant increase in the Dietrich, M., 1999. Explaining economic restructuring: An input–output analysis of organizational change in thegross purchases that manufacturing makes from European Union. International Review of Applied Eco-non-manufacturing (services and transport in nomics 13 (2), 219–240.particular). Domberger, S., 1998. The Contracting Organization: A In conclusion, it is argued that conventional Strategic Guide to Outsourcing. Oxford University Press, Oxford.economic views of UK manufacturing activity Hall, C., Domberger, S., 1995. Competitive tendering forunderestimate its importance and contribution domestic services: A competitive study of three hospitals into GDP. This is because existing macroeconomic New South Wales. In: Domberger, S., Hall, C. (Eds.), Thedata do not acknowledge that UK manufacturing Contracting Casebook: Competitive Tendering in Action.organizations, in pursuing greater efficiency, AGPS, Canberra, pp. 99–126.have outsourced many functions such as logistics, Harrison, B.T., 1994. Lean and Mean: The Changing Land- scape of Corporate Power in the Age of Flexibility. BasicIT, accounting telecommunications and legal Books, New York.services. This practice is the reverse of vertical Kakabadse, N., Kakabadse, A., 2000. Critical review—out-integration and has led to a significant extension of sourcing: A paradigm shift. Journal of Managementthe boundary of manufacturing organizations, Development 19 (8), 670–728.which in turn has shifted transaction costs and Lonsdale, C., Cox, A., 2000. The historical development of outsourcing: The latest fad? Industrial Management & Dataassociated economic value into other sectors, most Systems 100 (4), 444–450.notably the service sector. Thus, to recognize the Nikaido, H., 1970. Introduction to Sets and Mappings inreal value that manufacturing makes to an Modern Economics. North-Holland, Amsterdam.
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