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ARTICLE IN PRESS




                                       Int. J. Production Economics 88 (2004) 61–71




      The impact of outsourcing on the transaction costs and
                  boundaries of manufacturing
                                   Ian McCarthya,*, Angela Anagnostoub
                 a
                     SFU Business, Management of Technology, Simon Fraser University, 515 West Hastings Street,
                                                Vancouver, BC V6B 5K3, Canada
                                      b
                                        Brasenose College, University of Oxford, Oxford, UK

                                           Received 15 April 2003; accepted 16 May 2003


Abstract

  This paper discusses the concept of outsourcing, along with an account of the economic benefits that are achieved by
reconfiguring the organization and reducing the transaction costs of providing products and services. With the practice
of outsourcing experiencing exceptional growth, this paper examines the corresponding change (decline) in UK
manufacturing as an economic activity, and considers how the economic benefits of outsourcing alter the contribution
that an organization makes to a sector’s gross domestic product. To assess this issue, an input–output methodology for
measuring economic restructuring in UK manufacturing is presented.
r 2003 Elsevier B.V. All rights reserved.

Keywords: Outsourcing; Input–output methodology; Manufacturing; Boundary; Configuration




1. Introduction                                                       of information processing (design, marketing,
                                                                      R&D, customer service, etc.) geography proces-
  All businesses exist because they perform value-                    sing (distribution and logistics) and availability
adding processes that consist of transformation                       (retail outlets).
functions. Service, transportation and retail orga-                      Pioneered in the 1930s by organizations such as
nizations perform processes that focus on infor-                      the Ford Motor Company, which was fervent
mation, geographical distance and availability,                       about control, rationalization and the elimination
respectively. Manufacturing organizations focus,                      of uncertainty, many corporations since then have
by definition, on processing raw material, but since                   sought growth and power by conglomeration, and
the industrial revolution they have evolved into                      vertical and horizontal integration. The Ford
businesses that also deal with significant amounts                     Motor Company altered the boundary of its
                                                                      organization by acquiring and integrating busi-
                                                                      nesses that were parts of its supply chain. These
  *Corresponding author. SFU Business, Simon Fraser Uni-
versity, 515 West Hastings Street, Vancouver, BC V6B 5K3,
                                                                      included mining companies, shipping companies,
Canada. Tel.: +1-604-291-5298; fax: +1-604-291-5153.                  railway companies and rubber plantations. This
   E-mail address: imccarth@sfu.ca (I. McCarthy).                     strategy, not only provided ownership and
0925-5273/03/$ - see front matter r 2003 Elsevier B.V. All rights reserved.
doi:10.1016/S0925-5273(03)00183-X
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62                     I. McCarthy, A. Anagnostou / Int. J. Production Economics 88 (2004) 61–71


enhanced control of the supply chain and market,              to outsource, with durable goods manufacturers
but as reported by Lonsdale and Cox (2000) it                 accounting for 39% of all activity and non-durable
offered organizations the potential for economies             goods manufacturers accounting for 25% (Zhu
of scale and the opportunity to exercise greater              et al., 2001). In addition, with a global outsourcing
market power.                                                 market estimated at d188 billion in 1998, and
   Manufacturing organizations are complex sys-               with annual growth rates of 15% (Coombs &
tems that consciously evolve in response to market            Battaglia, 1998), the distinction between eco-
needs, competition and innovation. Directing this             nomic activities in different sectors has become
evolution is a key management responsibility that             blurred.
involves making decisions about the configuration                 With the practice of outsourcing experiencing
and boundary of an organization, to ensure                    exceptional growth, this paper examines a possible
competitiveness relative to market demands and                corresponding and related change, a decline in
stability. This concept is central to the transaction         manufacturing as an economic activity, and
cost perspective (see Section 2.2), which asserts             considers how outsourcing alters the perceived
that organizations seek to reduce costs (direct               contribution that an organization makes to a
costs and associated support costs) by forming                country’s GDP. The conclusion is that the
alliances or selecting structures and practices that          boundaries of manufacturing activity have altered,
lead to efficiency improvements. This cost mini-               changing the ownership of certain aspects of the
mization hypothesis has underpinned the purchas-              economic activity. Thus, to properly understand
ing function and is a key issue in both defining an            and measure the economic value of manufacturing
organization’s boundary and understanding the                 requires an approach that recognizes the highly
benefits of outsourcing. For instance, in the early            integrated and codependent set of activities that
1990s, many manufacturing organizations had                   constitute the modern economic system of manu-
evolved into businesses that were no longer just              facturing.
concerned with material processing and assembly.                 To review and assess this notion, this paper
They had extended their boundaries and remit to               will proceed as follows. Section 2 reviews the
focus on converting an idea or need into a                    economic benefits and drivers that motivate
marketable product, along with the provision of               manufacturing organizations to outsource. Section
appropriate product support and service. The                  3 provides an introductory account of the macro-
conglomeration and vertical integration activities            economic decline that has occurred in UK
of the previous 60 years had helped manufacturing             manufacturing and asserts that the decline has
organizations achieve this change in focus, but at            been influenced by the practice of outsourcing,
the expense of burdening the organization with                which has shifted activities and employment from
excess and inefficient processes and services, and             manufacturing to services. Section 4 examines this
uncompetitive transaction costs.                              claim by using an input–output methodology and
   With this development in organizational focus,             more specifically the decomposition approach
the need and trend for outsourcing emerged.                   (Dietrich, 1999) to investigate the impact that
It was based on the assumption that a competitive             outsourcing has had on the boundaries and
advantage would be gained if external suppliers               outputs of the manufacturing sector. This method
were contracted to carry out non-core processes               can be used to analyze the flow of goods and
more efficiently and effectively. To achieve                   services from every sector to every other sector in
more proficient and profitable functions in areas               the UK economy at a specific point of time. Thus,
such as accounting, logistics, catering, design,              flows of goods and services can be traced between
production, IT support and customer service,                  sectors and their relative contributions to econom-
manufacturing organizations began to utilize                  ic output, value added or productivity can be
the core-competencies of other manufacturing,                 estimated. The methodology is demonstrated using
service and transportation organizations. Today,              a range of UK input–output data. Section 5
manufacturing is the industry sector most likely              provides a conclusion.
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2. The case for and against outsourcing                       fied three reasons for outsourcing: (i) savings on
                                                              wage and benefit payments, (ii) transfer of demand
2.1. What is outsourcing?                                     uncertainty to the outside contractor, and (iii)
                                                              access to specialized skills and inputs that the
   Outsourcing has become an important business               organization cannot itself possess. Kakabadse and
approach, whereby a competitive advantage may                 Kakabadse (2000) report that the main reasons for
be gained when products or services are produced              outsourcing are: (i) economic—greater specializa-
more effectively and efficiently by outside suppli-            tion in the provision of services, as outsourcing
ers. It is an agreement in which one company                  allows economies of scale and the longevity of
contracts-out a part of their existing internal               demand for the activity; (ii) quality—access to
activity to another company. As a management                  skills, the competency and focus of potential
practice it has probably been in existence for over           suppliers and geographical coverage is increased;
200 years, but during the last 15 years, with the             and (iii) innovation—improvements in quality
support of academics, consultants and industry                through innovation, and the development of new
forums, it has developed into a popular strategic             service products, can lead to new demands.
management initiative. During this 15-year period,            Bendor-Samuel (1998) also asserts that outsour-
the economic value, strategic importance and                  cing provides certain power that is not available
complexity of the outsourced function (when                   within an organization’s internal departments.
considering manufacturing organizations) has in-              This power can have many dimensions: economies
creased; evolving from routine and non-value-                 of scale, process expertise, access to capital, access
adding functions, such as security, cleaning and              to expensive technology, etc. The combination of
catering, to key support and value-adding func-               these dimensions creates the cost savings inherent
tions, such as information technology, logistics              in outsourcing, because the outsourcing supplier
and accounting, to core manufacturing-related                 (the organization specializing in a particular
functions, such as design and certain production              business function) has the economy of scale, the
processes.                                                    expertise and the capital investments in leading
   Outsourcing not only purchases products or                 technology to perform the same tasks more
services from sources that are external to the                efficiently and effectively than the internal depart-
organization, but also transfers the responsibility           ments of the outsourcing ‘buyer’.
of the physical business function and often the                  Another possible benefit is that outsourcing
associated knowledge (tacit and codified) to the               provides companies with greater capacity for
external organization. It is this adaptation, driven          flexibility, especially in the purchase of rapidly
by transaction cost rewards, functional competi-              developing new technologies, fashion goods, or the
tiveness, strategic development and the business              myriad components of complex systems (Carlson,
pressures of globalization and technological                  1989; Harrison, 1994). Companies can buy tech-
change, that has altered the configuration (how                nology from a supplier that would be too
the organization is designed managed and oper-                expensive to replicate internally. A network of
ated) and boundary of the modern manufacturing                suppliers could provide an organization with the
organization. These changes not only affect an                ability to adjust the scale and scope of their
organization’s performance, but also the perceived            production capability upward or downward, at a
contribution of an organization and its industrial            lower cost, in response to changing demand
sector to an economy.                                         conditions and at a rapid rate. As such, out-
                                                              sourcing claims to provide greater flexibility than
2.2. The case for and against outsourcing                     the vertically integrated organization (Carlson,
                                                              1989; Harrison, 1994; Domberger, 1998). Further-
  There have been several studies that have                   more, outsourcing can decrease the product/
examined the motivations for and benefits of                   process design cycle time, if the client uses multiple
outsourcing. Abraham and Taylor (1993) identi-                best-in-class suppliers, who work simultaneously
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64                     I. McCarthy, A. Anagnostou / Int. J. Production Economics 88 (2004) 61–71


on individual components of the process (Quinn                between employers and employees, which in turn
and Hilmer, 1994).                                            can damage morale, trust and productivity.
   The case against outsourcing is based on                      In summary, the rationale for practicing
arguments such as loss of management control,                 outsourcing is to exploit external suppliers’ invest-
reduction in flexibility and increased costs. For              ments, innovations, and specialized professional
instance, competitive outsourcing requires a high             capabilities. This helps an organization to reduce
standard of supplier management to avoid the                  its operating costs, whilst achieving an increased
pitfalls of transferring critical functionality, or           focus on its core competencies. This obvious and
becoming too dependent on a supplier for day-to-              important benefit is consistent with transaction
day performance of vital business functions. In               cost economics, which was largely developed
addition, outsourcing can generate new risks, such            by Coase (1937) and Williamson (1975, 1979).
as the loss of critical skills, developing the wrong          Transaction cost analysis integrates economic
skills, the loss of cross-functional skills, and the          theory with management practice and organiza-
loss of control over suppliers (Domberger, 1998;              tion science to study why organizations exist,
Quinn and Hilmer, 1994). The possible loss of                 what are their configurations and what determines
flexibility is connected to the typical long-term              their boundaries based on the assumption that
contractual relationship that is formed as part of            transaction costs are minimized. Transaction costs
an outsourcing agreement, and that during the                 are the full cost of providing products or services
contract term, the customer’s business, the avail-            including negotiating, monitoring and enforcing
able technology, and the competitive and regula-              the contractual agreement. Therefore, regardless
tory environment may change dramatically. Thus,               of whether the motivation for outsourcing is
this inflexibility is mostly linked to an unyielding           strategic, operational, political, innovative or
and inappropriate contract. Although outsourcing              structural, transaction cost analysis asserts that
is undertaken by many organizations to control or             the properties and economic benefits of business
reduce costs, there is some evidence that it does             functions, whether internal or external, influence
not decrease costs as expected, and in some cases,            the configuration and boundary of the organiza-
costs increase. For instance, when an item is                 tion. How this effects the economic impact of
outsourced, the assumption is that the supplier’s             outsourcing on structure and perceived size of
costs and required contribution is less and will              industrial sectors is not clear. Yet, outsourcing
continue to be less than the cost of internal                 is a management process that alters the boundary
provision. A survey based on 1000 managers                    of an organization and therefore changes the
worldwide by the PA Consulting Group (PACG)                   economic contribution that an organization
revealed that only 5% of organizations gained                 makes to its industrial sector and thus to the
‘‘high’’ levels of economic benefit from outsour-              economy.
cing (PA Consulting Group (PACG), 1996) and
that 39% of organizations admitted ‘‘mediocre’’
economic benefit. Also, as outsourcing leads to a              3. The changing context and boundaries of UK
re-definition of organizational boundaries and, by             manufacturing
implication, structural adjustments involving hu-
man resources, these changes incur social as well                Although manufacturing is essential to success-
as financial costs. Although the social costs are              ful industrialization and has been regarded as one
transitory and can be mitigated by facilitating the           of the most important elements of the UK
adjustments through the re-training and re-                   economy up until the late 1960s, it no longer
deployment of staff within the organization, their            occupies that status. The period from the early
transfer to the supplier organization and ensuing             1970s to the early 1990s was one of many changes
redundancy payouts can still be considerable                  with recessions and recoveries. In particular, the
(Domberger, 1998; Hall and Domberger, 1995).                  oil crises of the early 1970s and the recession of
Also, outsourcing can lead to industrial disputes             1979–1981 had a severe impact on the structure of
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the UK industry. The UK economy underwent                     Table 1
a prolonged period of expansion in the 1980s. This            Value added (VA) as a percentage of gross value added (GVA)
                                                              and employment analyzed by industry over the period of 1980–
represented recovery from a deep recession
                                                              1999
and entailed considerable structural change,
particularly in manufacturing. Output fell at the                                     GVA                            Employment (1000s)
turn of the decade and only returned to its 1979                                      1980 1990 1999 1980                          1990        1999
level in 1987. Much effort in recent years has been
                                                              Agriculture    2.1                    1.9    1.2             654          592       525
devoted to comparisons of the UK’s industrial
                                                              Mining and     4.4                    2.7    2.3             361          208       107.8
performance with that of other industrialized                 quarrying
countries.                                                    Manufacturing 26.5                23.0      18.8         7081   5398   3936
   For a sustained period, UK manufacturing lost              Utilities      5.3                 2.3       2.3         2343   1820   1886
share in world markets and within the domestic                Construction   6.1                 6.9       5.3         1617   1559   1767
                                                              Services      59.9                67.1      70.2       14,937 14,547 20,718
economy. Manufacturing gross value added
(GVA) as a percentage of total national gross                 Source: UK National Accounts, 2000; National Statistics:
value added fell, from 26.5% in 1980 to 18.8% in              Monthly Digest of Statistics, 2000.
1999. This was accompanied by significant changes
in employment in the manufacturing industry. In                                   Traditional Single Organization Approach

the 1969 manufacturing provided over 8.1 million
                                                                          Flow of market
jobs in the UK (Yearbook of Industrial Statistics,                         needs or idea
                                                                                                                         Products and
                                                                                                                           services
1974) whereas in 1999 it provided four million jobs                                               Primary
(Yearbook of Industrial Statistics, 2001).                                                      Value Adding
                                                                                                Environment
   This relative reduction in manufacturing, and                         Flow of resource          (PVAE)                  Waste

particularly in manufacturing employment, was
accompanied by substantial changes in the relative
size of other sectors. In essence, there are definable
stages of economic development and the final                                        An Extended Enterprise based on a Value
                                                                                      Adding Network of Organizations
stages are characterized by a growing and healthy
tertiary sector (i.e. transport, construction, dis-                                                   PVAE
tribution and services) with growing preferences                Flow of market
                                                                needs or idea
                                                                                                                                        Products and
                                                                                                                                          services
for service products. In addition, the contribution                                                                  S
of value added from the services to national gross                                          S

value added has been rising gradually from 59.9%
in 1980 to 70.2% in 1999 (see Table 1), which                                                             OEM
                                                                                                                             T
suggests that the UK appears to be a service-
dominated economy.                                             Flow of resource                 T                                             Waste
   When considering this competitive and structur-                                                              OM

al change in UK manufacturing, it is important to
recognize that organizations are open systems.
They have permeable and changing boundaries
                                                                                                      OEM =original equipment manufacturer
that reflect the domain of an organization’s                                                           S = service organization
activities and functions. Outsourcing has encour-                                                     T = transportation organization
                                                                                                      OM = other manufacturer
aged manufacturing organizations to alter their
boundaries and become extended enterprises (see                            Fig. 1. Traditional and extended enterprise.
Fig. 1) by setting up partnerships, and by
collaborating and trading with other manufactur-
ing, service and transportation organizations. This           nizations creating wealth through the governance
has increasingly resulted in a nebulous manufac-              of knowledge and physical production activities.
turing sector, with indistinct manufacturing orga-            The result is that the conventional boundaries of
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66                         I. McCarthy, A. Anagnostou / Int. J. Production Economics 88 (2004) 61–71


Table 2                                                           4. A methodology for measuring economic
Value added and gross output (d millions), 1989–1998              restructuring
                    Manufacturinga       Tertiary share of
                    share of total       totalb                      Based on the assumption that supply equals
                                                                  demand, the input–output methodology permits
1989
  Value added       23.8                 69.0                     study of the structural changes in an economy by
  Gross outputc     31.8                 44.3                     separating economic activity into four categories:
1992                                                              intermediate deliveries, final demands, primary
  Value added       20.9                 75.9                     inputs and final demands of primary inputs.
  Gross output      27.1                 65.6
                                                                  Basically, supply or sectoral output must equal
1997
  Value added       20.8                 76.5                     final demand plus intermediate demand; and on
  Gross output      26.3                 67.5                     the production side, intermediate inputs and
1998                                                              primary inputs are combined to produce the level
  Value added       20.0                 78.3                     of output. Thus, the standard input–output
  Gross output      25.0                 69.4
                                                                  methodology for input–output data is based on
Source: UK National Accounts, 2000.                               the following identity:
  a
    Manufacturing value added divided by total value added.
  b
    Tertiary value added divided by total value added.            xi ¼ zi1 þ zi2 þ ? þ zij þ ? þ zin þ fi ;         ð1Þ
  c
    Constant price estimates of gross output by industry.
                                                                  where the total output of any industry can be
                                                                  disaggregated into amount bought by industry
                                                                  from industry j and the output from industry i (zij )
manufacturing value are not appropriate. The                      supplying final demand fi : For all n industries, in
manufacturing sector has been restructured and                    matrix notation,
extended into non-manufacturing sectors, thus
                                                                  x ¼ Z þ f:                                        ð2Þ
changing the contribution that this industrial
sector makes to a sector’s gross domestic product                    The intermediate deliveries Z denote transac-
(GDP).                                                            tions between economic (manufacturing) sectors.
   The significance of these differences is indicated              The manufacturing sectors use commodities of
in Table 2 where manufacturing value added and                    other sectors as inputs in production of their own
gross production are compared with that of a                      commodity. An element zij of the n  n matrix Z
broadly defined private tertiary sector (transport,                denotes the intermediate deliveries from sector i to
construction, distribution and services). As man-                 sector j: A large part of the production is used
ufacturing has reduced in value added and gross                   directly for consumption as raw material for
production (23.8–20% and 31.8–25%, respec-                        products or as a technology investment. The final
tively), the tertiary sector has increased in terms               demand f consists of the output of production
of both value added and gross production over                     sectors used for consumption, investment, govern-
the period 1989–1998 (69–78.3% and 44.3–69.4,                     ment expenditures, changes in stocks and exports.
respectively).                                                    An element fig of the matrix f denotes the deliveries
   Using the input–output methodology and more                    from sector i to final demand category g: A
specifically the decomposition approach explained                  manufacturing sector also requires inputs that are
below, the next section examines the impact that                  not produced solely by one of the sectors. Such
outsourcing has had on the boundaries and output                  inputs include payments for labor, capital, im-
of the manufacturing sector. The UK input–                        ports, indirect taxes minus subsidies, and profits.
output tables between 1984 and 1998 show that                     Hence, primary inputs consist of value added and
there has been a significant increase in the gross                 imports, and factor inputs may be used directly for
purchases that UK manufacturing makes from                        consumption, investment, etc.
non-manufacturing sectors (services and transport                    From the UK input–output tables, several
in particular).                                                   relationships and coefficients have been derived.
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The matrix with intermediate deliveries can be                    By rewriting Eq. (7) it is possible to decompose
expressed as a matrix of input coefficients with the             the growth of total output (Dx) in terms of changes
elements of the vector of total inputs on its main              in the Leontief inverse (DL) and changes in the
diagonal:                                                       final demand Df:
     #
Z ¼ Ax;                                               ð3Þ       Dx ¼ ðLtþ1 À Lt Þf tþ1 þ Lt ðf tþ1 À f t Þ
where which A is defined as                                         ¼ DL f tþ1 þ Lt Df                                     ð9Þ

A  ZxÀ1 ;
     #                                                ð4Þ       or

#
x denotes the digitalized matrix of the vector x.               Dx ¼ ðLtþ1 À Lt Þf t þ Ltþ1 ðf tþ1 À f t Þ
The matrix A consists of input coefficients aij as                  ¼ DL f t þ Ltþ1 Df:                                   ð10Þ
the amount of product x required per unit of
                                                                  In both equations, changes are weighted with
product j: Therefore, the input coefficients are the
                                                                figures of a different period. This raises a time
elements of the intermediate deliveries part of the
                                                                inconsistency in the weights of the changes. To
input–output table divided per column by the total
                                                                solve this inconsistency the decomposition can be
inputs of that sector:
                                                                rewritten as
     zij
aij ¼ ;                                         ð5Þ             Dx ¼ Ltþ1 f tþ1 ðÀLt f t þ Ltþ1 f t Þ À Ltþ1 f t
     xj
                                                                        þ Lt f tþ1 ðÀLt f tþ1 þ Lt f t Þ À Lt f t
which represents the direct requirements of the
output of any sector i per unit of any other                            ¼ DL f t þ Lt Df þ DL Df                         ð11Þ
purchasing sector j ði; j ¼ 1; 2; y; nÞ: From                   or as
Eqs. (3) and (2) yields
                                                                Dx ¼ Ltþ1 f tþ1 ðÀLt f t þ Ltþ1 f t Þ À Ltþ1 f t
x ¼ Ax þ f                                            ð6Þ
                                                                        þ Lt f tþ1 ðÀLt f tþ1 þ Ltþ1 f tþ1 Þ À Ltþ1 f tþ1
or                                                                      ¼ DL f tþ1 þ Ltþ1 Df þ DL Df:                     ð12Þ
x ¼ ðI À AÞÀ1 f ¼ Lf;                                 ð7Þ         Taking the arithmetic average of Eqs. (11) and
where I is the n  n identity matrix and L is the               (12), changes in output can be expressed as
Leontief inverse derived from the input coefficient              Dx ¼ 1 DLðf t þ f tþ1 Þ þ 1ðLt þ Ltþ1 ÞDf;
                                                                     2                    2                              ð13Þ
matrix A. Leontief inverse matrix represents the
direct and indirect requirements of sector i per unit           which is another possible method of decomposition.
of final demand for the output of sector j:                         The second part of the right-hand side (RHS) of
  A sufficient condition for the existence of the                Eq. (13) captures that part of the change in gross
Leontief inverse is that no column sum is larger                output which is attributable to the change in the
than 1 while at least one column sum is smaller                 technical coefficients, keeping final demand at its
than 1 (Nikaido, 1970; Takayama, 1985).                         second period level, while the first term captures
  Changes in the input–output data can be used to               the change in final demand, keeping the technical
describe the extent to which restructuring, invol-              coefficients fixed at the first period level. The first
ving outsourcing and related activities such as                 term on the RHS is the change in technical
contracting out, and subcontracting has occurred.               coefficients evaluated using the first period’s level
Suppose that changes in total output x are                      of final demand and the second term is the change
decomposed into the contributions of two fac-                   in final demand evaluated using second period
tors—the Leontief inverse and the final demand                   technical coefficients.
f—and if the value of total output is known at                     Thus, Eq. (13) separates the total change in
times t and t þ 1; the change in total output Dx is             gross output into final demand and inter-industry
given by                                                        effects, i.e. changing demand with given input–
                                                                output relationships and changing input–output
Dx ¼ xtþ1 À xt ¼ Ltþ1 f tþ1 À Lt f t :                ð8Þ       relationships with given demand.
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  For purposes of empirical measurement, we can                  4.1. Empirical investigation
rewrite Eq. (13) as follows:
                                                                    Input–output tables explicitly account for the
Dxav ¼ 1ðD1 þ D2Þ þ 1ðS1 þ S2Þ;
       2            2                                 ð14Þ       interdependence of different economic activities by
                                                                 incorporating the size and composition of the
where                                                            various industries’ mutual input demands (mea-
                                                                 sured by interdependent coefficients of the Leon-
D1 ¼ LtÀ1 f t À LtÀ1 f tÀ1 ¼ LtÀ1 Df t ;                         tief inverse), this permits analysis of both direct
D2 ¼ Lt f t À Lt f tÀ1 ¼ Lt Df t ;                               and indirect interactions. With the practice of
                                                                 outsourcing experiencing significant growth, it is
S1 ¼ Lt f t À LtÀ1 f t ¼ DLt f t ;                               possible to gauge how this management initiative
S2 ¼ Lt f tÀ1 À LtÀ1 f tÀ1 ¼ DLt f tÀ1 :              ð15Þ       may have altered the contribution that an indus-
                                                                 trial sector makes to GDP; thus, distorting the
   The first term on the RHS of Eq. (14) is the                   definition and boundaries of manufacturing sec-
average demand-induced change in output. The                     tor. As the effect of outsourcing is not recognized
second term defines the average supply-led change                 by national economic accounts, input–output
in output. Hence, it is possible to analyze the                  tables were used to assess if there is a significant
significance of this compositional effect by exam-                increase in the gross purchases that the tradition-
ining the relationship between demand changes                    ally defined manufacturing sector makes from
and the extent to which industries use services                  non-manufacturing sectors (services transport in
activities. The latter can be measured by the                    particular). It should be noted that the data were
average (input–output) coefficient for each manu-                 converted to 1995 prices using sector-specific price
facturing industry’s purchase of services. If this               deflators.
compositional effect is significant there should be a                Annual input–output tables for 1984 and 1989–
positive relationship between industry demands                   1998 were obtained from the UK Office of
and service coefficients. It is clear from Eqs. (11)              National Statistics (ONS). The 1998 tables at the
and (12) that if f t  f tÀ1 ; then final demand as a             time of writing were the latest available and
proportion of gross value is increasing, whereas if              provide the most up-to-date information about
Lt  LtÀ1 intermediate use of resources as a                     the inter-industry relations. Since the aim is to
proportion of gross value is expanding, thus                     study the impact of outsourcing on the boundaries
outsourcing is increasing.                                       of manufacturing, a higher degree of aggregation
   Based on the definition that outsourcing is an                 is adopted to focus on the relationship between the
agreement in which one company contracts-out a                   manufacturing sector as a whole and other sectors.
part of their existing internal activity to another              Thus, the following sectors were considered:
company, outsourcing can be quantified for                        agriculture, energy, manufacturing, construction,
measurement purposes as the proportion of                        distribution, transportation, communication, and
bought-in goods and services in gross output,                    services. This aggregation creates a potential
where gross output is calculated as bought-in                    difficulty, as the supply-side effects may not be
goods and services plus value added. This indi-                  operating at industry level for specific industries.
cator can be used for single companies, manufac-                 Instead, certain industries may make more inten-
turing sectors, or the whole economy, depending                  sive use of bought-in services and these industries
on the level of aggregation and boundary of                      may have become more important over time by
analysis. In the following section, the input–output             growing more rapidly than the average. However,
methodology and more specifically the decomposi-                  it is possible to analyze the significance of this
tion approach explained above (Eq. (13)) are used                compositional effect by examining the relationship
to examine the impact that outsourcing has had on                between demand changes and the extent to which
the boundaries and outputs of the UK manufac-                    industries use services activities. The latter can be
turing and service sectors.                                      measured by the average (input–output) coefficient
ARTICLE IN PRESS

                         I. McCarthy, A. Anagnostou / Int. J. Production Economics 88 (2004) 61–71                            69


Table 3                                                         Table 4
Supply-side and demand-side effects in the manufacturing        UK’s domestic manufacturing and total output (d million),
sector                                                          1979–1998

              Dxda           Dxs            Dx                           Manufacturinga       Total             Share of
                                                                         (d millions)         outputa           manufacturing
1989–1990     —              —              —                                                 (d millions)      to total output
1990–1991     54,212         À37,747        16,465
1991–1992     51,526         À10,990        40,536              1979     136,778                342,688         25.0
1992–1993     85,081         À34,668        50,413              1984     180,467                547,026         33.0
1993–1994     78,302         À23,715        54,587              1989     296,776              1,017,919         29.2
1994–1995     70,741         À25,670        45,071              1990     259,897                894,859         29.0
1995–1996     50,149         À20,900        29,249              1991     277,506              1,027,824         27.0
1996–1997     40,973         À25,712        15,261              1992     282,896              1,101,705         25.7
1997–1998     54,212          À9229         16,465              1993     299,060              1,168,193         25.6
  a
                                                                1994     326,554              1,271,305         25.7
    Dxd ¼ 0:5ðD1 þ D2Þ and Dxs ¼ 0:5ðS1 þ S2Þ as defined in      1995     350,739              1,359,593         25.8
Eq. (15).                                                       1996     368,154              1,450,016         25.4
                                                                1997     378,851              1,526,371         24.8
                                                                1998     376,090              1,601,222         23.5

                                                                Source: UK National Accounts, 1980–2000.
for each manufacturing industry’s purchase of                      a
                                                                     Domestic manufacturing and total output of products at
services. If this compositional effect is significant,           basic prices, i.e. total supply of products at purchasers’ prices
there should be a positive relationship between                 less imports, distributors’ trading margins, less taxes less
industry demands and service coefficients.                       subsidies on products.
   In this section, the use of input–output tables for
the period 1989–1998 is presented to illustrate the
                                                                Table 5
decompositions proposed by Eq. (13). The results                UK’s outsourcing in manufacturing (d millions), during 1979–
are shown in Table 3.                                           1998
   In Table 3, the decomposition of gross output is
                                                                             Outsourcing Contracting           Share of
used to identify what part of the changes in gross                           (d millions) out plus             manufacturing
output of manufacturing can be attributed to shifts                                       manufacturing        and outsourcing
in the final demand. In addition, what can be                                              domestic output      to total domestic
attributed to supply-side changes (i.e. changes in                                        (d millions)         output
the technical coefficients). For any period, the                 1979–1984      6930         187,397            34.3
change in gross output of the manufacturing sector              1984–1989      6322         303,098            29.8
can be attributed to the change in technical                    1989–1990    —              259,897            29.2
coefficients. Also, for each period, there is a high             1990–1991    37,747         297,644            33.3
                                                                1991–1992    10,990         288,496            28.1
increase in the demand-side and a significant                    1992–1993    34,668         317,564            28.8
supply-side effect captured by the change in                    1993–1994    23,715         322,775            27.6
technical coefficients. For example, during the                  1994–1995    25,670         352,224            27.7
period 1992–1993, manufacturing could have had                  1995–1996    20,900         371,639            27.3
recorded d34,668 million more output if the                     1996–1997    25,712         393,866            27.2
                                                                1997–1998      9229         388,080            25.4
supply-side effect had been accounted for. Also,
for the period 1997–1998, it appears that manu-                 Source: Input–Output Tables, 1979–1998; UK National Statis-
facturing’s gross output should have been some                  tics, 1979–2000.
d9,229 million higher, suggesting that the total
domestic output for 1998 from manufacturing,                    1990–1991 and 1992–1993. This suggests that the
instead of being the d376,090 million as listed in              contribution of manufacturing output in 1993 to
Table 4, would have been the d388,080 million as                be 28.8% instead of 25.6%, thus 2.2 percentage
listed in Table 5. The largest outsourcing out                  points higher. In addition, in 1998 it would be
periods between 1984 and 1998 occurred during                   25.4% instead of 23.5%, i.e. 1.9 percentage points
ARTICLE IN PRESS

70                     I. McCarthy, A. Anagnostou / Int. J. Production Economics 88 (2004) 61–71


higher. These results support the notion that                 economy, it is necessary to understand and
outsourcing has altered the configuration and                  measure the significant purchases it makes from
boundary of manufacturing organizations in terms              other sectors, using a method such as the input–
of value added and that true manufacturing                    output methodology that analyzes the flow of
output is underestimated.                                     goods and services between sectors. The service
                                                              sector by definition serves other sectors, and
                                                              initiatives such as outsourcing have helped to
5. Conclusions                                                develop and grow this sector. The input–output
                                                              data shows that manufacturing is a key customer
   There are several compelling reasons to out-               of the service sector, and through its purchases
source, but the underlying rationale is consistent            creates a significant and additional contribution to
with the principle of transaction cost economics,             a nations GDP.
i.e. to achieve economic improvement in the
performance of business functions. This involves
contracting out a function to a specialist supplier           References
in an attempt to reduce costs and to benefit from
competitive knowledge and practices. Thus, the                Abraham, K.G., Taylor, S.K., 1993. Firms’ use of outside
economics of outsourcing alter the configuration                  contractors: Theory and evidence. NBER Working Paper
and boundary of an organization and therefore                    No. 4468, NBER, Cambridge, MA.
                                                              Bendor-Samuel, P., 1998. The brave new world of outsourcing.
change the economic contribution that an organi-
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zation makes to its industrial sector and the                    everest.html.
economy. This suggests that even though a                     Carlson, B., 1989. Flexibility and theory of the organization.
reduction in the economic contribution of the                    International Journal of Industrial Organization 7 (1),
UK manufacturing sector has taken place, there                   189–203.
have been important structural changes in the                 Coase, R., 1937. The nature of the firm. In: Williamson, O.E.,
                                                                 Winther, G. (Eds.), The Nature of the Firm (1991). Oxford
composition of UK manufacturing at the enter-                    University Press, Oxford.
prise level which should provide a basis for                  Coombs, R., Battaglia, P., 1998. Outsourcing of business
stronger performance in the future. This is                      services and the boundaries of the organization. CRIC
reflected by the input–output data presented for                  Working Paper No. 5.
1992–1998, that shows a significant increase in the            Dietrich, M., 1999. Explaining economic restructuring: An
                                                                 input–output analysis of organizational change in the
gross purchases that manufacturing makes from                    European Union. International Review of Applied Eco-
non-manufacturing (services and transport in                     nomics 13 (2), 219–240.
particular).                                                  Domberger, S., 1998. The Contracting Organization: A
   In conclusion, it is argued that conventional                 Strategic Guide to Outsourcing. Oxford University Press,
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economic views of UK manufacturing activity
                                                              Hall, C., Domberger, S., 1995. Competitive tendering for
underestimate its importance and contribution                    domestic services: A competitive study of three hospitals in
to GDP. This is because existing macroeconomic                   New South Wales. In: Domberger, S., Hall, C. (Eds.), The
data do not acknowledge that UK manufacturing                    Contracting Casebook: Competitive Tendering in Action.
organizations, in pursuing greater efficiency,                    AGPS, Canberra, pp. 99–126.
have outsourced many functions such as logistics,             Harrison, B.T., 1994. Lean and Mean: The Changing Land-
                                                                 scape of Corporate Power in the Age of Flexibility. Basic
IT, accounting telecommunications and legal                      Books, New York.
services. This practice is the reverse of vertical            Kakabadse, N., Kakabadse, A., 2000. Critical review—out-
integration and has led to a significant extension of             sourcing: A paradigm shift. Journal of Management
the boundary of manufacturing organizations,                     Development 19 (8), 670–728.
which in turn has shifted transaction costs and               Lonsdale, C., Cox, A., 2000. The historical development of
                                                                 outsourcing: The latest fad? Industrial Management  Data
associated economic value into other sectors, most               Systems 100 (4), 444–450.
notably the service sector. Thus, to recognize the            Nikaido, H., 1970. Introduction to Sets and Mappings in
real value that manufacturing makes to an                        Modern Economics. North-Holland, Amsterdam.
ARTICLE IN PRESS

                           I. McCarthy, A. Anagnostou / Int. J. Production Economics 88 (2004) 61–71                        71


PA Consulting Group (PACG), 1996. Riding the Wave of              Yearbook of Industrial Statistics, 1974. United Nations,
   Channel Substitution. PACG, London.                               New York.
Quinn, J.B., Hilmer, F.G., 1994. Strategic outsourcing. Sloan     Yearbook of Industrial Statistics, 2001. United Nations,
   Management Review 35 (4), 43–55.                                  New York.
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The impact of outsourcing on the transaction costs and boundaries of manufacturing

  • 1. ARTICLE IN PRESS Int. J. Production Economics 88 (2004) 61–71 The impact of outsourcing on the transaction costs and boundaries of manufacturing Ian McCarthya,*, Angela Anagnostoub a SFU Business, Management of Technology, Simon Fraser University, 515 West Hastings Street, Vancouver, BC V6B 5K3, Canada b Brasenose College, University of Oxford, Oxford, UK Received 15 April 2003; accepted 16 May 2003 Abstract This paper discusses the concept of outsourcing, along with an account of the economic benefits that are achieved by reconfiguring the organization and reducing the transaction costs of providing products and services. With the practice of outsourcing experiencing exceptional growth, this paper examines the corresponding change (decline) in UK manufacturing as an economic activity, and considers how the economic benefits of outsourcing alter the contribution that an organization makes to a sector’s gross domestic product. To assess this issue, an input–output methodology for measuring economic restructuring in UK manufacturing is presented. r 2003 Elsevier B.V. All rights reserved. Keywords: Outsourcing; Input–output methodology; Manufacturing; Boundary; Configuration 1. Introduction of information processing (design, marketing, R&D, customer service, etc.) geography proces- All businesses exist because they perform value- sing (distribution and logistics) and availability adding processes that consist of transformation (retail outlets). functions. Service, transportation and retail orga- Pioneered in the 1930s by organizations such as nizations perform processes that focus on infor- the Ford Motor Company, which was fervent mation, geographical distance and availability, about control, rationalization and the elimination respectively. Manufacturing organizations focus, of uncertainty, many corporations since then have by definition, on processing raw material, but since sought growth and power by conglomeration, and the industrial revolution they have evolved into vertical and horizontal integration. The Ford businesses that also deal with significant amounts Motor Company altered the boundary of its organization by acquiring and integrating busi- nesses that were parts of its supply chain. These *Corresponding author. SFU Business, Simon Fraser Uni- versity, 515 West Hastings Street, Vancouver, BC V6B 5K3, included mining companies, shipping companies, Canada. Tel.: +1-604-291-5298; fax: +1-604-291-5153. railway companies and rubber plantations. This E-mail address: imccarth@sfu.ca (I. McCarthy). strategy, not only provided ownership and 0925-5273/03/$ - see front matter r 2003 Elsevier B.V. All rights reserved. doi:10.1016/S0925-5273(03)00183-X
  • 2. ARTICLE IN PRESS 62 I. McCarthy, A. Anagnostou / Int. J. Production Economics 88 (2004) 61–71 enhanced control of the supply chain and market, to outsource, with durable goods manufacturers but as reported by Lonsdale and Cox (2000) it accounting for 39% of all activity and non-durable offered organizations the potential for economies goods manufacturers accounting for 25% (Zhu of scale and the opportunity to exercise greater et al., 2001). In addition, with a global outsourcing market power. market estimated at d188 billion in 1998, and Manufacturing organizations are complex sys- with annual growth rates of 15% (Coombs & tems that consciously evolve in response to market Battaglia, 1998), the distinction between eco- needs, competition and innovation. Directing this nomic activities in different sectors has become evolution is a key management responsibility that blurred. involves making decisions about the configuration With the practice of outsourcing experiencing and boundary of an organization, to ensure exceptional growth, this paper examines a possible competitiveness relative to market demands and corresponding and related change, a decline in stability. This concept is central to the transaction manufacturing as an economic activity, and cost perspective (see Section 2.2), which asserts considers how outsourcing alters the perceived that organizations seek to reduce costs (direct contribution that an organization makes to a costs and associated support costs) by forming country’s GDP. The conclusion is that the alliances or selecting structures and practices that boundaries of manufacturing activity have altered, lead to efficiency improvements. This cost mini- changing the ownership of certain aspects of the mization hypothesis has underpinned the purchas- economic activity. Thus, to properly understand ing function and is a key issue in both defining an and measure the economic value of manufacturing organization’s boundary and understanding the requires an approach that recognizes the highly benefits of outsourcing. For instance, in the early integrated and codependent set of activities that 1990s, many manufacturing organizations had constitute the modern economic system of manu- evolved into businesses that were no longer just facturing. concerned with material processing and assembly. To review and assess this notion, this paper They had extended their boundaries and remit to will proceed as follows. Section 2 reviews the focus on converting an idea or need into a economic benefits and drivers that motivate marketable product, along with the provision of manufacturing organizations to outsource. Section appropriate product support and service. The 3 provides an introductory account of the macro- conglomeration and vertical integration activities economic decline that has occurred in UK of the previous 60 years had helped manufacturing manufacturing and asserts that the decline has organizations achieve this change in focus, but at been influenced by the practice of outsourcing, the expense of burdening the organization with which has shifted activities and employment from excess and inefficient processes and services, and manufacturing to services. Section 4 examines this uncompetitive transaction costs. claim by using an input–output methodology and With this development in organizational focus, more specifically the decomposition approach the need and trend for outsourcing emerged. (Dietrich, 1999) to investigate the impact that It was based on the assumption that a competitive outsourcing has had on the boundaries and advantage would be gained if external suppliers outputs of the manufacturing sector. This method were contracted to carry out non-core processes can be used to analyze the flow of goods and more efficiently and effectively. To achieve services from every sector to every other sector in more proficient and profitable functions in areas the UK economy at a specific point of time. Thus, such as accounting, logistics, catering, design, flows of goods and services can be traced between production, IT support and customer service, sectors and their relative contributions to econom- manufacturing organizations began to utilize ic output, value added or productivity can be the core-competencies of other manufacturing, estimated. The methodology is demonstrated using service and transportation organizations. Today, a range of UK input–output data. Section 5 manufacturing is the industry sector most likely provides a conclusion.
  • 3. ARTICLE IN PRESS I. McCarthy, A. Anagnostou / Int. J. Production Economics 88 (2004) 61–71 63 2. The case for and against outsourcing fied three reasons for outsourcing: (i) savings on wage and benefit payments, (ii) transfer of demand 2.1. What is outsourcing? uncertainty to the outside contractor, and (iii) access to specialized skills and inputs that the Outsourcing has become an important business organization cannot itself possess. Kakabadse and approach, whereby a competitive advantage may Kakabadse (2000) report that the main reasons for be gained when products or services are produced outsourcing are: (i) economic—greater specializa- more effectively and efficiently by outside suppli- tion in the provision of services, as outsourcing ers. It is an agreement in which one company allows economies of scale and the longevity of contracts-out a part of their existing internal demand for the activity; (ii) quality—access to activity to another company. As a management skills, the competency and focus of potential practice it has probably been in existence for over suppliers and geographical coverage is increased; 200 years, but during the last 15 years, with the and (iii) innovation—improvements in quality support of academics, consultants and industry through innovation, and the development of new forums, it has developed into a popular strategic service products, can lead to new demands. management initiative. During this 15-year period, Bendor-Samuel (1998) also asserts that outsour- the economic value, strategic importance and cing provides certain power that is not available complexity of the outsourced function (when within an organization’s internal departments. considering manufacturing organizations) has in- This power can have many dimensions: economies creased; evolving from routine and non-value- of scale, process expertise, access to capital, access adding functions, such as security, cleaning and to expensive technology, etc. The combination of catering, to key support and value-adding func- these dimensions creates the cost savings inherent tions, such as information technology, logistics in outsourcing, because the outsourcing supplier and accounting, to core manufacturing-related (the organization specializing in a particular functions, such as design and certain production business function) has the economy of scale, the processes. expertise and the capital investments in leading Outsourcing not only purchases products or technology to perform the same tasks more services from sources that are external to the efficiently and effectively than the internal depart- organization, but also transfers the responsibility ments of the outsourcing ‘buyer’. of the physical business function and often the Another possible benefit is that outsourcing associated knowledge (tacit and codified) to the provides companies with greater capacity for external organization. It is this adaptation, driven flexibility, especially in the purchase of rapidly by transaction cost rewards, functional competi- developing new technologies, fashion goods, or the tiveness, strategic development and the business myriad components of complex systems (Carlson, pressures of globalization and technological 1989; Harrison, 1994). Companies can buy tech- change, that has altered the configuration (how nology from a supplier that would be too the organization is designed managed and oper- expensive to replicate internally. A network of ated) and boundary of the modern manufacturing suppliers could provide an organization with the organization. These changes not only affect an ability to adjust the scale and scope of their organization’s performance, but also the perceived production capability upward or downward, at a contribution of an organization and its industrial lower cost, in response to changing demand sector to an economy. conditions and at a rapid rate. As such, out- sourcing claims to provide greater flexibility than 2.2. The case for and against outsourcing the vertically integrated organization (Carlson, 1989; Harrison, 1994; Domberger, 1998). Further- There have been several studies that have more, outsourcing can decrease the product/ examined the motivations for and benefits of process design cycle time, if the client uses multiple outsourcing. Abraham and Taylor (1993) identi- best-in-class suppliers, who work simultaneously
  • 4. ARTICLE IN PRESS 64 I. McCarthy, A. Anagnostou / Int. J. Production Economics 88 (2004) 61–71 on individual components of the process (Quinn between employers and employees, which in turn and Hilmer, 1994). can damage morale, trust and productivity. The case against outsourcing is based on In summary, the rationale for practicing arguments such as loss of management control, outsourcing is to exploit external suppliers’ invest- reduction in flexibility and increased costs. For ments, innovations, and specialized professional instance, competitive outsourcing requires a high capabilities. This helps an organization to reduce standard of supplier management to avoid the its operating costs, whilst achieving an increased pitfalls of transferring critical functionality, or focus on its core competencies. This obvious and becoming too dependent on a supplier for day-to- important benefit is consistent with transaction day performance of vital business functions. In cost economics, which was largely developed addition, outsourcing can generate new risks, such by Coase (1937) and Williamson (1975, 1979). as the loss of critical skills, developing the wrong Transaction cost analysis integrates economic skills, the loss of cross-functional skills, and the theory with management practice and organiza- loss of control over suppliers (Domberger, 1998; tion science to study why organizations exist, Quinn and Hilmer, 1994). The possible loss of what are their configurations and what determines flexibility is connected to the typical long-term their boundaries based on the assumption that contractual relationship that is formed as part of transaction costs are minimized. Transaction costs an outsourcing agreement, and that during the are the full cost of providing products or services contract term, the customer’s business, the avail- including negotiating, monitoring and enforcing able technology, and the competitive and regula- the contractual agreement. Therefore, regardless tory environment may change dramatically. Thus, of whether the motivation for outsourcing is this inflexibility is mostly linked to an unyielding strategic, operational, political, innovative or and inappropriate contract. Although outsourcing structural, transaction cost analysis asserts that is undertaken by many organizations to control or the properties and economic benefits of business reduce costs, there is some evidence that it does functions, whether internal or external, influence not decrease costs as expected, and in some cases, the configuration and boundary of the organiza- costs increase. For instance, when an item is tion. How this effects the economic impact of outsourced, the assumption is that the supplier’s outsourcing on structure and perceived size of costs and required contribution is less and will industrial sectors is not clear. Yet, outsourcing continue to be less than the cost of internal is a management process that alters the boundary provision. A survey based on 1000 managers of an organization and therefore changes the worldwide by the PA Consulting Group (PACG) economic contribution that an organization revealed that only 5% of organizations gained makes to its industrial sector and thus to the ‘‘high’’ levels of economic benefit from outsour- economy. cing (PA Consulting Group (PACG), 1996) and that 39% of organizations admitted ‘‘mediocre’’ economic benefit. Also, as outsourcing leads to a 3. The changing context and boundaries of UK re-definition of organizational boundaries and, by manufacturing implication, structural adjustments involving hu- man resources, these changes incur social as well Although manufacturing is essential to success- as financial costs. Although the social costs are ful industrialization and has been regarded as one transitory and can be mitigated by facilitating the of the most important elements of the UK adjustments through the re-training and re- economy up until the late 1960s, it no longer deployment of staff within the organization, their occupies that status. The period from the early transfer to the supplier organization and ensuing 1970s to the early 1990s was one of many changes redundancy payouts can still be considerable with recessions and recoveries. In particular, the (Domberger, 1998; Hall and Domberger, 1995). oil crises of the early 1970s and the recession of Also, outsourcing can lead to industrial disputes 1979–1981 had a severe impact on the structure of
  • 5. ARTICLE IN PRESS I. McCarthy, A. Anagnostou / Int. J. Production Economics 88 (2004) 61–71 65 the UK industry. The UK economy underwent Table 1 a prolonged period of expansion in the 1980s. This Value added (VA) as a percentage of gross value added (GVA) and employment analyzed by industry over the period of 1980– represented recovery from a deep recession 1999 and entailed considerable structural change, particularly in manufacturing. Output fell at the GVA Employment (1000s) turn of the decade and only returned to its 1979 1980 1990 1999 1980 1990 1999 level in 1987. Much effort in recent years has been Agriculture 2.1 1.9 1.2 654 592 525 devoted to comparisons of the UK’s industrial Mining and 4.4 2.7 2.3 361 208 107.8 performance with that of other industrialized quarrying countries. Manufacturing 26.5 23.0 18.8 7081 5398 3936 For a sustained period, UK manufacturing lost Utilities 5.3 2.3 2.3 2343 1820 1886 share in world markets and within the domestic Construction 6.1 6.9 5.3 1617 1559 1767 Services 59.9 67.1 70.2 14,937 14,547 20,718 economy. Manufacturing gross value added (GVA) as a percentage of total national gross Source: UK National Accounts, 2000; National Statistics: value added fell, from 26.5% in 1980 to 18.8% in Monthly Digest of Statistics, 2000. 1999. This was accompanied by significant changes in employment in the manufacturing industry. In Traditional Single Organization Approach the 1969 manufacturing provided over 8.1 million Flow of market jobs in the UK (Yearbook of Industrial Statistics, needs or idea Products and services 1974) whereas in 1999 it provided four million jobs Primary (Yearbook of Industrial Statistics, 2001). Value Adding Environment This relative reduction in manufacturing, and Flow of resource (PVAE) Waste particularly in manufacturing employment, was accompanied by substantial changes in the relative size of other sectors. In essence, there are definable stages of economic development and the final An Extended Enterprise based on a Value Adding Network of Organizations stages are characterized by a growing and healthy tertiary sector (i.e. transport, construction, dis- PVAE tribution and services) with growing preferences Flow of market needs or idea Products and services for service products. In addition, the contribution S of value added from the services to national gross S value added has been rising gradually from 59.9% in 1980 to 70.2% in 1999 (see Table 1), which OEM T suggests that the UK appears to be a service- dominated economy. Flow of resource T Waste When considering this competitive and structur- OM al change in UK manufacturing, it is important to recognize that organizations are open systems. They have permeable and changing boundaries OEM =original equipment manufacturer that reflect the domain of an organization’s S = service organization activities and functions. Outsourcing has encour- T = transportation organization OM = other manufacturer aged manufacturing organizations to alter their boundaries and become extended enterprises (see Fig. 1. Traditional and extended enterprise. Fig. 1) by setting up partnerships, and by collaborating and trading with other manufactur- ing, service and transportation organizations. This nizations creating wealth through the governance has increasingly resulted in a nebulous manufac- of knowledge and physical production activities. turing sector, with indistinct manufacturing orga- The result is that the conventional boundaries of
  • 6. ARTICLE IN PRESS 66 I. McCarthy, A. Anagnostou / Int. J. Production Economics 88 (2004) 61–71 Table 2 4. A methodology for measuring economic Value added and gross output (d millions), 1989–1998 restructuring Manufacturinga Tertiary share of share of total totalb Based on the assumption that supply equals demand, the input–output methodology permits 1989 Value added 23.8 69.0 study of the structural changes in an economy by Gross outputc 31.8 44.3 separating economic activity into four categories: 1992 intermediate deliveries, final demands, primary Value added 20.9 75.9 inputs and final demands of primary inputs. Gross output 27.1 65.6 Basically, supply or sectoral output must equal 1997 Value added 20.8 76.5 final demand plus intermediate demand; and on Gross output 26.3 67.5 the production side, intermediate inputs and 1998 primary inputs are combined to produce the level Value added 20.0 78.3 of output. Thus, the standard input–output Gross output 25.0 69.4 methodology for input–output data is based on Source: UK National Accounts, 2000. the following identity: a Manufacturing value added divided by total value added. b Tertiary value added divided by total value added. xi ¼ zi1 þ zi2 þ ? þ zij þ ? þ zin þ fi ; ð1Þ c Constant price estimates of gross output by industry. where the total output of any industry can be disaggregated into amount bought by industry from industry j and the output from industry i (zij ) manufacturing value are not appropriate. The supplying final demand fi : For all n industries, in manufacturing sector has been restructured and matrix notation, extended into non-manufacturing sectors, thus x ¼ Z þ f: ð2Þ changing the contribution that this industrial sector makes to a sector’s gross domestic product The intermediate deliveries Z denote transac- (GDP). tions between economic (manufacturing) sectors. The significance of these differences is indicated The manufacturing sectors use commodities of in Table 2 where manufacturing value added and other sectors as inputs in production of their own gross production are compared with that of a commodity. An element zij of the n  n matrix Z broadly defined private tertiary sector (transport, denotes the intermediate deliveries from sector i to construction, distribution and services). As man- sector j: A large part of the production is used ufacturing has reduced in value added and gross directly for consumption as raw material for production (23.8–20% and 31.8–25%, respec- products or as a technology investment. The final tively), the tertiary sector has increased in terms demand f consists of the output of production of both value added and gross production over sectors used for consumption, investment, govern- the period 1989–1998 (69–78.3% and 44.3–69.4, ment expenditures, changes in stocks and exports. respectively). An element fig of the matrix f denotes the deliveries Using the input–output methodology and more from sector i to final demand category g: A specifically the decomposition approach explained manufacturing sector also requires inputs that are below, the next section examines the impact that not produced solely by one of the sectors. Such outsourcing has had on the boundaries and output inputs include payments for labor, capital, im- of the manufacturing sector. The UK input– ports, indirect taxes minus subsidies, and profits. output tables between 1984 and 1998 show that Hence, primary inputs consist of value added and there has been a significant increase in the gross imports, and factor inputs may be used directly for purchases that UK manufacturing makes from consumption, investment, etc. non-manufacturing sectors (services and transport From the UK input–output tables, several in particular). relationships and coefficients have been derived.
  • 7. ARTICLE IN PRESS I. McCarthy, A. Anagnostou / Int. J. Production Economics 88 (2004) 61–71 67 The matrix with intermediate deliveries can be By rewriting Eq. (7) it is possible to decompose expressed as a matrix of input coefficients with the the growth of total output (Dx) in terms of changes elements of the vector of total inputs on its main in the Leontief inverse (DL) and changes in the diagonal: final demand Df: # Z ¼ Ax; ð3Þ Dx ¼ ðLtþ1 À Lt Þf tþ1 þ Lt ðf tþ1 À f t Þ where which A is defined as ¼ DL f tþ1 þ Lt Df ð9Þ A ZxÀ1 ; # ð4Þ or # x denotes the digitalized matrix of the vector x. Dx ¼ ðLtþ1 À Lt Þf t þ Ltþ1 ðf tþ1 À f t Þ The matrix A consists of input coefficients aij as ¼ DL f t þ Ltþ1 Df: ð10Þ the amount of product x required per unit of In both equations, changes are weighted with product j: Therefore, the input coefficients are the figures of a different period. This raises a time elements of the intermediate deliveries part of the inconsistency in the weights of the changes. To input–output table divided per column by the total solve this inconsistency the decomposition can be inputs of that sector: rewritten as zij aij ¼ ; ð5Þ Dx ¼ Ltþ1 f tþ1 ðÀLt f t þ Ltþ1 f t Þ À Ltþ1 f t xj þ Lt f tþ1 ðÀLt f tþ1 þ Lt f t Þ À Lt f t which represents the direct requirements of the output of any sector i per unit of any other ¼ DL f t þ Lt Df þ DL Df ð11Þ purchasing sector j ði; j ¼ 1; 2; y; nÞ: From or as Eqs. (3) and (2) yields Dx ¼ Ltþ1 f tþ1 ðÀLt f t þ Ltþ1 f t Þ À Ltþ1 f t x ¼ Ax þ f ð6Þ þ Lt f tþ1 ðÀLt f tþ1 þ Ltþ1 f tþ1 Þ À Ltþ1 f tþ1 or ¼ DL f tþ1 þ Ltþ1 Df þ DL Df: ð12Þ x ¼ ðI À AÞÀ1 f ¼ Lf; ð7Þ Taking the arithmetic average of Eqs. (11) and where I is the n  n identity matrix and L is the (12), changes in output can be expressed as Leontief inverse derived from the input coefficient Dx ¼ 1 DLðf t þ f tþ1 Þ þ 1ðLt þ Ltþ1 ÞDf; 2 2 ð13Þ matrix A. Leontief inverse matrix represents the direct and indirect requirements of sector i per unit which is another possible method of decomposition. of final demand for the output of sector j: The second part of the right-hand side (RHS) of A sufficient condition for the existence of the Eq. (13) captures that part of the change in gross Leontief inverse is that no column sum is larger output which is attributable to the change in the than 1 while at least one column sum is smaller technical coefficients, keeping final demand at its than 1 (Nikaido, 1970; Takayama, 1985). second period level, while the first term captures Changes in the input–output data can be used to the change in final demand, keeping the technical describe the extent to which restructuring, invol- coefficients fixed at the first period level. The first ving outsourcing and related activities such as term on the RHS is the change in technical contracting out, and subcontracting has occurred. coefficients evaluated using the first period’s level Suppose that changes in total output x are of final demand and the second term is the change decomposed into the contributions of two fac- in final demand evaluated using second period tors—the Leontief inverse and the final demand technical coefficients. f—and if the value of total output is known at Thus, Eq. (13) separates the total change in times t and t þ 1; the change in total output Dx is gross output into final demand and inter-industry given by effects, i.e. changing demand with given input– output relationships and changing input–output Dx ¼ xtþ1 À xt ¼ Ltþ1 f tþ1 À Lt f t : ð8Þ relationships with given demand.
  • 8. ARTICLE IN PRESS 68 I. McCarthy, A. Anagnostou / Int. J. Production Economics 88 (2004) 61–71 For purposes of empirical measurement, we can 4.1. Empirical investigation rewrite Eq. (13) as follows: Input–output tables explicitly account for the Dxav ¼ 1ðD1 þ D2Þ þ 1ðS1 þ S2Þ; 2 2 ð14Þ interdependence of different economic activities by incorporating the size and composition of the where various industries’ mutual input demands (mea- sured by interdependent coefficients of the Leon- D1 ¼ LtÀ1 f t À LtÀ1 f tÀ1 ¼ LtÀ1 Df t ; tief inverse), this permits analysis of both direct D2 ¼ Lt f t À Lt f tÀ1 ¼ Lt Df t ; and indirect interactions. With the practice of outsourcing experiencing significant growth, it is S1 ¼ Lt f t À LtÀ1 f t ¼ DLt f t ; possible to gauge how this management initiative S2 ¼ Lt f tÀ1 À LtÀ1 f tÀ1 ¼ DLt f tÀ1 : ð15Þ may have altered the contribution that an indus- trial sector makes to GDP; thus, distorting the The first term on the RHS of Eq. (14) is the definition and boundaries of manufacturing sec- average demand-induced change in output. The tor. As the effect of outsourcing is not recognized second term defines the average supply-led change by national economic accounts, input–output in output. Hence, it is possible to analyze the tables were used to assess if there is a significant significance of this compositional effect by exam- increase in the gross purchases that the tradition- ining the relationship between demand changes ally defined manufacturing sector makes from and the extent to which industries use services non-manufacturing sectors (services transport in activities. The latter can be measured by the particular). It should be noted that the data were average (input–output) coefficient for each manu- converted to 1995 prices using sector-specific price facturing industry’s purchase of services. If this deflators. compositional effect is significant there should be a Annual input–output tables for 1984 and 1989– positive relationship between industry demands 1998 were obtained from the UK Office of and service coefficients. It is clear from Eqs. (11) National Statistics (ONS). The 1998 tables at the and (12) that if f t f tÀ1 ; then final demand as a time of writing were the latest available and proportion of gross value is increasing, whereas if provide the most up-to-date information about Lt LtÀ1 intermediate use of resources as a the inter-industry relations. Since the aim is to proportion of gross value is expanding, thus study the impact of outsourcing on the boundaries outsourcing is increasing. of manufacturing, a higher degree of aggregation Based on the definition that outsourcing is an is adopted to focus on the relationship between the agreement in which one company contracts-out a manufacturing sector as a whole and other sectors. part of their existing internal activity to another Thus, the following sectors were considered: company, outsourcing can be quantified for agriculture, energy, manufacturing, construction, measurement purposes as the proportion of distribution, transportation, communication, and bought-in goods and services in gross output, services. This aggregation creates a potential where gross output is calculated as bought-in difficulty, as the supply-side effects may not be goods and services plus value added. This indi- operating at industry level for specific industries. cator can be used for single companies, manufac- Instead, certain industries may make more inten- turing sectors, or the whole economy, depending sive use of bought-in services and these industries on the level of aggregation and boundary of may have become more important over time by analysis. In the following section, the input–output growing more rapidly than the average. However, methodology and more specifically the decomposi- it is possible to analyze the significance of this tion approach explained above (Eq. (13)) are used compositional effect by examining the relationship to examine the impact that outsourcing has had on between demand changes and the extent to which the boundaries and outputs of the UK manufac- industries use services activities. The latter can be turing and service sectors. measured by the average (input–output) coefficient
  • 9. ARTICLE IN PRESS I. McCarthy, A. Anagnostou / Int. J. Production Economics 88 (2004) 61–71 69 Table 3 Table 4 Supply-side and demand-side effects in the manufacturing UK’s domestic manufacturing and total output (d million), sector 1979–1998 Dxda Dxs Dx Manufacturinga Total Share of (d millions) outputa manufacturing 1989–1990 — — — (d millions) to total output 1990–1991 54,212 À37,747 16,465 1991–1992 51,526 À10,990 40,536 1979 136,778 342,688 25.0 1992–1993 85,081 À34,668 50,413 1984 180,467 547,026 33.0 1993–1994 78,302 À23,715 54,587 1989 296,776 1,017,919 29.2 1994–1995 70,741 À25,670 45,071 1990 259,897 894,859 29.0 1995–1996 50,149 À20,900 29,249 1991 277,506 1,027,824 27.0 1996–1997 40,973 À25,712 15,261 1992 282,896 1,101,705 25.7 1997–1998 54,212 À9229 16,465 1993 299,060 1,168,193 25.6 a 1994 326,554 1,271,305 25.7 Dxd ¼ 0:5ðD1 þ D2Þ and Dxs ¼ 0:5ðS1 þ S2Þ as defined in 1995 350,739 1,359,593 25.8 Eq. (15). 1996 368,154 1,450,016 25.4 1997 378,851 1,526,371 24.8 1998 376,090 1,601,222 23.5 Source: UK National Accounts, 1980–2000. for each manufacturing industry’s purchase of a Domestic manufacturing and total output of products at services. If this compositional effect is significant, basic prices, i.e. total supply of products at purchasers’ prices there should be a positive relationship between less imports, distributors’ trading margins, less taxes less industry demands and service coefficients. subsidies on products. In this section, the use of input–output tables for the period 1989–1998 is presented to illustrate the Table 5 decompositions proposed by Eq. (13). The results UK’s outsourcing in manufacturing (d millions), during 1979– are shown in Table 3. 1998 In Table 3, the decomposition of gross output is Outsourcing Contracting Share of used to identify what part of the changes in gross (d millions) out plus manufacturing output of manufacturing can be attributed to shifts manufacturing and outsourcing in the final demand. In addition, what can be domestic output to total domestic attributed to supply-side changes (i.e. changes in (d millions) output the technical coefficients). For any period, the 1979–1984 6930 187,397 34.3 change in gross output of the manufacturing sector 1984–1989 6322 303,098 29.8 can be attributed to the change in technical 1989–1990 — 259,897 29.2 coefficients. Also, for each period, there is a high 1990–1991 37,747 297,644 33.3 1991–1992 10,990 288,496 28.1 increase in the demand-side and a significant 1992–1993 34,668 317,564 28.8 supply-side effect captured by the change in 1993–1994 23,715 322,775 27.6 technical coefficients. For example, during the 1994–1995 25,670 352,224 27.7 period 1992–1993, manufacturing could have had 1995–1996 20,900 371,639 27.3 recorded d34,668 million more output if the 1996–1997 25,712 393,866 27.2 1997–1998 9229 388,080 25.4 supply-side effect had been accounted for. Also, for the period 1997–1998, it appears that manu- Source: Input–Output Tables, 1979–1998; UK National Statis- facturing’s gross output should have been some tics, 1979–2000. d9,229 million higher, suggesting that the total domestic output for 1998 from manufacturing, 1990–1991 and 1992–1993. This suggests that the instead of being the d376,090 million as listed in contribution of manufacturing output in 1993 to Table 4, would have been the d388,080 million as be 28.8% instead of 25.6%, thus 2.2 percentage listed in Table 5. The largest outsourcing out points higher. In addition, in 1998 it would be periods between 1984 and 1998 occurred during 25.4% instead of 23.5%, i.e. 1.9 percentage points
  • 10. ARTICLE IN PRESS 70 I. McCarthy, A. Anagnostou / Int. J. Production Economics 88 (2004) 61–71 higher. These results support the notion that economy, it is necessary to understand and outsourcing has altered the configuration and measure the significant purchases it makes from boundary of manufacturing organizations in terms other sectors, using a method such as the input– of value added and that true manufacturing output methodology that analyzes the flow of output is underestimated. goods and services between sectors. The service sector by definition serves other sectors, and initiatives such as outsourcing have helped to 5. Conclusions develop and grow this sector. The input–output data shows that manufacturing is a key customer There are several compelling reasons to out- of the service sector, and through its purchases source, but the underlying rationale is consistent creates a significant and additional contribution to with the principle of transaction cost economics, a nations GDP. i.e. to achieve economic improvement in the performance of business functions. This involves contracting out a function to a specialist supplier References in an attempt to reduce costs and to benefit from competitive knowledge and practices. Thus, the Abraham, K.G., Taylor, S.K., 1993. Firms’ use of outside economics of outsourcing alter the configuration contractors: Theory and evidence. NBER Working Paper and boundary of an organization and therefore No. 4468, NBER, Cambridge, MA. Bendor-Samuel, P., 1998. The brave new world of outsourcing. change the economic contribution that an organi- http://www.outsourcing-journal.com/issues/may1998/html/ zation makes to its industrial sector and the everest.html. economy. This suggests that even though a Carlson, B., 1989. Flexibility and theory of the organization. reduction in the economic contribution of the International Journal of Industrial Organization 7 (1), UK manufacturing sector has taken place, there 189–203. have been important structural changes in the Coase, R., 1937. The nature of the firm. In: Williamson, O.E., Winther, G. (Eds.), The Nature of the Firm (1991). Oxford composition of UK manufacturing at the enter- University Press, Oxford. prise level which should provide a basis for Coombs, R., Battaglia, P., 1998. Outsourcing of business stronger performance in the future. This is services and the boundaries of the organization. CRIC reflected by the input–output data presented for Working Paper No. 5. 1992–1998, that shows a significant increase in the Dietrich, M., 1999. Explaining economic restructuring: An input–output analysis of organizational change in the gross purchases that manufacturing makes from European Union. International Review of Applied Eco- non-manufacturing (services and transport in nomics 13 (2), 219–240. particular). Domberger, S., 1998. The Contracting Organization: A In conclusion, it is argued that conventional Strategic Guide to Outsourcing. Oxford University Press, Oxford. economic views of UK manufacturing activity Hall, C., Domberger, S., 1995. Competitive tendering for underestimate its importance and contribution domestic services: A competitive study of three hospitals in to GDP. This is because existing macroeconomic New South Wales. In: Domberger, S., Hall, C. (Eds.), The data do not acknowledge that UK manufacturing Contracting Casebook: Competitive Tendering in Action. organizations, in pursuing greater efficiency, AGPS, Canberra, pp. 99–126. have outsourced many functions such as logistics, Harrison, B.T., 1994. Lean and Mean: The Changing Land- scape of Corporate Power in the Age of Flexibility. Basic IT, accounting telecommunications and legal Books, New York. services. This practice is the reverse of vertical Kakabadse, N., Kakabadse, A., 2000. Critical review—out- integration and has led to a significant extension of sourcing: A paradigm shift. Journal of Management the boundary of manufacturing organizations, Development 19 (8), 670–728. which in turn has shifted transaction costs and Lonsdale, C., Cox, A., 2000. The historical development of outsourcing: The latest fad? Industrial Management Data associated economic value into other sectors, most Systems 100 (4), 444–450. notably the service sector. Thus, to recognize the Nikaido, H., 1970. Introduction to Sets and Mappings in real value that manufacturing makes to an Modern Economics. North-Holland, Amsterdam.
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