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Keywords:

  • outsourcing;
  • subsidiaries;
  • geographic distance;
  • political distance;
  • cultural distance

Abstract

  1. Top of page
  2. Abstract
  3. Introduction
  4. Connecting to the Supply Base to Outsource
  5. Methods
  6. Results
  7. Discussion
  8. Implications and Limitations
  9. Conclusions
  10. Acknowledgements
  11. References

Firms outsource through connecting to local and global supply bases and making such connections produces costs of search and evaluation, which are a function of transaction characteristics and firm capabilities. We argue that firms outsource more when those costs are low. Hence, domestic subsidiaries of multinational firms, with low cost access to both local and global supply bases, outsource more than either domestic firms or foreign subsidiaries, as confirmed by evidence from a large data panel. We also propose that among foreign subsidiaries, distance from the home country co-determines search and evaluation costs such that subsidiaries from more distant countries outsource less. This is confirmed for geographic distance, but a positive effect is found for political distance and a mixed effect for cultural distance.


Introduction

  1. Top of page
  2. Abstract
  3. Introduction
  4. Connecting to the Supply Base to Outsource
  5. Methods
  6. Results
  7. Discussion
  8. Implications and Limitations
  9. Conclusions
  10. Acknowledgements
  11. References

Outsourcing is a topic that has received substantial research attention over the past few decades, just as its use in practice has grown explosively. Outsourcing and offshoring are some of the key means firms utilize to devise more modular production strategies, through disaggregation of activities and more modular organizations (Brusoni, Prencipe, and Pavitt, 2001; Jensen and Petersen, 2013; Lewin, Massini, and Peeters, 2009; McDermott, Mudambi, and Parente, 2013; Mudambi, 2008). While in recent years the research focus in global strategy has shifted toward offshore outsourcing (e.g., Bertrand and Mol, 2013), there is at least as much domestic outsourcing and almost all of the theorizing around outsourcing has in fact emerged from the study of the domestic variety (e.g., Leiblein, Reuer, and Dalsace, 2002). Theories that have been especially prominent as explanations for outsourcing choices include transaction cost economics (Murray, Kotabe, and Wildt, 1995; Williamson, 1991) and the resource-based and knowledge-based views of the firm (Leiblein and Miller, 2003; Poppo and Zenger, 1998), but alternative explanations have come from perspectives as diverse as institutional theory (Loh and Venkatraman, 1992), real options (Leiblein and Miller, 2003), evolutionary economics (Mahnke, 2001), and firm positioning (Porter, 1997).

Causal explanations of outsourcing choices operate at one of four contextual levels (Mol, 2007): the transaction (activity), the firm, the industry, and the broader environment. The outsourcing decision, also referred to as the make-or-buy decision, varies heavily with context: for instance, transaction-level variations in asset specificity and uncertainty (Williamson, 1991) and firm level variations in capabilities (Barney, 1999). Most research, especially in strategy, tackles one or both of the first two levels of transactions and firms (e.g., Leiblein et al., 2002), and little work exists that directly tests how national level indicators impact outsourcing decisions, leaving aside some work that looks at the impact of economic liberalization (Toulan, 2002). In other words, in the literature, the connection between outsourcing and global strategy is weak. Specifically, little focus has been placed on which firms can effectively access a large and wide-ranging supply base, even though it has been observed casually that utilizing specialized and low cost suppliers globally provides important advantages (Quinn, 1999).

Yet this question of access to local and global supply bases is highly relevant, both from a practical and an academic point of view. Practitioners make connections to new and existing suppliers on a daily basis and, in doing so, often face a range of obstacles. Identifying the conditions that produce or lower those obstacles could be highly valuable. For scholars, however, this produces interesting puzzles from a theory of the firm perspective, in terms of whether and how firm boundaries are shaped by ease of access to the supply base and, from a global strategy perspective, in terms of whether and how multinational firms shape that access. Resolving these puzzles adds to our understanding of governance choices of organizations.

Therefore, in this article, we specifically seek to develop new theory and provide empirical tests around this notion of connecting to the supply base. We apply the idea that access to a supply base is conditioned by the costs of search and deliberation that emerge when firms seek exchange partners such as suppliers, as developed by Rangan (2000a, 2000b). High transaction costs increase costs of search and deliberation, while a firm's governance capabilities lower them. Costs of search and deliberation are typically higher when the exchange partner operates in another country (Rangan, 2000b). We build upon this and distinguish firms on two dimensions—namely whether they are home or host businesses and whether they have only local operations or are part of a multinational corporation, arguing that different types of firms differ in their ability to access local and global supply bases. Furthermore, we hypothesize that the more distant a foreign subsidiary's home country, the costlier access to the local supply base will be, due to greater problems in searching for and evaluating suppliers and, therefore, the less the subsidiary will outsource. Much global strategy literature looks at market entry choices in terms of the effects of cross-national distance, but we are not aware of studies doing this for outsourcing choices.

Our central questions are whether firms' choices to outsource are conditioned by: (1) the type of firm; and (2) in the case of subsidiaries of a host multinational, distance from the home country. In line with the literature (e.g., Lei and Hitt, 1995; Kotabe et al., 2012) we define outsourcing as the undertaking of activities by external suppliers and we study the outsourcing ratio of a firm, i.e., the degree to which it externally sources the inputs required for selling its products. We focus on total outsourcing, including domestic and offshore outsourcing.

We proceed by formulating specific hypotheses and then present a six-year panel data study of close to 5,000 businesses in The Netherlands. As predicted, the findings suggest that compared to home-based subsidiaries of Dutch multinationals (‘domestic subsidiaries’), there is less outsourcing among both subsidiaries of foreign multinationals (‘foreign subsidiaries’) and purely local Dutch firms (‘local firms’). As expected, geographic distance from the home country leads to less outsourcing. But, contrary to expectations, political distance has a positive effect, while the effect of cultural distance is unclear.

This article contributes to the study of outsourcing by proposing that effective access to supply bases, as shaped by the type of firm and distance from the home country, influences firms' outsourcing choices, demonstrating how existing transaction cost and capabilities explanations are consistent with such a view. We contribute to theory on global strategy by extending the notion of search and deliberation to outsourcing and, specifically, through arguing that being a multinational provides a bridge to global supply bases and operating at home improves the ability to connect to local supply bases. Finally, we contribute to the understanding of the effects of different dimensions of cross-national distance (e.g., Berry, Guillen, and Zhou, 2010) by demonstrating not only that distance matters, but by laying out how different types of distance may have differing effects.

Connecting to the Supply Base to Outsource

  1. Top of page
  2. Abstract
  3. Introduction
  4. Connecting to the Supply Base to Outsource
  5. Methods
  6. Results
  7. Discussion
  8. Implications and Limitations
  9. Conclusions
  10. Acknowledgements
  11. References

Because the outsourcing literature has grown explosively over time, it has been reviewed from all kinds of angles (Mol, 2007). Without repeating those reviews, two common conclusions are that outsourcing has grown to encompass many different activities, from manufacturing to a variety of services, and that our theories, especially transaction cost economics (Williamson, 1991) and the resource-based view of the firm (Barney, 1999), help explain why and how much firms outsource. While a significant part of the outsourcing literature focuses on specific outsourcing decisions or specific outsourcing partnerships, we apply a firm-level perspective, aggregating all outsourcing. This produces disadvantages, such as the inability to measure asset specificity or relate choices to characteristics of specific partners and supply markets. But it has major advantages too, focusing not on some arbitrary sample of outsourced activities but on a firm's entire outsourcing portfolio and allowing us to convincingly relate firm-level characteristics, including firm nationality, to outsourcing choices.

Importantly, in order to outsource, firms first need to connect to suppliers. Making such connections is costly, as is any attempt to transact through markets, and the more costly it is, compared to internal transactions, the less likely the firm is to outsource (Coase, 1937). The industrial marketing and purchasing literature has long maintained that finding suitable exchange partners is far from straightforward (Webster and Wind, 1972). And the global strategy literature has specifically argued that these processes of connecting to the supply base produce costs of search and deliberation (Rangan, 2000b). As Rangan (2000a: 816) states:

‘[s]earch is undertaken with the aim of identifying potential exchange partners and is defined here as activity that involves scanning and transmitting supply-demand signals pertaining to the object of potential exchange.’

Search can come about to find entirely new suppliers or, alternatively, to replace existing ones, and produces high costs when transmission of supply-demand signals is problematic (Rangan, 2000a). As firms engage in transactions in unknown environments, such as other countries, problems with transmission of supply-demand signals increase significantly (Rangan, 2000b).

Deliberation (Rangan, 2000a: 818)

‘occurs when exchange is contemplated with an attractive but unfamiliar potential exchange partner. Deliberation will be a nonissue if actors can be certain or nearly certain about (1) the quality of what is to be exchanged and (2) the manner in which exchange partners will discharge mutual obligations in the future.’

Yet in many instances in outsourcing, such certainty does not exist, for instance due to uncertainty about future volumes and technologies (Williamson, 1985) or because the accumulation of resources and capabilities is subject to dynamic and uncertain processes (Helfat et al., 2007), and we submit that this lack of certainty is especially present when partners come from different countries, and more so when those countries are distant.

We build on these definitions to argue that as firms actively search for suppliers and deliberate whether a supplier fits their needs, they will incur search and deliberation costs. And the costliness of connecting to an outside supplier can stimulate firms to revert to the alternative of internal production, i.e., to shy away from outsourcing because decision makers frame outsourcing choices in relative terms, comparing the attractiveness of internal and external options (Jacobides and Winter, 2005).

Fundamentally, firms can access two supply bases—a local (domestic) one and a global one. Search and deliberation costs increase significantly when firms try to connect to suppliers in another country (Rangan, 2000b). We can relate the search and deliberation costs involved in connecting the supply base to the dominant theoretical approaches on outsourcing in a straightforward way. Search and deliberation costs are, in fact, a form of transaction costs, defined by Williamson (1985, following Arrow) as the cost of running the economy. Williamson (1985) points at how the nature of the market, such as the number, diversity, and strength of suppliers, determines the costs of transacting. Where transaction costs are high, internalization, rather than outsourcing is the optimal choice (Williamson, 1985). This may occur when the market is thin and lacks significant numbers of suppliers, particularly when specific assets are required or transaction volumes are uncertain (Williamson, 1985). In global strategy, much work exists that shows transaction costs rise when transacting across borders, going back to Buckley and Casson (1976), and high costs of searching for and evaluating partners are a key reason for this (Rangan, 2000b).

Resource-based and capabilities arguments (Barney, 1999; Jacobides and Winter, 2005; McDermott et al., 2013), however, suggest that firms will outsource less (more) as their productive capabilities vis-à-vis external suppliers are higher (lower). It is widely argued in the global strategy literature that to compensate for the liability of foreignness (those additional costs only faced by foreign firms) (Kostova and Zaheer, 1999: 73), firms that operate abroad must have stronger resources in some shape or form. But these same stronger resources may well make foreign firms less likely to outsource because, relative to suppliers, they can produce better or cheaper inputs, making them less willing to incur search and deliberation costs.

Furthermore, literature on capabilities produces the notion that the same supply base connection may be more or less costly, depending on the governance capabilities of firms (Mayer and Argyres, 2004; Mayer and Salomon, 2006). This implies that search and deliberation costs are a function of the firm's governance capabilities and sources of variance in governance capabilities directly shape the firm's ease of access to local and global supply bases. As we will argue later, some types of firms have governance capabilities that make local access easier, yet for others global access is easier.

The research hypotheses that follow build upon the idea that increases in search and deliberation costs occur when operating across borders, tying this first to the type of firm seeking to connect to a supply base (Hypotheses 1 and 2) and then to the distance between home and host countries faced by foreign subsidiaries of multinational firms (Hypotheses 3a through 3c).

Local firms, domestic subsidiaries, and foreign subsidiaries

We propose that the ability to effectively access either of the two supply bases (local and global) to outsource will be shaped by the type of firm that seeks to access them. In line with the broader global strategy literature, it is possible to distinguish three types of firms, along two dimensions. One dimension is whether a firm is a home or host firm, i.e., whether it originates from the focal country or not. The second dimension is whether businesses are part of multinational firms or local players, i.e., whether they have operations in multiple countries or just a single country. This then generates the three types we refer to as local firms, foreign subsidiaries, and domestic subsidiaries. 1 Figure 1 captures these types and the proposed effects.

figure

Figure 1. Three types of focal businesses and the proposed effects for each of these types

Download figure to PowerPoint

We argue that firm type has a profound impact on effective access to local and global supply bases. Foreign subsidiaries differ from domestic subsidiaries in their outsourcing behavior because they have problems in establishing themselves in host cultural and institutional environments due to the liability of foreignness (Kostova and Zaheer, 1999). Lacking the networks that local firms and domestic subsidiaries have, they are cut off from potential local suppliers due to problems of search and deliberation in unknown environments (Rangan, 2000b) or, if they do have access to these suppliers, they are unable to build the strong kind of relationships that domestic firms enjoy between themselves. Therefore, foreign subsidiaries rely on internal capabilities to a larger extent, as they face voids in the institutional provision (Khanna and Palepu, 1999). Thus, while foreign subsidiaries have similar access to the global supply base, it is more difficult for them to access the local supply base effectively. Replacing that access entirely by offshore outsourcing is generally not an option due to the costs associated with doing this (Mol, van Tulder, and Beije, 2005). Put differently, home subsidiaries have better capabilities for governing relationships with local suppliers than do foreign subsidiaries. Illustrations of this include the idea of foreign firms setting up transplant supplier networks because they are new to a country (Kenney and Florida, 1995) and the notion that local embeddedness built up over a long period of time is an important precondition of effective supplier networks (Uzzi, 1997). Thus, we would expect foreign subsidiaries to resort to internalization of more of their activities when compared to domestic subsidiaries.

The second relevant comparison is between domestic subsidiaries and purely local firms. Both types have similar access to the local supply base, having been established in the country. But there will be a large gap between them in terms of accessing the global supply base. Local firms are known to be much less likely to outsource internationally because engaging in international outsourcing induces significant additional transaction costs (Buckley and Casson, 1976; Mol et al., 2005). Governance capabilities are an effective means for overcoming transaction costs (Mayer and Salomon, 2006), but when dealing with foreign suppliers, local firms do not possess these capabilities to the same extent as multinational firms, whether domestic subsidiaries or foreign subsidiaries. A lack of experience abroad, a local mind-set throughout their operations, the same problems of search and deliberation (Rangan, 2000a, 2000b), and the inability to operate outside the managerial ‘comfort zone’ (Jensen and Petersen, 2013) imply that local firms will not have effective access to the global supply base and are, therefore, much less likely to outsource globally. By contrast, domestic subsidiaries can draw upon their existing international networks, such as the links that fellow subsidiaries abroad have established with potential suppliers and links they themselves have garnered (through, for instance, export activities), to outsource more activities globally.

In short, we expect that domestic firms will be good at connecting to the local supply base, subsidiaries of multinationals will be good at connecting to the global supply base, and firms that are both domestic and multinational (i.e., domestic subsidiaries) can do both. Thus, and in view of our logic that effective access to a supply base shapes outsourcing choices, the latter type of firm should be expected to outsource more, while the other two types should outsource less. 2

  • Hypothesis 1: Being a foreign subsidiary, as opposed to being a domestic subsidiary, negatively influences the outsourcing ratio of a firm.
  • Hypothesis 2: Being a local firm, as opposed to being a domestic subsidiary, negatively influences the outsourcing ratio of a firm.

Cross-national distance

Next we turn to foreign subsidiaries, ignoring local firms and domestic subsidiaries, to ask whether the characteristics of their home country, in relation to the host country, influence their outsourcing choices. We specifically focus on distance between the home and host countries as the critical variable here, in line with much previous research (e.g., Berry et al., 2010; Dikova, Rao Sahib, and van Witteloostuijn, 2010; Kogut and Singh, 1988; Reus and Lamont, 2009).

How would distance affect choices whether to outsource or not among foreign subsidiaries? We propose that distance has a large effect on local outsourcing and some effects on outsourcing to the home country, but we will assume it does not systematically affect outsourcing to other (third) countries. Given the argument outlined earlier (that foreign subsidiaries find it particularly difficult to connect to the local supply base), we suggest that costs of search and evaluation rise in line with distance from the home country. The more distant the home country, the more we would expect transmission of supply-demand signals to fail and lack of familiarity with trading partners to increase (Rangan, 2000a). This is due to difficulties between buyers and suppliers—for instance, with communicating in different languages, using different measurement systems, having to deal with different intellectual property rules, having different expectations on the degree to which problem solving is an individual or a collective exercise, and even the sheer physical distance between home and host countries. And where transmission of supply-demand signals fails and the parties in an exchange become less familiar with one another, the costs of search and evaluation increase (Rangan, 2000a). Accordingly, distance ought to make outsourcing costlier. Kenney and Florida (1995) provide an empirical example when describing the struggles of Japanese electronics companies that tried to build a supply base in the United States.

From a transaction cost perspective, distance increases the likelihood that there is a dearth of viable suppliers, because transaction costs rise when transacting in less familiar environments (Buckley and Casson, 1976). From a capabilities perspective, the relative value of a firm's productive capabilities can be expected to depend on similarities between the home and host countries: The more distant the home country, the less valuable will be a firm's internal capabilities. These problems produced by distance are widely documented in the market entry literature. But another point specific to outsourcing is that foreign subsidiaries from less distant countries will have better governance capabilities, due to higher familiarity with the local context, than subsidiaries from distant countries. This means they can outsource at a reduced transaction cost (Mayer and Salomon, 2006), which should make outsourcing more prevalent among firms from less distant countries. Finally, in case of outsourcing from the home base, larger distance leads to increases in transportation costs.

If we accept that distance from the home country should generally make it harder for foreign subsidiaries to outsource locally as well as from their home base, then what type or types of distance could be expected to matter here? There are two alternative explanations for cross-national comparisons in the field of international management, namely culture and institutions, so both must be considered. There is a large literature that discusses how national culture, which we interpret as the prevailing norms and values in a country, and institutions, a country's rules of the game, are related. Recently, some authors have distinguished between formal and informal institutions (e.g., Dikova et al., 2010; Slangen and Beugelsdijk, 2010), the latter referring to culture, while other scholars see culture as simply one part of institutions (e.g., Berry et al., 2010). Here we apply various types of distance to see whether they matter in the case of outsourcing. We propose that three key types of distance are cultural distance, geographic distance, and political distance.

Cultural distance makes any economic activity across borders more difficult and costly (Hofstede, 1980; Hofstede and Minkov, 2010; House et al., 2004) and should, therefore, make outsourcing across borders harder. Decision makers differ in their understanding of appropriate objectives for firms and in their behaviors, because they grew up in different cultures (Hofstede et al., 2002). Such differences affect their search and evaluation behaviors, including where they search and what evaluation criteria they use; the foreign subsidiary will differ significantly in its relationship objectives and its ways of working from local suppliers and such difficulties will lead the subsidiary to shy away from local outsourcing. Similarly, as we have argued, governance capabilities will become less useful in culturally distant locations. Thus, we propose:

  • Hypothesis 3a: Cultural distance between the home and host countries negatively influences the outsourcing ratio of a foreign subsidiary.

A second type of distance, important in the context of manufacturing industries, is geographic distance between the home and host countries. Geographic distance directly reduces the attractiveness of outsourcing from the home base, as the costs of transporting goods to the host country increase with distance. So any production cost advantages that outsourcing to a home country supplier provides evaporate quickly and, thus, geographically distant foreign subsidiaries will either have to find local suppliers, involving high search and evaluation costs or, as noted earlier, they will internalize the activity. Furthermore, geographic distance makes it more complex and costly to transfer people and other assets to a supplier.

  • Hypothesis 3b: Geographic distance between the home and host countries negatively influences the outsourcing ratio of a foreign subsidiary.

Finally, political distance and differences in political stability, democracy, and trade bloc membership (Berry et al., 2010), is a third type of cross-national distance that could affect outsourcing decisions of foreign subsidiaries. The comparative capitalisms literature (Jackson and Deeg, 2008) discusses how differences in institutional arrangements and complementarities between groups of states can affect firm-level practices such as outsourcing (Hall and Soskice, 2001; Whitley, 1999). Firms operating in the same common market, such as the European Union, encounter many institutional similarities in the form of technical standards or other forms of trade bloc-wide regulation that make it easier to connect to local suppliers, and this will increase the attractiveness of outsourcing to local suppliers. By contrast, firms from politically distant countries may not be as familiar with those institutions. Furthermore, such firms will find it harder to outsource from their home countries, due to trade protection regimes including local content regulation. Therefore our final hypothesis is:

  • Hypothesis 3c: Political distance between the home and host countries negatively influences the outsourcing ratio of a foreign subsidiary.

Methods

  1. Top of page
  2. Abstract
  3. Introduction
  4. Connecting to the Supply Base to Outsource
  5. Methods
  6. Results
  7. Discussion
  8. Implications and Limitations
  9. Conclusions
  10. Acknowledgements
  11. References

Statistics Netherlands (Centraal Bureau voor de Statistiek) collects yearly census data at the business unit level from all Dutch manufacturing firms and foreign subsidiaries with more than 20 employees. Firms are legally obliged to provide answers to Statistics Netherlands. We were granted access to data on business units operating from 1993 to 1998.

A number of firm-level measures were created in a panel data structure with six years of data. The database contains information on industry membership as well as firm-level variables such as the type of firm, including firm nationality. Manufacturing, as it is defined here, includes NACE codes 15 through 37, the NACE system being the European equivalent to SIC codes. It should be noted that outsourcing in The Netherlands started increasing significantly in the 1980s, including in high-tech industries (Mol, 2005), and this trend continued during the time period studied here. There is significant foreign ownership of manufacturing firms, although a database like this is heavily populated with smaller firms, where foreign ownership is rarer.

Measures

Consistent with our definition and with earlier studies (e.g., Kotabe et al., 2012), the dependent variable of outsourcing ratio (‘outsourcing’) was calculated as all industrial purchasing divided by total sales. This measure indicates to what extent a firm relies on external suppliers to produce its products and, as expected, has a wide spread. Empirically we cannot explicitly distinguish domestic and offshore outsourcing in our data, but we know from previous survey research in The Netherlands (Mol et al., 2005) undertaken on a subset of the firms we study here that close to 50 percent of all outsourcing is foreign, that multinational firms engage much more in offshore outsourcing and, ceterus paribus, that domestic firms engage much more in domestic outsourcing.

A dummy variable ‘foreign subsidiary’ takes a value of ‘1’ if a business is foreign owned. The global headquarters of these subsidiaries are spread across multiple developed countries, but are strongly concentrated in a few large countries (i.e., the United States, the United Kingdom, France, Germany, and Japan). Similarly, there is a dummy with a value of ‘1’ for ‘local firm’ and a dummy with value of ‘1’ for a ‘domestic subsidiary’ that is part of a Dutch multinational. Consistent with Hypotheses 1 and 2, the latter variable is omitted to use it as the base value.

Following Hypotheses 3a through 3c, we created a number of distance variables. A few firms with the nationality of Netherlands Antilles or Bermuda were removed due to the high likelihood that these nationalities were chosen for tax purposes. The ‘cultural distance-Hofstede’ variable is calculated through the well-known Kogut and Singh (1988) index of cultural distance based on the four dimensions of culture of Hofstede (1980) and then assigned to each individual firm based on its nationality. The Hofstede measures are controversial and, therefore, we follow recent practice (Reus and Lamont, 2009) by also including a measure of distance based on the GLOBE study of culture and leadership. ‘Cultural distance-GLOBE’ is calculated in the manner proposed by Kogut and Singh (1988), but GLOBE uses nine dimensions of culture. We use the GLOBE ‘practices’ scores, as opposed to the values scores, as we are interested in actual decision making. Berry et al. (2010) propose a measure based on the World Values Survey, but it does not cover The Netherlands. For the other distance variables, we use the measures described and provided by Berry et al. (2010). Thus ‘geographic distance’ is the great circle distance between the geographic centers of countries. ‘Political distance’ covers differences in political stability, democracy, and trade bloc membership, as calculated by Berry et al. (2010) using the Mahalanobis method. This measure is time variant, and we use the version in their data that applies yearly covariances.

Given that outsourcing is highly context dependent (Williamson, 1985), it is important to check for firm and industry effects. We include industry dummies, as modularization strategies may vary from one industry to the next due to technical differences in production systems (McDermott et al., 2013) and some of these dummies have significant effects (results available upon request). At the firm level, the ‘uncertainty’ a firm faces was calculated as the variance in its sales level from 1993 to 1998, a standard measure for volume uncertainty that is expected to be a negative predictor of outsourcing due to the difficulties of contracting for uncertain volumes (Williamson, 1991). Smaller firms may find it difficult to outsource effectively, given the scale of their activities, so we control for ‘firm size’ using the logarithm of the number of employees. Outsourcing could be a trait of rapidly changing firms, so we calculate a variable to capture internal and external ‘change’ facing a firm, using the variance in return on sales from 1993 to 1998. A next measure is the firm's ‘market share,’ calculated by dividing the firm's own sales by the sales of its three-digit industry and then taking a logarithm. Industrial organization (Porter, 1997) posits that larger, more powerful firms in an industry hold more bargaining power over suppliers, which could make outsourcing more profitable. We include the ‘productivity’ of a firm by calculating its sales per employee. Firms are more productive due to a stronger resource base and this could lead to less outsourcing. Firms that export much are exposed to a wider range of potential suppliers globally and could apply this knowledge and experience when making outsourcing decisions. In terms of our framework, firms that engage in outward internationalization lower their search and deliberation costs abroad through improved governance capabilities for international transactions. Therefore, we control for ‘export ratio,’ total exports divided by total sales.

Estimation technique

Given the structure of the data, panel data analysis is appropriate. Panel data analysis provides advantages over a cross-section in terms of consistency of estimates, and it lessens concerns around endogeneity (Cameron and Trivedi, 2005), as does the causal direction of our hypotheses. Fixed effects estimation is not an option since the independent variables are mostly time invariant. Given the distribution of the dependent variable, which is relatively normal, and the nature of the independent and control variables, a random effects generalized least squares (GLS) regression is appropriate. A Breusch-Pagan test suggested heteroskedaticity is a problem in the data. Compared to the ordinary least squares estimator, generalized least squares provides efficiency advantages when heteroskedasticity is present (Cameron and Trivedi, 2005). We use Stata's xtgls command to simultaneously account for this heteroskedasticity and for autocorrelation, because firms' outsourcing ratios proved to be correlated from one year to the next.

We decided not to present the analyses for Hypotheses 3a through 3c through clustering by country. Although observations from the same home country may not be independent, which could affect the standard errors of estimates, the limited number of clusters in the data and the uneven sizes of these clusters are known to produce incorrect inferences (Kézdi, 2004, suggests as many as 50 clusters may be needed, where we have a maximum of 16). Our panel is very balanced, which is helpful because an unbalanced panel produces important disadvantages, such as a less representative sample when data are missing in a nonrandom manner, and may require sample selection methods for consistent estimation (Cameron and Trivedi, 2005).

Results

  1. Top of page
  2. Abstract
  3. Introduction
  4. Connecting to the Supply Base to Outsource
  5. Methods
  6. Results
  7. Discussion
  8. Implications and Limitations
  9. Conclusions
  10. Acknowledgements
  11. References

Table 1 contains the means and standard deviations of the key variables used to test Hypotheses 1 and 2. Local firms are overwhelmingly smaller and have lower market shares, although these correlations were not strong enough to present problems of multicollinearity—we calculated variance inflation factors in an OLS regression, none of which exceeded 2.24, and we additionally ran the _rmdcoll command. By the same token, both foreign subsidiaries and domestic subsidiaries are larger and hold bigger market shares. This suggests that controlling for firm size is important to uncover the true effect of being a local firm or a foreign subsidiary. As expected, there is some positive correlation between the measures for volume uncertainty and change. Export-intensive firms are larger and tend to be foreign or domestic subsidiaries.

Table 1. Means, standard deviations, and correlations of variables
   123456789
  1. N = 27,209

 1 Outsourcing47.4416.481        
 2 Local firm0.660.47−0.181       
 3 Foreign subsidiary0.100.300.06−0.471      
 4 Home subsidiary0.230.420.15−0.78−0.191     
 5 Firm size4.120.880.14−0.550.380.351    
 6 Volume uncertainty1,011.48,214.50.040.00−0.020.01−0.041   
 7 Change38.5573.35−0.070.03−0.01−0.02−0.080.111  
 8 Market share−0.891.480.26−0.430.300.270.64−0.03−0.071 
 9 Export ratio27.3032.780.17−0.270.300.090.360.000.050.381
10 Productivity304.8384.90.32−0.220.160.130.140.01−0.060.240.16

Table 2 contains the same statistics as Table 1, but for the smaller subsample of foreign subsidiaries used in Hypotheses 3a through 3c, therefore including measures of distance. The cultural distance measures based on the Hofstede and GLOBE studies are positively correlated, but not very strongly due to differences in conceptualization and measurement (e.g., Reus and Lamont, 2009) and the focus on a single host country. The measures for geographic and political distance are correlated positively. This equally makes sense because of how these variables get measured: geographic distance to The Netherlands is small for other European countries in the sample, such as Germany and France, and those nearby countries are also members of the same trade bloc (the European Union)—a key component of political distance.

Table 2. Means, standard deviations, and correlations of variables
   12345678910
  1. N = 2,536

 1 Outsourcing50.5315.441         
 2 Cultural distance—Hofstede30.4313.670.011        
 3 Cultural distance—GLOBE1.260.51−0.030.231       
 4 Geographic distance2,970.33,347.6−0.050.08−0.441      
 5 Political distance92.6369.870.05−0.35−0.560.611     
 6 Firm size5.140.96−0.04−0.06−0.110.120.101    
 7 Volume uncertainty673.12,941.20.02−0.03−0.010.01−0.03−0.061   
 8 Change37.3373.360.010.01−0.080.050.02−0.080.141  
 9 Market share0.431.400.080.01−0.060.190.150.71−0.05−0.081 
10 Export ratio57.2738.140.10−0.02−0.200.280.260.240.020.130.211
11 Productivity473.1855.60.22−0.03−0.080.130.120.060.01−0.030.180.03

In Table 3, we present the results for Hypotheses 1 and 2. Model 1 features the control variables. Model 2 contains the independent variables of local firm and foreign subsidiary, while domestic subsidiary is used as the baseline. The table provides clear evidence in support of both Hypothesis 1 and Hypothesis 2, in that local firms and foreign subsidiaries outsource significantly less than domestic subsidiaries. We additionally tested for differences between local firms and foreign subsidiaries by using the latter as the base value and assessing whether local firms outsource significantly more or less, which they do not (Z-value of 0.92, significance level 0.36). From the perspective of our theory, this suggests that the split between domestic and international outsourcing components is fairly even in this sample, which is in line with findings in prior survey research among a subset of these firms in The Netherlands (Mol et al., 2005). All other firm-level variables are significant as well. Export intensity and market share positively predict outsourcing, as do labor productivity and volume uncertainty; change and firm size are negative predictors.

Table 3. Random effects GLS estimation of outsourcing. Showing coefficients and standard errors (in brackets)
 Model 1Model 2Model 3Model 4Model 5
  1. Significance levels: *** 0.1%; ** 1%; * 5%

Firm size−1.00 (0.07) ***−1.47 (0.07) ***−4.22 (0.27) ***−3.91 (0.27) ***−4.18 (0.25) ***
Volume uncertainty7.0E-5 (6.0E-6) ***6.8E-5 (6.4E-6) ***2.3E-5 (3.9E-5)4.7E-5 (3.9E-5)4.7E-5 (4.4E-5)
Change−0.01 (6.7E-4) ***−0.01 (6.2E-4) ***−1.8E-3 (4.3E-3)5.0E-3 (4.0E-3)3.0E-3 (3.1E-3)
Market share2.23 (0.05) ***2.13 (0.04) ***2.88 (0.23) ***2.74 (0.23) ***3.01 (0.22) ***
Export ratio0.03 (1.5E-3) ***0.04 (1.4E-3) ***0.04 (3.9E-3) ***0.04 (4.2E-3) ***0.05 (4.1E-3) ***
Productivity0.01 (2.5E-4) ***0.01 (2.4E-4) ***3.5E-3 (3.6E-4) ***3.1E-3 (4.7E-4) ***3.2E-3 (4.6E-4) ***
Local firm −3.32 (0.13) ***   
Foreign subsidiary −3.50 (0.20) ***   
Cultural distance—Hofstede   0.06 (0.02) *** 
Cultural distance—GLOBE    −0.68 (0.38)
Geographic distance   −9.3E-4 (8.8E-5) ***−8.1E-4 (7.6E-5) ***
Political distance   0.04 (4.1E-3) ***0.02 (3.2E-3) ***
Constant6.43 (0.33) ***10.74 (0.34) ***21.69 (1.35) ***17.74 (1.61) ***22.17 (1.36) ***
Wald Chi215,428.66 ***33,807.2 ***1,869.5 ***1,971.8 ***2,408.0 ***
Groups4,7004,700438438438
Observations per group5.85.85.85.85.8
N27,20927,2092,5362,5362,536

Next, we reduce the sample to include only subsidiaries of foreign firms, with the aim of testing Hypotheses 3a through 3c. Model 3 contains only control variables. The big reduction in sample size leads two control variables (volume uncertainty and change) to become insignificant. Models 4 and 5 include the independent variables and apply two alternative measures of cultural distance, based on the work of Hofstede (Model 4) and the GLOBE project (Model 5).

These models suggest support for the hypothesized negative effect of geographic distance (as per Hypothesis 3b). But the results for cultural distance are a little unclear: Hypothesis 3a, when measured through the Kogut and Singh (1988) index of Hofstede's (1980) cultural dimensions, is found to be positive and significant, albeit with a much smaller magnitude than that found for the other two distance measures. Yet for the GLOBE measure of cultural distance we find a negative and insignificant effect, although some might call it marginally significant (at 10 percent). This demonstrates the value of looking at alternative measures (Reus and Lamont, 2009), but provides a bit of a puzzle. We discuss this later. Furthermore, political distance has a positive and significant effect, where a negative effect was hypothesized in Hypothesis 3c. Later, we will discuss this further.

Robustness checks

The xtgls command used here is more suitable for a large number of time periods and a small panel, and we have the exact opposite here. So, we additionally used Stata's xtreg command, which is more suitable for large panels with few time periods (such as ours), but cannot account for autocorrelation. The main findings are the same, except for the result for cultural distance as measured through the Hofstede approach, which now also becomes insignificant.

Measuring firm size through the logarithm of the number of employees, as we have done here, potentially leads to distortions if the labor intensity of industries differs. Therefore, we tried estimating our models using sales as a measure of firm size, although that could produce its own interindustry biases when firms in some industries engage more heavily in trading of products rather than production. These results are broadly consistent with those presented here, but are not included because of this measure's high correlation with the market share variable.

Finally, to better understand the sources of variance in outsourcing ratios, we conducted an analysis of variance using Stata's xtmixed function, following Marchenko (2006) and similar to recent work in global strategy (Goldszmidt, Brito, and de Vasconcelos, 2011). It suggested that 18.4 percent of the explained variance comes from three-digit industry dummies and 33.9 percent comes from country dummies, with the remainder due to firm- and time-specific factors, confirming our finding that country-level factors play an important role in shaping firms' outsourcing decisions.

Discussion

  1. Top of page
  2. Abstract
  3. Introduction
  4. Connecting to the Supply Base to Outsource
  5. Methods
  6. Results
  7. Discussion
  8. Implications and Limitations
  9. Conclusions
  10. Acknowledgements
  11. References

The analysis tells two tales. Hypotheses 1 and 2, whether the firm is part of a multinational corporation or not and whether the firm is a local or a foreign firm, were strongly confirmed. This supports our theory, namely that the costs of search and evaluating outside suppliers (Rangan, 2000a, 2000b), as shaped by transaction costs and firm capabilities, differ among these types of firms. For local firms, both purely local firms and domestic subsidiaries, it is easier to connect to the local supply base. For units of multinational corporations, both domestic subsidiaries and foreign subsidiaries, making connections to the global supply base is easier.

We also found support for Hypothesis 3b on geographic distance, which is perhaps unsurprising: overcoming geographical distance with outsourced manufactured products is still costly, although such transportation costs continue to fall.

But our theory further suggested that among foreign subsidiaries the cultural distance between home and host countries ought to negatively affect outsourcing ratios. The evidence here was contradictory and the magnitude of the observed effects small. What could explain this? First, we note that culture is a complex concept with many definitions (Kroeber and Kluckhohn, 1952) and that there has been much criticism of the measures used by Hofstede (e.g., Gerhart and Fang, 2005; McSweeney, 2002) and GLOBE (Durvasula et al., 2006). They may not accurately reflect cultural distance. In our data, the two measures of cultural distance are positive correlated, but not overly strongly. In other words, they may represent different constructs (cf. Reus and Lamont, 2009).

On a more conceptual level, we think that market entry research, which has long pointed to the effects of cultural distance on entry decisions, may hold some clues to explain our findings. It is argued that the more culturally distant a country is, the less willing a firm will be to commit resources to it (e.g., Brouthers and Hennart, 2007; Kogut and Singh, 1988). This could be interpreted as saying that the high commitment mode of vertical integration (i.e., little outsourcing) ought to be associated with low distance, meaning that outsourcing is associated with high distance. Yet outsourcing decisions are choices around upstream governance and differ from downstream entry decisions. In our study, foreign subsidiaries have already entered the country, as they would otherwise not be in the sample and, therefore, have committed to the country and borne the costs of internalization by acquiring or starting a subsidiary. It is not immediately obvious that subsequent decisions to outsource activities reduce a firm's commitment much. While outsourcing decisions may lower fixed costs, outsourcing also involves transaction and hidden costs, and these costs are likely to be significantly amplified in an international context and more so as cultural distance increases. This suggests that outsourcing may not be a natural solution for dealing with problems of cultural distance. Slangen and Beugelsdijk (2010) suggest that, unlike formal institutional differences, cultural distance can often be resolved or reduced and this is what we may be observing in this sample of firms. Given this empirical and conceptual puzzle, we think this is a fruitful area for future research.

We were initially puzzled by the positive effect of political distance on outsourcing. It seems as though firms from more politically distant home countries from other trade blocs (like Japan and the United States in this sample) are more prone to outsource than firms from nearby countries, like Germany and France. It may, again, be the case that entry decisions and outsourcing decisions are intertwined: if firms from Japan and the United States choose to come to The Netherlands to manufacture goods, they may do so in order to gain a foothold into the European Union, not to gain production capacity, whereas for French and German firms this choice would reflect a desire to really undertake production in The Netherlands. Alternatively, it could be that what we find here is that it is not distance to the host country, but rather the characteristics of the home country that play a key role: firms from France and Germany are known to be reluctant to outsource activities (Mol, 2007). To investigate this further, it would be insightful to look at the effect of home country characteristics compared to distance; unfortunately this extends beyond the boundaries of the current study.

Implications and Limitations

  1. Top of page
  2. Abstract
  3. Introduction
  4. Connecting to the Supply Base to Outsource
  5. Methods
  6. Results
  7. Discussion
  8. Implications and Limitations
  9. Conclusions
  10. Acknowledgements
  11. References

Outsourcing is an important part of firms' modularization strategies. Explaining outsourcing, so far, has mostly been a matter of looking at activity and firm characteristics. The first distinct conceptual contribution this article makes is to view outsourcing from the perspective of making connections to a supply base: where such connections are particularly costly, because the costs of searching for and evaluating outside suppliers are high, firms will seek to integrate more activities. We base this idea particularly on the work of Rangan (2000b), who applied it to international trade patterns. This is a novel contribution as far as the outsourcing literature is concerned, although we demonstrated how it relates to theories on transaction costs (Williamson, 1985) and capabilities, especially the idea of governance capabilities (Mayer and Argyres, 2004).

The second distinct contribution of this article concerns how foreign and domestic subsidiaries differ from local firms when it comes to outsourcing. Our work suggests multinationals have a unique ability to connect to the global supply base that does not exist in purely local firms. This is an interesting addition to work on global strategy, which still tends to discuss the multinational firm more in terms of how it serves a multitude of markets, not how it accesses supply sources (Lewin et al., 2009). We concur with Rangan (2000b) that being a global firm makes it easier to outsource inputs to the global supply base, but we bring local firms into the picture as well, which allows us to demonstrate that such firms find it particularly hard to access global supply bases. Our work also ties in to more recent discussions about modularity and disaggregation of value chains through offshoring (Lewin et al., 2009; Mudambi, 2008).

A further contribution comes from what we did and did not find when looking at cross-national distance. Simple geographic distance proved to negatively affect outsourcing ratios. At the same time, the results on cultural differences are equivocal and political distance seems to be positively associated with outsourcing. Earlier we discussed some possible explanations. These results are interesting both from the perspective of theorizing around outsourcing (Mol, 2007) and in terms of the literature on cross-national distance (Berry et al., 2010).

In terms of future work, it would be interesting to understand better whether and how outsourcing strategies of multinational firms differ across countries. Do firms export their homegrown outsourcing practices, which are likely shaped by home institutions and cultures, when they internationalize? Or do they seek to adapt them to local circumstances? If firms do not replicate their outsourcing policies abroad, even though they might outsource some activities to their home countries, we should expect key cultural and institutional traits not to matter for outsourcing choices in a host country (in this case, The Netherlands). Cross-national survey research or case studies to compare outsourcing choices by the same firms in different countries could be a useful study design to investigate whether the host country is a better predictor for outsourcing ratios than the home country. Work on human resource policies by Brewster, Wood, and Brookes (2008) found that host multinationals have human resource management strategies that are distinct from those practiced by local firms but do not reflect those used in their own home countries either. Perhaps search efforts sometimes follow a simple passive decision-making heuristic and, due to high search and deliberation costs, are driven by the marketing efforts of suppliers rather than deliberate choices by the outsourcing firm (Mol and Kotabe, 2011).

The managerial implications of our work have to do with both how the type of firm may restrict or enable the ability to effectively access the supply base and with how cross-national distance affects the outsourcing strategy of foreign subsidiaries. Firms that are purely local and firms that operate in host countries both face distinct problems in connecting to the supply base. Managers, therefore, have a choice between two evils in that they can either try to overcome these outsourcing problems, at a cost, or simply avoid outsourcing by internalizing activities, in which case they may need to develop costly in-house production capabilities. Investing in outsourcing governance capabilities to overcome a problem with one specific input could help in future outsourcing efforts. Investing in productive capabilities to manufacture an activity internally could help with other production processes. We suggest picking the trajectory where future learning generates the largest complementarities. On the point of cross-national distance, the distances that seem to matter the most in this article, geographic distance and trade bloc membership, cannot be actively managed and changed, unlike, say, cultural distance. Therefore, we can suggest only that managers ought to remain aware of these effects.

This study faces some limitations due to the nature of available data. First, this being a study of a single host country, we are not able to assess whether the observed patterns are due to specific conditions in the Dutch economy. Second, the number of home countries is fairly limited, implying that for Hypothesis 3, we are unable to pick up the full spectrum of cross-national distances. The inclusion of firms from emerging or developing economies could potentially change the findings. A further limitation is in the nature of the control variables. More detailed firm-level variables, for instance on the nature of the multinational network and the time and mode of establishment in The Netherlands, would help answer more intricate questions about how firms connect to their supply bases. For instance, older firms may have used the time available to them to build up relationships with outside suppliers, so age could positively influence outsourcing levels. Alternatively, and consistent with an ‘imprinting’ logic (Stinchcombe, 1965), it could be that younger firms choose less vertically integrated models of production because the general trend among firms globally has been toward more outsourcing. Finally, the data used in this article are somewhat dated, and although the database contains hard data rather than perceptions, it is longitudinal in nature and contains a well-balanced and very large panel.

Conclusions

  1. Top of page
  2. Abstract
  3. Introduction
  4. Connecting to the Supply Base to Outsource
  5. Methods
  6. Results
  7. Discussion
  8. Implications and Limitations
  9. Conclusions
  10. Acknowledgements
  11. References

In concluding, we note that this article is an effort both to move outsourcing research into new directions and to connect it more directly with work in global strategy. In their modularization strategies, firms face continuing challenges to decide on not only the locations they wish to source from (offshoring), but also on what aspects of their operations to externalize (outsourcing). Research efforts must grapple with that dual challenge while moving forward the state of our theoretical and our empirical knowledge.

Acknowledgements

  1. Top of page
  2. Abstract
  3. Introduction
  4. Connecting to the Supply Base to Outsource
  5. Methods
  6. Results
  7. Discussion
  8. Implications and Limitations
  9. Conclusions
  10. Acknowledgements
  11. References

The authors would like to thank Statistics Netherlands (Centraal Bureau voor de Statistiek) for kindly allowing them to access the data employed in this study and the anonymous reviewers for their comments. A previous version was presented at the 2012 Strategic Management Society conference in Prague. The usual disclaimer applies.

Footnotes
  1. 1

    Notionally, there is a fourth type in this matrix we might call the foreign local firm (i.e., a firm that is local but in another locale). But, in any empirical analysis of a specific country or set of countries, it is logically inexistent, i.e., in a sample of businesses in The Netherlands, a local German firm does not feature at all, until it decides to start operating in The Netherlands; but in doing so, it becomes a host multinational. Thus, we limit our analysis to the other three types.

  2. 2

    Later we also test for empirical differences in outsourcing ratio between foreign subsidiaries and local firms, but in view of our theoretical arguments, we have no a priori expectations for how they compare. We expect local firms to outsource more domestically and foreign subsidiaries to outsource more abroad, but this tells us nothing about the sum of domestic and offshore outsourcing that is the focus of our article, since that sum depends on an empirical quantity in the sample, namely the balance between domestic and offshore outsourcing.

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  4. Connecting to the Supply Base to Outsource
  5. Methods
  6. Results
  7. Discussion
  8. Implications and Limitations
  9. Conclusions
  10. Acknowledgements
  11. References
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