Outsourcing, Modularity, and the Theory of the Firm

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ABSTRACT

Firms have increasingly moved productive activities from within to outside the firm through outsourcing arrangements. According to some estimates, the value of outsourcing contracts has been nearly 100 billion dollars per year since 2004. Firm outsourcing happens for a number of reasons, including to save labor costs, capture the benefits of regulatory arbitrage, and take advantage of economies of scale in the provision of firm needs. We review a number of outsourcing contracts for evidence that contract techniques are used to help modularize the relationship between the firm and its service provider. Consistent with what modularity theory might predict, some contract terms seem to work to thin the interactions between the firm and its service provider, and this thinning serves to make contracting for otherwise intrafirm services more feasible. Other contract terms serve to help the parties manage the fact that inevitably their relationship will be thick with interactions.

TABLE OF CONTENTS

I. Introduction ............................................................. 265

II. HIERARCHY AND MODULARITY IN THE THEORY OF THE FIRM ....................................................................... 269

A. The Role of Hierarchy. ................................................. 273

B. Knowledge, Transfers, and Interdependence of Production .................................................................. 276

1. The role of knowledge in theories of the firm ............... 277

2. Interconnectedness vs. decomposability ....................... 279

3. The role of "complex, interdependent, and iterative transfers" .............................................................. 282

4. Implications for outsourcing contracts ...................... 287

III. OUTSOURCING CONTRACTS AND THEIR ROLE IN CROSSING-POINT MANAGEMENT ................................... 289

A. Our Contracts ............................................................ 289

B. Thick and Thin Crossing Points. ................................... 290

1. Creating thin crossing points .................................... 290

a. "Master Agreement" plus "Statement of Work" structure .......................................................... 291

b. Identifying a small number of key personnel as decision-makers. ............................................... 292

2. Specification or standardization of terms and procedures ............................................................. 293

a. Invoking or developing standardized metrics ....... 294

b. Codification of processes ...................................... 295

c. Periodic (rather than continuous) evaluation of performance against standards ......................... 297

3. Management of thick crossing points ......................... 298

a. Customer control over Service Provider personnel . 299

b. Termination provisions ....................................... 300

IV. OBSERVATIONS AND COMPARISONS ............................... 301

A. Outsourcing Contracts and Transactions Costs ............. 301

B. Generalizing Crossing-Point Management in Outsourcing ................................................................ 303

C. Litigation over Outsourcing Contracts ......................... 308

V. CONCLUSION ................................................................... 310

I. INTRODUCTION

In recent years the practice of "outsourcing" and "offshoring" of production and services by firms in a wide range of industries has become quite common.1 This represents a change in the organization of production in many firms, from inside to outside the firm. As such, it challenges theorists in management, economics, and the law to rethink some of the accepted explanations that theorists have offered about the boundaries of the firm. …