To Outsource or Not: Tadelis Study Sheds Light on Pitfalls and Benefits

In the 50th anniversary edition of the Haas School's California Management Review, published in November, Associate Professor Steven Tadelis answers "yes" — but not without substantial caveats. Companies that jump on the bandwagon without a thorough cost-benefit analysis are setting themselves up for trouble, he says.

 

His article, "The Innovative Organization: Creating Value Through Outsourcing," lays out a strategic framework to help managers avoid the pitfalls. He cites a 2005 Deloitte Consulting survey of 25 large corporations that found 44 percent saved nothing by outsourcing. Half blamed hidden costs, such as managing the contract, transfer of institutional knowledge, and reduced flexibility. One in four ended up "backsourcing," returning the task in-house at a loss. "To me as an economist, a hidden cost means you didn't have a good way of thinking through your problem," says Tadelis, also associate dean for strategic planning.

 

At the heart of outsourcing problems, he reasons, is the fundamental conflict of interest in every contracting relationship: The buyer wants to save a buck and the seller wants to make one. Opportunities to exploit that tension grow as the task becomes more complex, Tadelis explains. That means some tasks are poor candidates for outsourcing.

 

"If I can't describe exactly what I want done, the person I hire will have incentive to do it in a cost-minimizing way," Tadelis says. "Once I'm in the relationship, I become a captive client and can have the juice squeezed out of me."

 

Deciding whether to outsource is easier said than done. The activity considered for outsourcing should be peripheral, not core to the business, according to Tadelis, and that determination requires foresight since businesses often evolve rapidly. To take full advantage of the marketplace through competitive bidding, the function should be clearly defined and not likely to change over the life of the contract, since renegotiation adds costs.

 

Some of the biggest failures, such as JPMorgan Chase's $5 billion contract with IBM, have centered on information technology. Because technology is inherently complex and fast-changing, Tadelis reasons that large companies with economies of scale are better off keeping IT in-house.

 

Outsourcing should not be confused with offshoring, Tadelis says — in other words, the "whether" should be separated from the "where." Companies should not be tempted solely by the low price of labor abroad, and must take into account the additional cost of cultural barriers, travel, and different — often less stringent — legal and intellectual property protections.

 

Ultimately, Tadelis concludes, thoughtful outsourcing can be an effective way to give managers some slack to focus on their central business, freeing them up to innovate.