You might think that outsourcing is relatively recent – dreamt up in the 1980s as a way for hardware manufacturers to move out of one-off box sales and into lovely long-term recurring revenue contracts or for industrial companies to move fixed assets off their balance sheets.
However, the theoretical underpinnings can be traced back further to a 1937 paper by Ronald Coase: ‘The Nature of the Firm’. Ronald is still with us and celebrated his 101st birthday on 29 December. Happy birthday Ronald!
Whilst Ronald’s contemporaries worried about the operation of markets and the macro-economy, he was the first economist to consider the question of why firms exist, and to the extent that they do why their boundaries are where they are. His core insight was that market transactions have a cost associated with them and that in some circumstances the costs associated with internal co-ordination of certain activities are less than the costs associated with market transactions. The boundary between the firm and the market can be established by comparing these costs.
His insight was developed further by Oliver Williamson in the 1970s in his work on transaction cost economics where by using some behavioural observations (that people can’t predict the future and are sometimes opportunistic) and categorising transasctions by frequency, uncertainty and asset specificity he helps apply Ronald’s insights in a more practical way.
Now for those regularly advising on outsourcing contracts, a theory which suggests that the use of provisions including ongoing information exchange and governance (to deal with bounded rationality) or using service levels (to deter opportunism) may seem like teaching grandmothers to suck eggs, but his framework can still be useful when looking at something novel. In particular, the discipline of comparing the costs of internal co-ordination with monitoring and enforcing and external outsourcing arrangement is very useful to undertake early in the process, and can be helpful in identify the optimal scope of any proposed outsourcing.
It is going to be interesting to see how often I will be able blog now I am back at work. I have covered a variety of topics, but if there is an area you’d like to hear more about let me know.