Understanding the Manufacturing Location Decision: The Case for the Transaction Cost and Capability Perspectives

Authors


  • Note: This invited essay underwent a double-blind peer review.

Abstract

This article highlights the value of employing the resource-based view (RBV) and transaction cost economics (TCE) to understand the manufacturing location decision. The RBV can assist with analyzing manufacturing capabilities, which can link the decision with performance and the competitive position of the organization. TCE provides a powerful theoretical lens to augment this analysis. Understanding transaction costs allows an organization to adopt a relationship strategy, which reduces the risks of outsourcing while at the same time leverages the specialist capabilities of suppliers. Moreover, further research is required to enhance our understanding of how the variables from the RBV and TCE interact in sourcing decisions. In particular, it is argued that employing these theories in the manufacturing location decision would contribute to the academic debate on the complementary and contradictory prescriptions of TCE and the RBV in outsourcing decision-making contexts.

Organizations continue to pursue a variety of location choices for manufacturing operations including local, nearshore and offshore. More recently, some organizations have begun to repatriate manufacturing processes to local locations in order to improve demand flexibility, reduce inventory costs and colocate design and manufacturing operations to enhance innovation potential. Nearshore locations offer organizations the benefits of lower production costs while at the same time benefiting from lower transaction costs in comparison with offshore locations (De Treville & Trigeorgis, 2010). However, many organizations continue to make decisions on how to source manufacturing processes on a piecemeal basis, and fail to develop sourcing strategies that allow them to compete in the global economy (Pisano & Shih, 2012). In many cases, the choice of which parts of manufacturing to outsource is based on ascertaining what will save most on overhead costs, rather than how the decision impacts upon the long-term capabilities of the organization (Porter & Rivkin, 2012). In some instances, organizations are outsourcing manufacturing processes that are critical to competitive advantage, and over time are relinquishing important knowledge sets and capabilities that impact the ability to create new commercially viable products.

Two important theories that can enhance our understanding of this phenomenon are transaction cost economics (TCE) and the resource-based view (RBV) of the firm. TCE specifies the conditions under which an organization should manage an economic exchange internally within its boundaries and the conditions suitable for managing an economic exchange externally, that is outsourcing (Williamson, 1975, 1985). TCE argues that organizations should consider the level of transaction-specific investment in the economic exchange as the principal determinant of whether an economic exchange should be managed internally within the organization. A further theory for understanding the outsourcing decision is the RBV, which views the firm as a bundle of assets and resources that, if employed in distinctive ways, can create competitive advantage (Barney, 1991; Peteraf, 1993). A major concern of the resource-based view is how an organization's capabilities develop and affect its competitive position and performance. Proponents of the resource-based view argue that heterogeneity in an organization's knowledge-based resources and capabilities explain differences in performance and the sustainability of a competitive advantage (Teece, Pisano & Shuen, 1997). The RBV is important to the study of outsourcing, as superior performance achieved in organizational activities relative to competitors would explain why such activities are internalized within the organization.

Although the RBV and TCE are focusing on two different issues (1) the search for competitive advantage and (2) the most efficient governance structure, organizations have to deal with these two important issues when making decision on where to source manufacturing processes. Practitioners have to assess their capabilities across a range of manufacturing processes as they are increasingly being confronted with constraints on resources. This means that they have to prioritize resource allocation in certain key manufacturing processes where they possess strengths and outsource less critical processes. Indeed, the trend toward specialization in manufacturing has opened up opportunities for further outsourcing as specialist, global suppliers chase demand through offering a wider range of capabilities in more critical manufacturing processes.

Furthermore, organizations perceive outsourcing as a means of achieving performance improvements, as specialist suppliers are expected to deliver cost efficiencies while at the same time offer a higher level of value. Employing the RBV as a theoretical lens to understand the sourcing of manufacturing processes can help to address a number of important questions: How can outsourcing be employed to achieve improvements in manufacturing performance? Should an organization maintain and build upon a superior performance position in a manufacturing process or outsource the process and leverage the capabilities of suppliers? Why can an organization not achieve the performance levels attained by competitors or suppliers in the process? What are the resource implications of investing in a process to perform it internally? What are the implications for internal manufacturing capabilities of continually seeking suppliers in the lowest cost regions of the world? How can the outsourcing relationship with suppliers in different locations be managed to jointly build difficult-to-imitate manufacturing capabilities?

However, the potential for performance improvement has to be balanced against the potential for opportunism in dealing with external suppliers. Organizations have to consider how transaction costs such as the level of specific investments with the supplier, performance measurement difficulties and the inclusion of contractual safeguards to allow for uncertainty and changes in requirements influence opportunism (Williamson, 1985). The challenges of dealing with transaction costs are further amplified as organizations' work with suppliers in more distant locations. Cultural and geographic distance hinders communication and the development of trust with the supplier, and language differences can lead to employees in the supplier failing to understand buyer requirements, which in turn can affect product quality. However, possessing an understanding of transaction costs allows an organization to adopt a relationship strategy, which reduces the risks of outsourcing while at the same time leverages the specialist capabilities of suppliers. Employing TCE as a theoretical lens to explain the sourcing of manufacturing processes can help to address a number of important questions: Are there complex interdependencies between the outsourced process and other internal processes? How can an organization better understand and reduce the complexities of internal processes? If outsourcing is necessary, how can processes be better understood to derive clearer requirements specifications for suppliers in more distant locations? Is it possible to reduce the level of specificity by removing idiosyncratic requirements from the process? How difficult is it to establish performance measures for supplier performance in providing the process? Are future changes associated with the process difficult to assess?

Employing the RBV and TCE also allows the outsourcing decision to be examined at both the strategic and operational levels. The RBV provides a valuable theoretical lens for resource allocation decisions in an organization at the strategic level. As organizations face constraints on a resource, it is important to understand how allocating the resource through internal sourcing strategies allows an organization to improve performance and develop capabilities at the operations level. Many of the exemplars of superior capabilities in the resource-based literature such as service excellence, innovation and rapid time-to-market cycles are developed at the operations level (Coates & McDermott, 2002; Vastag, 2000). The RBV can assist with analyzing manufacturing capabilities, which can link the manufacturing location decision with performance and the competitive position of the organization. TCE provides a powerful theoretical lens to augment this analysis. In addition to assisting in assessing supplier performance at the operational level, combining TCE with the RBV can extend the potential relationship strategies available to an organization when outsourcing is deemed a potential option. TCE provides a sound theoretical basis for analyzing market versus hierarchical mechanisms in the outsourcing decision, whereas from the perspective of the RBV, interorganizational collaboration can be employed to access and develop complementary resources that contribute to competitive advantage (Barney, 1991).

Further research that employs TCE and the RBV would also contribute to the academic debate on the complementary and contradictory prescriptions of TCE and the RBV in outsourcing decision-making contexts (McIvor, 2009). In TCE, the prescription in relation to the outsourcing decision is influenced primarily by the potential for opportunism. In the RBV, the prescription in relation to the outsourcing decision is influenced by the capability of an organization to develop a sustainable advantage in the resource. Considering the lower and upper limits of each theory — potential for opportunism (TCE) and resource position (RBV) — illustrates both the complementary and contradictory prescriptions of each theory in outsourcing decisions as shown in Figure 1. Quadrants 2 and 3 illustrate how the theories are complementary — that is perform internally in the case of a superior resource position and high opportunism potential, while outsource in the case of a weaker resource position and low opportunism potential. Quadrants 1 and 4 illustrate how the theories can be contradictory. In the case of a superior resource position and low potential for opportunism in Quadrant 1, the RBV prescribes perform internally option, while TCE prescribes outsource. In the case of a weaker resource position and higher potential for opportunism in Quadrant 4, the RBV prescribes the outsource option, while TCE prescribes perform internally.

Figure 1.

Complementary and Contradictory Prescriptions of the Transaction Cost and Capability Perspectives in Outsourcing Decisions

Further research is required in a wider number of research settings to examine the outcomes of global manufacturing location decisions that exhibit similar characteristics to each of the potential scenarios outlined in Figure 1. Longitudinal research assessing the success of each alternative might indicate in which context the variables associated with either theoretical perspective — alone or in combination — predict a more successful decision. This would involve carrying out a fine-grained analysis of the local, nearshore and offshore location options, and how the RBV and TCE variables impact each option. For example, organizations with strong capabilities in building supplier relationships across different cultures may be in a position to outsource to more distant locations even in the face of high opportunism. Moreover, prior to outsourcing to offshore locations organizations can reduce the level of asset specificity in a manufacturing process by standardizing certain elements of the process to increase the number of suppliers available in the target location. Finally, it may be possible to outsource more critical manufacturing processes to nearshore locations because of better property rights protection laws, and cultural and language similarities making it possible to develop collaborative relationships with suppliers.

Biography

  • Ronan McIvor (Ph.D., University of Ulster) is Professor of Operations Management at the University of Ulster in Northern Ireland (United Kingdom). He has carried out extensive research in the area of outsourcing and supply chain management, and his work has been published in many prestigious journals, including the Journal of Operations Management, the European Management Journal, the Journal of General Management, the International Journal of Production Economics, and OMEGA. In addition, Dr. McIvor serves on the editorial boards of several international journals and has authored a number of books, including Global Services Outsourcing (Cambridge University Press).

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