Academic journal article Journal of International Business Research

The Economics of Outsourcing in a De-Integrating Industry

Academic journal article Journal of International Business Research

The Economics of Outsourcing in a De-Integrating Industry

Article excerpt

INTRODUCTION

An important problem in supply chain management is to decide which set of capabilities to develop among partners and which to develop in-house. This decision impacts the strategic issue concerning the location of key resources within the supply chain network. Literature suggests that for a chain to successfully compete against other chains, such resource development decisions be made so as to optimize across the chain rather than from the point of view of any individual player (Christopher, 1998).

Developing and managing supply chains in emerging markets is becoming increasingly important as firms position themselves to take advantage of global outsourcing to low income countries. Emerging markets are dominated by low scale economy industries, such as textiles, leather and light engineering. However, supply chains in many low scale economy industries in emerging markets remain suboptimal due to activities being performed within larger firms, even though better alternatives are available through outsourcing. High levels of vertical integration are often common in the early stages of industrial development. As markets develop, government policies change, technology diffuses, and new competitors emerge, large firms are forced to evaluate outsourcing options.

Reduction of transaction costs has been identified as an important objective of supply chain management, and the analysis of transaction costs provides a useful theoretical basis for the study of supply chain management (Ettlie & Sethuraman, 2002; Holstrom & Roberts, 1998). Based on a case-study of outsourcing practices and de-integration in Pakistan's footwear industry, and concepts from transaction cost economics, a framework is developed for determining which set of products and activities to outsource and which to keep in-house. The framework is of relevance not only to large firms developing supply chains, but also to small and medium enterprises (SMEs) as they consider expansion decisions. Given the significant impact of government policy on vertical integration/de-integration decisions, the findings are also relevant to policy makers concerned with development of SME networks.

The following section enumerates factors leading to vertical integration, followed by a section on the discussion on drivers of de-integration. Based on these discussions, Section 4 lists the key determinants of which products and activities are best outsourced and which are best kept in-house. Section 5 presents a case study of vertical integration and recent de-integration in Pakistan's footwear industry with examples of considerations affecting outsourcing decisions. Section 6 proposes a 'framework' for making outsourcing decisions and also enumerates some ideas for future research.

DRIVERS OF VERTICAL INTEGRATION

Multiple factors contribute to the establishment and continued existence of large integrated firms despite inherent inefficiencies. These can be described in terms of reduced costs, weak supply networks, increased market power, and government policy. These factors are important during the early stages of an industry, and particularly important during early stages of economic development.

Cost Reductions

Integrated firms have a cost advantage over smaller firms by avoiding transaction costs in imperfect markets, particularly during early stages of market development. According to (Hennart, 1993), transaction costs include 'the cost of measuring output in all of its dimensions and the consequence of not measuring it perfectly'. These include the costs of writing, monitoring and enforcing contracts with supply chain and other partners. Supply networks in early stages of development are characterized by imperfect markets resulting in high transaction costs. Such costs are further amplified under conditions of specialized assets, complexity, uncertainty, and information asymmetry. …

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