Toward a model of strategic outsourcing

Journal of Operations Management 25 (2007) 464–481 www.elsevier.com/locate/jom

Toward a model of strategic outsourcing Tim R. Holcomb *, Michael A. Hitt 1 Texas A&M University, Mays Business School, Department of Management, College Station, TX 77843-4221, United States Available online 16 June 2006

Abstract Acknowledging efficiency motives, firms have increasingly turned to outsourcing in an effort to capture cost savings. Transaction cost theory (TCT) has been the dominant means of explaining outsourcing as an economizing approach whereby cost efficiencies are achieved by assigning transactions to different governance mechanisms. Recent research has used the resourcebased view (RBV) to examine the role of specialized capabilities as a potential source of value creation in relationships between firms. Although research in supply chain management has expanded substantially, only limited applications of TCT and the RBVare available, especially in the field of operations management. We extend both perspectives to explain conditions leading to strategic outsourcing. # 2006 Elsevier B.V. All rights reserved. Keywords: Strategic outsourcing; Operations strategy; Resource-based view; Transaction cost theory; Resource management; Value creation; Operations management; Supply chain management; Capabilities; Vertical disintegration; Intermediate markets

1. Introduction Understanding how firms establish firm scope has interested management scholars for some time, and a body of research has explored the boundary conditions firms consider when choosing to source activity from the marketplace (e.g. Fine and Whitney, 1999; Gilley and Rasheed, 2000; Quinn, 1999). In particular, this research highlights the complex choices firms make when deciding whether to internalize or outsource production. On the one hand, internalization requires firms to commit resources to a course of action, which may limit strategic flexibility and be difficult to reverse

* Corresponding author. Tel.: +1 979 845 4852; fax: +1 979 845 9641. E-mail addresses: [email protected] (T.R. Holcomb), [email protected] (M.A. Hitt). 1 Tel.: +1 979 458 3393; fax: +1 979 845 9641.

(Leiblein et al., 2002). On the other hand, internalization may be required by firms to more effectively carry out production. The complexity of these boundary decisions has intensified in recent years stimulated by increased competitive pressures, the rapidity of technological change, and the dispersion of knowledge across different organizations and geographic markets (Hoetker, 2005; Teece, 1992). Accordingly, a variety of outsourcing arrangements has emerged. We rely on both transaction-based and resource-based logics to explain the emergence of one such arrangement strategic outsourcing in which firms rely on intermediate markets to provide specialized capabilities that supplement existing capabilities used in production. What determines firm scope? A well-developed approach for boundary decisions associated with firm scope is transaction cost theory (TCT). According to this perspective, firms integrate production to minimize costs from opportunism and bounded rationality of

0272-6963/$ – see front matter # 2006 Elsevier B.V. All rights reserved. doi:10.1016/j.jom.2006.05.003

Electronic copy available at: http://ssrn.com/abstract=1321061

T.R. Holcomb, M.A. Hitt / Journal of Operations Management 25 (2007) 464–481

firms and their suppliers, the uncertainty and frequency of market exchange, and asset specificity that arises from supplier-firm or firm-customer relationships (Coase, 1937; Williamson, 1985). This theory holds that certain types of governance mechanisms manage exchanges with particular characteristics more efficiently than others; cost economizing therefore reflects a firm’s efforts to minimize costs arising from the governance of market exchanges.2 Accordingly, the decision to outsource often rests on economizing motives related to the fit between firms’ governance choices and specific attributes about an economic exchange (Grover and Malhotra, 2003; Silverman et al., 1997). Recently, however, scholars have presented resource-based perspectives of integration that augment transaction-based views and sharpen the focus on firms’ relative advantages (Combs and Ketchen, 1999; Leiblein and Miller, 2003; Poppo and Zenger, 1998). This growing body of work, which is based on the original work of Penrose (1959) and uses Barney’s (1991) more recent translation of the resource-based view (RBV) of the firm, emphasizes the importance of resources in guiding firm activity and the management of a firm’s portfolio of capabilities as central to competitive advantage.3 More specifically, this research contends that the reasons for internalization extend beyond the cost of transacting through the market to the conditions that enable firms to establish, maintain, and use capabilities more efficiently than markets can do (Conner, 1991; Ghoshal and Moran, 1996; Teece et al., 1997).

2 There are multiple sources and aspects of transaction costs. Coase (1937), for example, emphasized the ‘frictional’ costs, such as those costs that arise from negotiating, drafting, and monitoring contracts. Williamson (1975, 1985) expanded this perspective by focusing attention on the costs of transactional hazards (e.g. difficulties) and governance mechanisms to limit such hazards. Whereas Williamson focuses on the tendency of transaction difficulties to emerge as a function of the exchange, Coase’s frictional costs are a feature of economic conditions that occur independent of deliberate calculation or motives (see also Jacobides and Winter, 2005). 3 Resources, broadly defined, have often been used in the literature in a generic sense to include capabilities (e.g. Barney, 1991). Other scholars have claimed that capabilities represent how firms manage resources (e.g. Dutta et al., 2005; Helfat and Peteraf, 2003) or that capabilities represent a unique combination of resources that enable firms to pursue specific actions that create value (Sirmon et al. in press). For purposes of this paper, we use ‘resources’ to represent tangible or intangible assets owned or controlled by firms (Barney, 1991; Grant, 1996) and ‘capabilities’ to represent organizational routines that allow firms to effectively integrate and use resources to implement their strategies (Lavie, 2006; Winter, 2003).

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The resulting convergence between these two theories has stimulated a number of empirical studies, which has created a more effective understanding of what drives strategic outsourcing. For example, in recent years, transaction cost scholars have accepted that transaction-based and resource-based perspectives ‘‘deal with partly overlapping phenomena, often in complementary ways’’ and that capability endowments matter to boundary decisions (Williamson, 1999, p. 1098). Combs and Ketchen (1999) found evidence that firms often place resource-based concerns ahead of exchange economies when deciding on potential interfirm cooperation. Complementary to this view, Madhok (2002) pursued the question of how firms should organize production given certain resourcebased conditions (e.g. pre-existing strengths and weaknesses). He suggested that boundary decisions depend not only on the conditions surrounding the transaction, but also on capability attributes, and the governance context that it creates. Thus, substantial empirical support exists for the proposition that capability considerations trade-off with economizing constraints in the decision to outsource (e.g. Hoetker, 2005; Jacobides and Winter, 2005; Poppo and Zenger, 1998). Our work contributes to this stream by extending earlier conceptualizations of outsourcing based on economizing conditions, such as asset specificity, small numbers bargaining, and technological uncertainty, to include factors that influence the selection and integration of capabilities from intermediate markets (Argyres and Liebeskind, 1999; Jacobides and Winter, 2005). In particular, we consider the complementarity of capabilities, strategic relatedness, relational capability-building mechanisms, and cooperative experience as four important conditions that establish a resource-based context for strategic outsourcing. According to this perspective, in the decision regarding the strategic outsourcing of production, firms evaluate internally accessed capabilities and those capabilities available externally from intermediate markets, and consider how they might best be integrated to produce the greatest value. Therefore, this work goes beyond the question of governance mechanisms to enrich our understanding of capability selection and use, providing a more meaningful understanding of strategic outsourcing. Whereas transaction-based perspectives typically confine outsourcing to more specialized, repetitive activities such as manufacturing, logistics, and facilities management, resource-based theory provides a context to explain strategic outsourcing arrangements for more visible and

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potentially sensitive functions such as research and development (R&D), engineering design, and customer support. This trend is evident in the personal computer (PC) and communications equipment sectors, where growing demand for new product offerings has driven the market for third-party R&D and design. As a result, the volume of outsourced R&D, design, and manufacturing services in these two sectors is expected to grow almost two-fold between 2004 and 2009, from $179 billion to $345.5 billion (Carbone, 2005). Despite the dramatic increase in strategic outsourcing in recent years, few systematic studies of strategic outsourcing have been completed (Gilley and Rasheed, 2000). In fact, this topic has received only limited exposure in the fields of healthcare management (e.g. Billi et al., 2004; Roberts, 2001), economics (e.g. Chen et al., 2004a; Shy and Stenbacka, 2003), and strategic management (e.g. Fine and Whitney, 1999; Quinn, 1999; Quinn and Hilmer, 1994). Accordingly, this work represents an early attempt to frame and provide a theoretical understanding to the strategic outsourcing concept in operations and supply chain management research using both transaction-based and resource-based logics. This work follows Grover and Malhotra’s (2003) call for more research by operations management scholars that integrate strategic management and organizational theory into the study of interfirm relationships. In particular, our work contributes to the stream of research synthesizing TCT and the RBV by integrating them to extend earlier conceptualizations of outsourcing. We also make three important contributions to the outsourcing literature. First, we offer a more concise definition of strategic outsourcing that extends transaction-based logics and considers value created when firms more effectively leverage the specialized capabilities these relationships provide. Second, we explain how developing a ‘capabilities view’ better informs the discourse about the outsourcing choices that firms make. Prior work has established a relationship between outsourcing and cost economies from the selection of more efficient governance mechanisms (e.g. Cachon and Harker, 2002; Walker and Weber, 1984). However, to date, there has been little understanding provided of the role that internal and external capabilities play in strategic outsourcing decisions. Herein, we shift the focus on value creation from different exchange conditions to value chain structures and to the process by which firms produce goods and services. Thus, we provide managers with a richer framework to understand the trade-offs between internalization, past relationships

and experience, and capabilities that guide their decision to internalize or outsource. Third, we highlight the expanded role that boundaries serve in the formation of strategic outsourcing relationships. Establishing firm boundaries requires understanding more than how internally- and externally-sourced production activities affect performance (Araujo et al., 2003). It also requires a better understanding of the bridging function that boundaries perform in linking firms’ production activity with intermediate markets (McEvily and Zaheer, 1999). Accordingly, we argue that a more complete understanding of the organization of economic activity requires a greater sensitivity to the interdependence of capabilities, production activity, and interfirm relations that emerge from boundary decisions, as suggested by Coase (1988). Fig. 1 summarizes our model for strategic outsourcing. This model depicts conditions for value creation integrated with economizing arguments for strategic outsourcing. These theoretical arguments are examined in the following sections. We begin with a concise review of the literature and derive a more complete definition of strategic outsourcing. Next, transaction-based and resource-based arguments for outsourcing are reviewed. Building on these two perspectives, we present a model of strategic outsourcing that uses transaction- and capability-based factors to examine a firm’s decision to outsource. Finally, we discuss opportunities for future research. 2. Theoretical foundation Whereas transaction-based perspectives explain different governance mechanisms, resource-based theory considers the relative capabilities of focal firms and exchange partners as important in vertical integration decisions (e.g. Afuah, 2001; Argyres, 1996). According to this view, firms are largely heterogeneous in terms of their resources and capabilities (e.g. Barney, 1991; Wernerfelt, 1984), and thus often carry out the same activity with different production efficiencies and costs. As a result, separate firms that display different ways of accomplishing the same task achieve different cost efficiencies and performance outcomes. 2.1. Strategic outsourcing defined We define strategic outsourcing as the organizing arrangement that emerges when firms rely on intermediate markets to provide specialized capabilities that supplement existing capabilities deployed along a


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Fig. 1. A theoretical model for strategic outsourcing.

firm’s value chain.4 Further, we suggest that strategic outsourcing creates value within firms’ supply chains beyond those achieved through cost economies. As explained later, intermediate markets that provide specialized capabilities emerge as different industry conditions intensify the partitioning of production. As a result of greater information standardization and simplified coordination, clear administrative demarcations emerge along a value chain (Jacobides, 2005). Partitioning of intermediate markets occurs as the coordination of production across a value chain is simplified and as information becomes standardized, making it easier to transfer activities across boundaries (Richardson, 1972). Accordingly, an orientation toward strategic outsourcing evolves, as specialized capabilities emerge, resulting in a greater dependence on intermediate markets for production (Fine and Whitney, 1999; Quinn, 1999). The decision to outsource existing production represents the simplest form of strategic outsourcing.

4 A value chain, as defined herein, consists of the set of value-adding activities within a supply chain that may be undertaken for a product to be made or a service to be rendered. The concept of the value chain was originally used to conceptualize the set of productive activities that occur within the boundaries of any given firm, such as research and development, engineering design, inbound/outbound logistics, marketing, etc. (see Porter, 1985). Our definition of the term is consistent with the general use (e.g. Porter, 1985) to mean a structured set of activities associated with a firm’s productive output, regardless of whether they take place within the boundaries of a single integrated firm or occur externally using intermediate markets. Focusing on distinct activities that firms perform provides an efficient way of examining how boundaries change and how specialized capabilities from intermediate markets can be leveraged to accommodate some or all of the activities within a value chain.

Gilley and Rasheed (2000) refer to this organizing form as ‘substitution-based outsourcing.’ With substitution, firms discontinue internal production (e.g. the production of goods or services) and replace existing activities and/or factors of production (e.g. resources) with capabilities provided by intermediate markets. Accordingly, applying a capabilities perspective, we suggest that firm scope is partly determined by considering the performance differential between existing internal capabilities and those available in intermediate markets for substitution. By contrast, firms can also decide to outsource production a priori. Gilley and Rasheed refer to this form as ‘abstention-based outsourcing,’ which occurs when firms acquire capabilities from intermediate markets, rather than incur the necessary investments to internalize production. Thus, firm scope is also determined by examining the differential between the costs of internally developing new capabilities against accessing these capabilities in intermediate markets (Argyres, 1996; Langlois and Robertson, 1995). Research indicates that economizing firms often consider the value of their capabilities in decisions about internalizing an activity or conducting it through intermediate markets (e.g. Argyres, 1996; Combs and Ketchen, 1999; Hoetker, 2005). Specifically, in deciding whether or not to internalize, firms often compare their capabilities with those of other firms—as signaled by the price and quality terms that exchange partners are prepared to provide (Jacobides and Winter, 2005). However, due in part to ambiguity that emerges based on imperfections in the market, boundedly rational agents are often unable to foresee potential synergies from the integration of distinctive capability combinations.

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An important distinction introduced herein is how resource-based logics influence the decision to strategically outsource more effective specialized capabilities along a value chain, beyond that which we know by examining different governance mechanisms. More effective capabilities can enable firms to increase inventory turns, shorten product development cycles, and reduce the time-to-market for new products (Clark and Fujimoto, 1992; Petersen et al., 2005). Stated differently, we contend that strategic outsourcing not only creates cost economies by shifting production activity from a focal firm to intermediate markets, but also creates economic value, especially when production involves the use of potentially more valuable specialized capabilities (Fine and Whitney, 1999; Mowery et al., 1996). Argyres (1996) was one of the first to provide qualitative evidence on the role of capabilities in internalization decisions, observing that capabilities are a significant driver of firm scope in the cable connector industry. When comparing transactionand firm-level influences on firm scope, Leiblein and Miller (2003, p. 854) found that firm-level capabilities ‘‘independently and significantly’’ influence firms’ boundary decisions. Jacobides and Hitt (2005, p. 1222) examined how capability differences shape the make-versus-buy decision concluding that, ‘‘productive capabilities can and do play a major role in the determination of vertical scope, and account for ‘mixed governance modes’.’’ 2.2. Specialized capabilities and the emergence of intermediate markets A stream of research originally characterized as ‘vertical disintegration’ (Stigler, 1951) helps explain strategic outsourcing by developing a ‘capabilities view’ (e.g. Langlois and Robertson, 1995; Leiblein and Miller, 2003). According to this perspective, the emergence of new intermediate markets is driven largely by the desire of firms to pursue gains from the trade of specialized production. Richardson (1972) was one of the first to suggest that boundaries were contingent on the different activities in which firms engage, the capabilities such activities require, and the selection and use of those capabilities along a value chain. Jacobides (2005) examined conditions leading to increased specialization. He explained the emergence of new intermediate markets on the basis of gains from intrafirm specialization that condition a market, dividing previously integrated value chains among different sets of specialized firms and shifting the focus on value creation from the final market for goods or services ‘‘to

the value chain structure and the process by which the good or service is produced’’ (2005, p. 490). In the automobile sector, for example, advances in engineering and production technologies have led manufacturers to decouple supply chain capabilities giving up parts of the value chain to newly formed specialists in intermediate markets (Fine and Whitney, 1999). Similar trends are evident in the PC and communications sectors, with the emergence of electronics manufacturing services (EMS) and original design manufacturing (ODM) firms, such as Flextronics, Hon Hai, Sanmina, and Compal Communications, and the corresponding growth of original equipment manufacturers in these sectorsthat only market, but do notdesign or manufacture their own equipment. In the banking sector, standardization and advances in information technology led to significant specialization of production activities such as application development and data processing, which enabled non-financial firms such as IBM, EDS, and Accenture to become key participants in the intermediate market for information services. Accordingly, given advances in technology and standardization, new intermediate markets emerge, decomposing the value chain, allowing firms to ‘acquire’ valuable yet specialized capabilities cost-effectively via the market. As a result, firm boundaries shift as activities that were carried out internally are ‘transferred’ to newly formed intermediate markets. We therefore argue that strategic outsourcing not only allows firms to reduce costs, but also to enhance their portfolio of capabilities, and value creation potential, especially whenfirmsproduce unique combinationsusing capabilities provided by these markets. We suggest that three assumptions underlie resourcebased views about strategic outsourcing. First, selection determines gains available to firms from capabilities accessed in the intermediate markets and then intensifies the effect of these capabilities on firm performance. Complementarity and relatedness creates uniquely valuable synergy, especially when specialized capabilities are effectively combined and when no other combination can replicate the resulting value chain activities (Harrison et al., 1991, 2001; Prahalad and Bettis, 1986; Richardson, 1972; Tsai, 2000). To the extent that intermediate markets have superior capabilities that complement a firm’s existing capabilities, selection processes will combine the specialized internal and external capabilities. By contrast, if a firm possesses superior capabilities that are already integrated, selection will accommodate internalization. Second, strategic outsourcing relationships form within a social context. Ties, both direct and indirect, with firms in intermediate markets create a network


(Uzzi, 1997), and become an important source of information about the reliability and performance of current and future exchange partners (Granovetter, 1985). Such information helps a focal firm to learn about capabilities available in intermediate markets. Repeated ties improve trust in current and potential exchange partners and increase the likelihood of future cooperation (Gulati, 1995). Accordingly, cooperative experience forges close bonds over time and increases confidence that exchange partners will pursue mutually compatible interests thereby reducing the probability of opportunism (Das and Teng, 1998), and facilitating the exchange of capabilities crucial for performance (Combs and Ketchen, 1999; Uzzi, 1996). Because strategic outsourcing involves coordinating the actions of two or more firms, cooperative experience is vital to its success. Third, firms enhance their ability to leverage specialized capabilities by developing and refining mechanisms that strengthen the synergies such capabilities provide. We refer to these mechanisms as relational capability-building mechanisms (Dyer and Singh, 1998; Makadok, 2001), which allow firms to enhance the potential value of specialized capabilities deployed along a value chain. When purposefully developed, relational capability-building mechanisms allow firms to accumulate, integrate, and leverage experience over time; they are derived from previous capability-building actions, the results of those actions, and the future actions firms pursue (Fiol and Lyles, 1985). From a transaction-based perspective, these mechanisms reduce coordination and integration costs and enable firms to exploit new opportunities in the market, especially when they develop the mechanisms to more effectively manage the portfolio of capabilities they acquire from intermediate markets. These mechanisms also create causal ambiguity, obscuring the use of capabilities deployed across a value chain and making it difficult for competitors to determine a priori the sources of value within firms’ supply chains. In sum, we contend that specialized capabilities accessed by strategic outsourcing may allow firms to achieve greater performance gains. In the following two subsections, we briefly describe several economic incentives behind strategic outsourcing and contrast this organizing arrangement with two related concepts: strategic purchasing and strategic alliances. 2.3. Economic motives and incentives behind strategic outsourcing Although previous empirical studies of outsourcing have produced equivocal results, there is increasing

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evidence that certain economic motives may prompt a firm’s decision to pursue this organizing form. We provide three possible economic motives behind strategic outsourcing. First, strategic outsourcing potentially reduces bureaucratic complexity. As firms grow, information asymmetries emerge (Hitt et al., 1996). Asymmetries produce information deficits. Information deficits add to the administrative demands of organizing transactions. Excessive bureaucratic costs associated with governance oversight reduce firm performance (D’Aveni and Ravenscraft, 1994; Rothaermel, Hitt and Jobe, in press). In turn, these demands distract managerial attention from important sources of innovation and growth and add to the costs of internalization (D’Aveni and Ravenscraft, 1994). As transaction volumes increase, mobility and exit barriers form reducing strategic flexibility and often trapping firms in obsolescent technologies (Harrigan, 1985). Thus, strategic outsourcing helps firms align competing priorities, focus management attention on growth and innovation opportunities, and target resources to those tasks firms do best. Second, strategic outsourcing improves production economies, especially when firms fail to achieve sufficient production scale to overcome cost disadvantages (Teece, 1980). Because decisions about price and production are made before actual demand is observed, as transaction volumes vary, firms may find it difficult to make optimal use of available capacity or may ration production when existing production scale limits activity (Green, 1986). Strategic outsourcing allows firms to avoid or reduce rationing and meet production requirements by relying on intermediate markets as demand varies over time; it also provides a mechanism for firms to reduce uncertainty, transfer risk, and share scale economies with specialized firms from these markets. As a result, overhead is reduced, production costs decline, and investments in certain facilities and equipment are eliminated, which in turn reduces firms’ break-even points. Based on the considerations noted above, financial advantages evolve in three ways. First, firms pursuing strategic outsourcing through substitution (Gilley and Rasheed, 2000) benefit from financial capital (cash) exchanged for internal factors of production (e.g. facilities, equipment, management and production personnel, etc.) when assets are transferred or sold to firms in intermediate markets. The nature and size of this financial capital-factor exchange often has substantial effects on the total value of strategic outsourcing ‘deals’. Second, with strategic outsourcing, firms can reduce or eliminate longer-term capital outlays to fund future investments related to the

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‘outsourced’ production. This allows firms to partly shift specific internal costs, including fixed charges, such as amortization and depreciation costs, to intermediate markets. Finally, strategic outsourcing can buffer firms by providing access to resources (Miner et al., 1990). Thus, firms reduce their exposure as capacity and costs are more directly linked to actual production output (e.g. the number of ‘units’ produced). This allows firms to transfer the risk of changes in production as well as responsibility for future capital outlays to intermediate markets. Third, increases in bureaucratic complexity increase the coordination costs associated with different factors of production, especially when specialization reduces the degrees of freedom (Rothaermel et al., in press). Diminishing returns result when the loss of strategic flexibility and the increase in administrative costs outweigh the benefits of integration (Jones and Hill, 1988). Accordingly, when increased specialization simplifies coordination across a value chain (Jacobides, 2005), or when internal production is more efficient through intermediate markets, firms are more likely to integrate and use specialized capabilities. 2.4. Strategic outsourcing and related concepts We draw a distinction between strategic outsourcing and strategic purchasing. Strategic purchasing refers to the ongoing process of soliciting, negotiating, and contracting for the delivery of goods and services from suppliers (Chen et al., 2004b; Murray and Kotabe, 1999). Key activities include procurement, supplier and contract management, and other related supply chain management actions (Salvador et al., 2002) that involve arms-length transactions with suppliers (Chen and Paulraj, 2004). Firms regularly purchase products or services from suppliers on a frequent or recurring basis—from the procurement of production inputs to the purchase of supplies for office and administrative use (Walker and Weber, 1987). Accordingly, these decisions tend to be more routine and rarely involve the transfer of resources (Chen et al., 2004a). By contrast, strategic outsourcing is less common, and may involve the transfer or sale of resources to firms in intermediate markets. Moreover, strategic outsourcing reflects a primary ‘‘relational view’’ involving linkages with exchange partners that provide access to specialized capabilities. This relational view explains performance gains that arise when these capabilities are configured along the value chain to create value that cannot be realized through internalization (Das and Teng, 1998; Sirmon et al., in press). Equating strategic outsourcing

with the purchase of goods and services fails to capture full nature of this organizing form. We also differentiate strategic outsourcing from strategic alliances. Strategic alliances represent collaborative arrangements that firms establish to achieve common goals in which benefits are ultimately shared by alliance partners (Inkpen, 2001). As such, in alliances, individual firm performance is a function of both the total value generated by the alliance and the share of this value each firm appropriates (Alvarez and Barney, 2001; Hamel, 1991). Alliances also allow partners to share risks and resources (Ireland et al., 2002), to gain access to new knowledge (Dyer and Singh, 1998), and to obtain access to new product markets (Hitt et al., 2000). By contrast, strategic outsourcing arrangements generally involve a focal firm’s decision to deploy specialized capabilities along its value chain thereby linking firm performance directly to the productive activities it controls. While alliances infer joint decision-making and shared residuals, strategic outsourcing primarily benefits firms that originate the action (Insinga and Werle, 2000) by allowing them to appropriate directly the residual value such actions create. Accordingly, outsourcing decisions are not based on appropriation logic per se, rather on economic terms defined by a focal firm after considering the different cost/performance trade-offs. 3. Transaction-based arguments for strategic outsourcing Efficiency assumptions in TCT drive the classical reasoning for strategic outsourcing. With this view, difficulties that emerge from market-based exchanges generate transaction costs. Such costs include negotiation, contracting, monitoring, and enforcement costs, as well as costs incurred when resolving disputes. Based on this perspective, the performance implications of outsourcing and thus the decision criteria firms apply are based on the alignment of different governance structures with attributes of the exchange and the underlying contracting environment. For example, a firm that selects a simple governance structure lacking adequate safeguards and controls is exposed to moral hazard and hold-up risks when the contracting environment is complex or when it involves transaction-specific investments (Leiblein et al., 2002). By contrast, selecting an excessively complex governance structure for a simple contracting environment unnecessarily intensifies bureaucratic complexity, which reduces decision-making speed, decreases strategic flexibility, and increases overall costs (Williamson,


1985). Accordingly, cost economies as a consequence of effective governance structures represent important criteria in the decision to strategically outsource. We briefly describe three transaction-based considerations for strategic outsourcing: asset specificity, small numbers bargaining, and technological uncertainty. 3.1. Asset specificity Among the exchange conditions originally identified by Williamson (1975), asset specificity has been perhaps the most robust empirically. Specific assets, in contrast to general purpose assets, are considered an obstacle to market efficiency, because they are costly to redeploy to alternative uses (Williamson, 1991). Thus, asset specificity is the principal factor giving rise to transaction costs. Williamson (1985) defined asset specificity as durable investments that are made in support of particular exchange transactions. Specific assets are investments made in specific, non-marketable resources and reflect ‘‘the degree to which an asset can be redeployed to alternative uses and by alternative users without sacrificing productive value’’ (Williamson, 1991, p. 281). Highly specific supply chain assets, for example, might include investments in facilities, equipment, personnel, and firm- or process-specific training associated with the production of goods or services that have little or no use outside the exchange relationship (Grover and Malhotra, 2003). With strategic outsourcing, one of the principal challenges in deciding whether to make a specific investment concerns the possibility that exchange partners might act opportunistically. Asset specificity creates a bilateral interdependency between the firms (Carney, 1998; Jones, 1983). As such, conditions of outsourcing often lead to one or more firms being ‘‘locked in’’ and increasingly vulnerable. Trading hazards created by the structure of the market exchange, in turn, produce transactions costs. Diseconomies related to weak incentives and monitoring costs emerge. Under these conditions, asset specificity exposes outsourcing firms to potential opportunism, when exchange partners advance their own self-interest. Contracting in such situations is difficult, expensive, and often counter-productive. Consequently, where resource investments by focal firms are idiosyncratic to an exchange relationship, interfirm cooperation is likely to involve internalization. Thus, we propose that: Proposition 1a. Requirements for firm-specific investments by a focal firm in exchange-specific assets between the firm and specialized firms from intermedi-

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ate markets negatively affect the likelihood a firm will pursue strategic outsourcing. Under certain conditions, however, asset specificity may serve as a catalyst for interfirm cooperation. When firms involved in outsourcing relationships are required to invest collectively in the development of specific assets or new capabilities, such collaboration can form a reciprocal interdependency that increases the level of cooperation and reduces the incentive to engage in opportunism. These conditions reduce the costs of using capabilities from intermediate markets (Combs and Ketchen, 1999; Teece, 1992). Accordingly, in contexts that involve mutual investments in capabilities, collaboration may encourage mutual gain, even when such investments result in exchange-specific assets, and thus increase the likelihood a firm will pursue strategic outsourcing. Thus, we propose that: Proposition 1b. Requirements for collaborative investments in exchange-specific assets between a firm and specialized firms from intermediate markets positively affect the likelihood a firm will pursue strategic outsourcing. 3.2. Small numbers bargaining TCT scholars also argue that small numbers bargaining situations create market inefficiencies that create higher switching costs and increase the likelihood of opportunistic behavior (e.g. Klein et al., 1978; Williamson, 1975). The possibility of opportunistic behavior arises when the number of specialized firms in intermediate markets is small, resulting in small numbers bargaining (Williamson, 1975). Moreover, the likelihood of opportunistic behavior is most severe when focal firms are required to make significant exchange-based investments because such investments may be subject to hold-up by external partners (Klein et al., 1978). Small numbers bargaining affects the distribution of bargaining power in outsourcing relationships. Bargaining power is defined as the ability to influence the outcomes of negotiated relations (Bacharach and Lawler, 1981; Schelling, 1956). Firms with more bargaining power can obtain more favorable outcomes. In this case, bargaining power is important because it can lead specialized firms to act opportunistically in order to gain an advantage in outsourcing relationships. Thus, small numbers bargaining reduces the likelihood firms will pursue outsourcing. Moreover, when the degree of competitiveness within intermediate markets is low (e.g. small number of specialized firms), specialized firms acting oppor-

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tunistically may be less willing to share costs caused by changes in production volume or design specifications, thereby increasing transaction costs for a focal firm (Walker and Weber, 1987). By contrast, the higher the degree of competitiveness in an intermediate market, the more likely that partners will collaborate to share scale economies by leveraging adjustment costs across customers (Walker and Weber, 1984). Such economies dampen opportunistic bargaining, reduce potential transaction costs, and therefore provide a stronger incentive for firms to outsource. Accordingly, the greater the density of specialized firms, the lower a focal firm’s exposure to small numbers bargaining, and the more likely that strategic outsourcing will emerge. Thus, we propose that: Proposition 2. The number of specialized firms from intermediate markets is positively related to the likelihood a firm will pursue strategic outsourcing. 3.3. Technological uncertainty Technological uncertainty refers to unanticipated changes in circumstances surrounding technology, i.e., new generations of technology that render existing technology obsolete (Folta, 1998; Robertson and Gatignon, 1998). Broadly defined, technology represents theoretical and practical knowledge, skills, production and supply chain systems, and related artifacts that can be deployed along a firm’s value chain to develop goods and services (Burgelman et al., 1996). Changes in technology create new complexities for structuring value chain activities, especially when new knowledge is applied at a faster rate reducing the time between innovations (Song and Montoya-Weiss, 2001). In the presence of technological uncertainty, greater resource commitments produce more exposure to negative ‘shocks’. Thus, relative to arrangements that provide ‘on-demand’ access to capabilities through intermediate markets, technological uncertainty may serve as a disincentive to internalize because it often requires greater resource commitments. These conditions may prompt firms to pursue strategic outsourcing to reduce their exposure to unforeseen contingencies and to improve financial and operational stability and predictability. Schoonhoven (1981, pp. 355–356) found that ‘‘destandardization’’ and ‘‘decentralization’’ of task execution had positive effects on firm performance under conditions of technological uncertainty. Harrigan (1985, 1986) argued that increases in technological uncertainty may lead firms to use less firm-specific resources. As

a consequence, internalization is likely to decrease in the long-run, because strategic outsourcing allows firms to partly transfer the risk of task variability to the intermediate markets. Specialized firms in these markets may be better able to achieve cost efficiencies that are difficult for focal firms to achieve by balancing task requirements across multiple customers. As technological uncertainty increases, internal economies of specialization deteriorate in relation to the external economies of specialized firms (Teece, 1980). As such, strategic outsourcing not only can provide scale economies during periods of technological uncertainty, but may also act as a coping strategy helping to deal with risk. From this perspective, strategic outsourcing provides more predictable and orderly patterns of exchange within and between firms. However, at higher levels of technological uncertainty, larger information deficits increase the likelihood for opportunism, making it costly to handle exchanges through intermediate markets. These asymmetries reduce the ability to foresee potential contingencies that may occur in the future making it costly to write, monitor, and enforce complete contracts (Grossman and Hart, 1986). As a result, parties to such exchanges are more likely to regularly renegotiate the terms of their relationship, which increases the likelihood of opportunism. At increasingly higher levels of uncertainty, greater information deficits emerge, reducing cost economies and increasing the difficulty of interfirm collaboration. Reductions in cost economies lead to diminishing returns. At higher levels of technological uncertainty, firms find it difficult to accurately predict a priori the combination of possible events and outcomes that are likely to emerge from production (March and Simon, 1958). Thus, beyond a certain level of technological uncertainty, we expect this relationship to be negative. Specifically, we propose that: Proposition 3. Technological uncertainty will have a non-linear (inverse U-shaped) effect on the likelihood a firm will pursue strategic outsourcing, with the slope positive at low and moderate levels of technological uncertainty but negative at high levels of technological uncertainty. 3.4. Critique of transaction-based arguments for strategic outsourcing While providing a number of important insights regarding the most efficient means to govern a particular economic exchange (Grover and Malhotra, 2003), TCT generally involves a set of restrictive


assumptions that ignore the potential influence of a firm’s extant governance forms, its portfolio of exchange transactions, and other firm-specific capabilities on value created through value chain activities. Thus, in equilibrium, TCT implies that all firms facing a similar set of exchange conditions and transactional attributes will reach similar conclusions regarding which activities to internalize and which activities to outsource (Leiblein and Miller, 2003). However, this proposition is untenable. Comparisons of internalization decisions across firms in the same industry suggest that the internalization decisions often differ dramatically. For instance, while companies such as IBM and Nokia have remained historically integrated, other companies such as Dell, HP, Ericsson, and Motorola outsource a variety of production functions ranging from R&D and engineering design to manufacturing and logistics. Moreover, variance in performance within and between these two groups of firms suggests a more complex set of factors affect the decision to outsource. Thus, using economizing motives alone limits the quality of discourse about the decision to outsource. In the following section, we extend the conceptual orientation of strategic outsourcing to consider resource-based factors. 4. Resource-based arguments for strategic outsourcing Drawing on the RBV, we extend transaction-based perspectives of strategic outsourcing by focusing attention on the role of specialized capabilities obtained through intermediate markets. This approach, however, requires a refinement in the traditional role of boundaries. In particular, while conventional approaches to boundary conditions emphasize boundaries as an economizing buffer to environmental contingencies (Araujo et al., 2003), boundaries also act as a bridge to intermediate markets through relationship ‘ties’ formed by a focal firm. In other words, boundaries integrate as well as separate a firm from its environment. In this work, we define bridging as the process by which firms establish linkages with intermediate markets, suggesting that new capabilities may be obtained through relationships established within and across a firm’s relationship network (e.g. Burt, 1992; Granovetter, 1973). Herein, our focus is on the specialized capabilities provided through these relationships. The ability to access new and potentially more valuable capabilities is a critical driver of strategic outsourcing because these actions can fundamentally

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alter a firm’s capability endowments (Morrow et al., 2005), making it easier to pursue new opportunities in the market. We maintain that different conditions affect the value of capabilities sourced from intermediate markets. In particular, we briefly describe four resourcebased considerations for strategic outsourcing: complementarity of capabilities, strategic relatedness, relational capability-building mechanisms, and cooperative experience. 4.1. Complementarity of capabilities Beginning with Penrose (1959), strategy scholars have proposed that firms enhance value chain performance when they align with exchange partners in order to access complementary capabilities (e.g. Harrison et al., 1991; Rothaermel, 2001; Teece, 1986). Applied to strategic outsourcing, this argument suggests that firms seek ties with specialized firms that possess capabilities beneficial to and needed by a focal firm. Such capabilities may be required to replace existing capabilities deployed along a value chain (e.g. substitution-based outsourcing) or to fulfill a specific need not currently available in a firm (e.g. abstentionbased outsourcing). Capability complementarity reflects a situation in which specialized capabilities enhance the value creation potential of a focal firm’s own capability endowments. Complementary capabilities are different, yet mutually supportive (Luo, 2002a; Hitt et al., 2001). Richardson (1972) suggests that capabilities are complementary when they ‘‘represent different phases of production and require in some way or another to be coordinated’’ in order to create maximum value (Richardson, 1972, p. 889). Where complementarities exist, the integration of internal and external capabilities enhances the potential performance gains firms realize, especially when economies of scope in production increase their market power (Mahoney and Pandian, 1992). When complementary capabilities are idiosyncratic and indivisible, and thus not otherwise available in the factor markets (Barney, 1986), strategic outsourcing can provide access to them. When complementary capabilities are linked together, they are especially difficult for competitors to duplicate because imitation not only requires obtaining the capabilities from intermediate markets, but also duplicating their deployment along a value chain (Holcomb et al., 2006). Barney (1988) suggested that acquiring firms gain above normal returns from acquisitions only when private or uniquely valuable

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synergies can be realized. Private and uniquely valuable synergy is created when information about the combination is obscured from rivals and when no other combination of firms could produce the same value. Research suggests that firms participating in exchange relationships that involve complementary capabilities perform better than firms with relationships that are formed to achieve cost economies (Harrison et al., 2001; Holcomb et al., 2006). Chung et al. (2000) also found the likelihood of alliance formation was positively related to the complementarity of investment banks’ capabilities. Similarly, other research suggests that firms consider the potential for complementarity an important partner selection criterion (Hitt et al., 2000, 2004). Different but complementary resources can help a firm improve scale economies, enhance responsiveness and innovative potential, and increase quality. Furthermore, because complementary capabilities are generally relationship-specific (Dyer and Singh, 1998), the value created may be unavailable to rivals through alternative sources (e.g. private; Barney, 1988), which may create a sustainable competitive advantage. Thus, strategic outsourcing relationships are more important to value-creating activities when these relationships provide specialized capabilities that are complementary to those currently held by a firm, especially when the integration of those capabilities across a value chain create private and uniquely valuable synergy. From the resource-based perspective, firm scope then is determined by the limits in specialization and the need to maximize gains from the combination of complementary capabilities along a value chain. By applying this logic, we argue that strategic outsourcing is a likely alternative when benefits from specialized capabilities accessed from intermediate markets are based on complementarity. A complementarity perspective for strategic outsourcing suggests that a firm will ally with partners in whom the greatest complementarity exists between the firm’s capability endowments and those held by partners in intermediate markets. Thus, we conclude that the complementarity of capability endowments between a firm and its exchange partners has a positive effect on the likelihood the firm will pursue strategic outsourcing. Specifically, we propose that: Proposition 4. The extent of complementarity that exists between a firm’s existing capability endowment and capabilities available from intermediate markets positively affects the likelihood a firm will pursue strategic outsourcing.

4.2. Strategic relatedness Strategic relatedness characterizes the degree to which firms are strategically similar; it reflects the extent to which firms produce similar goods and services, serve similar markets, utilize similar production and supply chain systems, or rely on similar technologies. Relatedness provides a rationale for capability-sharing between firms (Prahalad and Bettis, 1986; Rumelt, 1974; Tsai, 2000). We expand this view of ‘relatedness’ to include goal congruence and the commonality of knowledge-sharing routines. A high degree of relatedness between a firm and its exchange partners implies that they share common goals and are able to transfer knowledge between them more effectively. Accordingly, strategic relatedness is an important factor in a firm’s decision to pursue strategic outsourcing. Goal congruence is the degree to which firms’ operational, strategic, and performance objectives overlap and/or reinforce one another. When firms’ goals are not congruent, performance considered satisfactory to a focal firm may not be satisfactory to exchange partners and vice versa. Likewise, behavior promoting the interests of a focal firm may not promote the interests of those partners (Luo, 2002b). The presence of congruent goals helps to resolve these potential concerns. Despite the importance of goal congruity for success in exchange relationships (Luo, 2002a), evidence suggests a lack of goal congruity in many such relationships. As profit-maximizing goals are aligned, strategic outsourcing not only reduces monitoring and enforcement costs associated with the arrangement but also increases synergies as well. When goals are aligned, specialized firms are more likely to share common interests with a focal firm and thus be more supportive of exploiting new opportunities, even if such opportunities require these firms make additional investments. These synergies enable firms with ‘common goals’ to more quickly exploit competitive imperfections observed in the market (Mahoney and Pandian, 1992), and thus hold the potential to create value beyond cost savings alone. Goal congruency also reduces conflict and encourages cooperative behavior (Parkhe, 1993). Thus, firms with exchange partners that share congruent goals find it easier to collaborate thereby enhancing the value of these relationships. Moreover, congruent goals improve the quality of relationships with exchange partners, which reduce the probability of opportunism (Granovetter, 1985; Uzzi, 1996). With the threat of opportunism reduced, exchange partners may be more


willing to make additional resources available. Finally, congruent goals can reduce the need for formal contractual arrangements (Dyer and Singh, 1998). These informal agreements in turn promote adaptability and reduce the need for formal governance mechanisms (Uzzi, 1997). Thus, costs are reduced to the extent that less monitoring and enforcement is required. By contrast, incongruent goals often lead to the development of sub-goals, which exchange partners may pursue at the expense of a focal firm (Williamson, 1975). Incongruent goals also impede cooperation, limit the exchange of resources between exchange partners (Luo, 2002a), and can lead to early termination of these relationships. Furthermore, in the presence of incongruent goals, the time and energy spent resolving disputes detract from developing and implementing innovative strategies and can prevent valuable strategies from emerging. Incongruent goals therefore make it difficult to leverage specialized capabilities accessed by firms through strategic outsourcing. Thus, we argue that goal congruency affects the likelihood a firm will pursue capabilities from intermediate markets through strategic outsourcing. Specifically, we propose that: Proposition 5a. Goal congruency between a firm and specialized firms from intermediate markets positively affect the likelihood a firm will pursue strategic outsourcing. A high degree of strategic relatedness also results when focal firms and specialized firms share common or similar knowledge-sharing routines (Dyer and Singh, 1998). We define knowledge-sharing routines as regular patterns of interactions that permit the transfer, assimilation, and integration of new knowledge (Grant, 1996). The advantage of such routines lies in the ability to economize effort, which reduces coordination costs and affords greater capacity for knowledge-sharing between firms. Common knowledge-sharing routines may emerge as new intermediate markets are formed by increasing specialization within an industry (Jacobides, 2005). For example, with the emergence of intermediate markets specializing in information services, firms have increasingly transferred in-house computing systems resources—i.e., programming and data center operations personnel, computer hardware, and enterprise application software as well as software design and programming processes and methodologies—to firms in these markets (e.g. EDS, IBM, and Accenture) who integrate and use these resources. As a result of these transfers, focal firms commonly share routines with their partners, which facilitates knowledge-sharing.

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Further, because firms within an industry often share common knowledge structures, the emergence of vertically specialized markets in an industry increases the likelihood they will share common knowledgesharing routines. Accordingly, the emergence of intermediate markets increases the diffusion of knowledge and thus increases the probability of strategic outsourcing in an industry. Various scholars have argued that interorganizational learning is also critical to competitive success, noting that firms’ partners are, in many cases, the most important sources of new knowledge (Powell et al., 1996; Von Hippel, 1988). Common knowledge-sharing routines between a firm and its exchange partners enable more efficient absorption and use of acquired knowledge (Cohen and Levinthal, 1990). Absorptive capacity includes relationship-specific capabilities, such as knowledge-sharing routines, that arise when firms develop mutually specialized ways of exploiting each other’s capabilities. Dyer and Singh (1998) define partner-specific absorptive knowledge as a function of (1) the extent to which firms develop overlapping knowledge bases, and (2) the extent to which partners develop routines that maximize the benefit of their interactions. In sum, we conclude that effective knowledge-sharing routines are crucial to the exploitation of intermediate markets and thus affect the likelihood firms will pursue strategic outsourcing. Thus, we propose that: Proposition 5b. Commonality of knowledge-sharing routines between a firm and specialized firms from intermediate markets positively affects the likelihood a firm will pursue strategic outsourcing. 4.3. Relational capability-building mechanisms Evidence suggests that firm performance is affected by its abilities to integrate, build, and reconfigure resources. This process is referred to as dynamic capabilities (Teece et al., 1997). According to Loasby (1998, p. 139), ‘‘‘managing capabilities’ is itself a capability’’; that is, firms develop capabilities over time that help them develop and link productive capabilities across a value chain. In particular, dynamic capabilities have been used to explain why firms in the same industry perform differently. For example, Helfat and Peteraf (2003) suggest that dynamic capabilities are embedded within firms and consist as a set of specific and identifiable strategic and organizational routines. We use the work on the dynamic capabilities (e.g. Teece et al., 1997; Helfat and Peteraf, 2003) to define relational

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capability-building mechanisms as routines that allow firms to synthesize and leverage specialized capabilities (Dyer and Singh, 1998; Makadok, 2001). Our view of these mechanisms also complements ‘recombinatory’ (e.g. Galunic and Rodan, 1998; Grant, 1996; Kogut and Zander, 1992) views of capabilities, which emphasize the manipulation of competences residing within the firm. Accordingly, these mechanisms improve a firm’s ability to accumulate, integrate, and leverage specialized capabilities across a value chain, and affect its ability to pursue new opportunities in the future. Relational capability-building mechanisms also act as a focal point for learning and leveraging experiences from past capability-building actions, the results of those actions, and the firm’s future actions (Fiol and Lyles, 1985). They represent a more systematic and routine implementation of dedicated processes that support production activity involving the use of specialized capabilities. For example, Kale et al. (2002) found that firms with a dedicated capability to manage interfirm relationships generated substantially higher market value than firms without such capability. Stated differently, firms that systematically invest in developing the ability to manage interfirm relationships consistently perform better than others that choose not to make such investments. Zollo and Singh (2004) found that dedicated processes in which firms accumulate and explicitly codify acquisition experience significantly improved overall acquisition performance by counteracting the coordination problems that future contingencies create. Accordingly, we expect investments in development of relational capability-building mechanisms will reduce coordination and integration costs, and improve the synergistic benefits available through strategic outsourcing. In sum, relational capability-building mechanisms not only enable firms to generate greater value (Mahoney and Pandian, 1992; Makadok, 2001), but also create additional ambiguity that allow firms to sustain certain advantages over time (Rumelt, 1984). Under these conditions, we expect relational capabilitybuilding mechanisms to directly affect the likelihood firms pursue strategic outsourcing. Accordingly, we propose that: Proposition 6. Relational capability-building mechanisms positively affect the likelihood a firm will pursue strategic outsourcing. 4.4. Cooperative experience Strategic outsourcing relationships are formed within a social context that influences selection

decisions and the pattern of interfirm linkages that emerge. We represent cooperative experience as repeated ties, direct and indirect, formed with specialized firms from intermediate markets. Repeated ties with these firms create a pattern of relationships in which focal firms can access information about the reliability and performance of current and future partners (Granovetter, 1985; Uzzi, 1997). These ties reduce information asymmetries, heighten awareness about specialized capabilities and firms from intermediate markets, and establish a basis for trust. In turn, trust enhances the potential benefits of strategic outsourcing by reducing the risk of adverse selection and improving the level of collaboration once such relationships are established. Herein, we define trust as a firm’s confidence in the reliability of a specialized firm to fulfill its obligations and act fairly when the possibility for opportunism is present. Zaheer et al. (1998) found that organizational trust formed by repeated market exchanges is an important driver of interfirm relationships because it enhances overall performance, decreases the complexity and costs of negotiation processes, and reduces conflict. Examining international joint ventures (IJVs), Luo (2002b) found that cooperation had a linear effect on IJV performance, especially at higher levels of contract term specificity and contingency adaptability, which represents the extent to which unanticipated contingencies are accounted for and the guidelines for handling such contingencies are specified in a contract. We suggest that a focal firm’s cooperative experience with specialized firms reduces information asymmetry and opportunistic behavior, and thus enhances the potential benefits of strategic outsourcing. Accordingly, cooperative experience increases the likelihood that additional outsourcing arrangements will be pursued with these firms in the future. Whereas, according to the transaction-based view, interfirm cooperation occurs only when the costs of governing production can be minimized, the resourcebased perspective suggests that firms share capabilities in order to stimulate growth (Combs and Ketchen, 1999). As such, cooperation represents ‘‘the willingness of a partner firm to pursue mutually compatible interests . . . rather than act opportunistically’’ (Das and Teng, 1998, p. 492). Because market exchanges are embedded in a social context, the governance of interfirm exchanges involve more than contracts; they depend on the level of cooperation between the firm and its partners (Luo, 2002b). For such relationally-governed exchanges, the enforcement of obligations, promises, and expectations involves social processes that promote norms of


adaptation and information exchange. The significance of cooperative experience is reflected in the paradox that results: firms are expected to pursue strategies and programs that best serve their interests; however, interfirm relationships require simultaneous investment and restraint in order for each party to gain maximum value from the relationship (cf. Das and Teng, 1998). The pattern of cooperation that emerges when intermediate markets form around specialized capabilities (Jacobides, 2005; Richardson, 1972) encourages firms to engage in repeated exchanges, especially as these markets mature improving accessibility to specialized capabilities. Repeated ties with specialized firms improve trust and increase the likelihood of future cooperation (Gulati, 1995). This pattern of connections broadens the firm’s scope and also affects the nature of ongoing capability development processes (Araujo et al., 2003; Jacobides and Winter, 2005), i.e., the way in which a firm shapes or improves its value chain over time. Changes in capabilities then reshape intermediate markets, allowing additional firms to participate. These changes facilitate growth in the number of potential suppliers but also increase the complexity of the selection and coordination process. Cooperative experience provides knowledge that helps in selecting and coordinating specialized capabilities in which relationship ties serve as a valuable conduit for rich information. Previous cooperation, defined in terms of both the length and quality of the exchange relationship, fosters a climate of trust, openness and confidence. Repeated interactions or ‘‘cycles of exchange’’ between parties strengthen their willingness to trust each other and to expand the boundaries the relationship (Rousseau et al., 1998). Over time, such relationships become integrated into the social context that develops between firms, which fosters knowledge-sharing, supports adaptability, and deters opportunism. In so doing, the synergy from exchange relationships is magnified. Specifically, exchange relationships based on trust are more likely to exploit market opportunities requiring access to resources from exchange partners. Such relationships are more likely to result in collaborative efforts to exploit emerging opportunities in the market. We conclude that cooperative experience affects the likelihood firms will pursue strategic outsourcing. Thus, we propose that: Proposition 7. Cooperative experience between a firm and specialized firms from intermediate markets, defined by the length and the quality of previous relationships, positively affects the likelihood a focal firm will pursue strategic outsourcing.

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5. Discussion and conclusion The dominant goal most often cited for strategic outsourcing is cost efficiency. According to this perspective, firms internalize value chain activity to minimize costs from opportunism and bounded rationality, the uncertainty of frequent market exchanges, and specific assets that may arise from this organizing arrangement. This rationale, in part, holds that specific governance mechanisms used to manage certain exchanges are more efficient and reflects the view of firm boundaries as the point at which resource owners relinquish control over access and use. Accordingly, transaction-based perspectives develop logic for strategic outsourcing on the basis of economizing motives linking governance choices to attributes of an exchange. The restrictive assumptions offered by TCT suggest that, in equilibrium, firms with similar exchange conditions will make the same decisions about strategic outsourcing. However, the arguments presented herein show this proposition to be incomplete. Strategic outsourcing enables firms to bridge boundaries and access capabilities from intermediate markets that are subsequently deployed along the value chain. According to the RBV, resource heterogeneity leads to otherwise similar firms displaying significantly different ways of accomplishing the same set of value chain activities, emboldened by the use of different capabilities. We argued that by linking value chain activities with intermediate markets for the purpose of gaining access to valuable specialized capabilities, firms can accrue value beyond the cost economies available through more efficient governance mechanisms. Thus, we augmented transaction-based arguments with resource-based perspectives to sharpen the focus on conditions that might favor the use of specialized capabilities. The purpose of this work has been to extend our understanding of strategic outsourcing by integrating transaction-based and resource-based logics. First, we offered a more concise definition of strategic outsourcing and extended the focus on cost economies resulting from more efficient governance mechanisms to consider value that is created when firms more effectively leverage the specialized capabilities that outsourcing relationships provide. An important distinction introduced herein is how firms’ understanding of their capabilities and those of specialized firms affect their decision to strategically outsource. We also showed how the emergence of new intermediate markets (e.g. vertical disintegration; Jacobides, 2005;

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Richardson, 1972) provides a theoretical framework explaining the logic for a ‘capabilities view’ of strategic outsourcing. In particular, we shift the focus on value creation from different exchange conditions to value chain structures and to the process by which firms produce goods and services. Accordingly, intermediate markets that maintain specialized capabilities emerge as conditions within an industry intensify the partitioning of production activity. As a result, boundaries shift to accommodate access to specialized capabilities that are then deployed along a firm’s value chain. Second, we extended the view of boundaries as providing a bridge between firms and intermediate markets (Araujo et al., 2003) to explain how value chain linkages are enabled through strategic outsourcing. On the one hand, boundaries provide a space for the development of valuable and difficult-to-imitate capabilities within the firm—the buffering function. On the other hand, boundaries provide a bridge to access specialized capabilities outside the control of the firm. While TCT generally establishes firm boundaries on the basis of anticipated efficiencies, our extended model of strategic outsourcing accommodates a view of boundaries in which firms join with exchange partners to create synergies they cannot realize alone. This extended model of strategic outsourcing suggests several research questions worthy of further investigation. First, we still know very little about the process by which specialized capabilities are deployed and integrated along a value chain. For example, how do firms integrate specialized capabilities along the value chain? What performance measures best reflect synergies created by the use of specialized capabilities across the value chain? Although exchange transactions through the market can often be economized, value derived from strategic outsourcing lies more in the combinative value of specialized capabilities available through intermediate markets. Thus, scholars should closely examine the underlying processes involved with integration and measurement of specialized capabilities along a value chain. Second, our understanding of the sources of value creation is limited. Do focal firms pursuing outsourcing benefit more by selecting valuable capabilities from intermediate markets or by more effectively integrating these capabilities in difficult-to-imitate ways? Using our model of strategic outsourcing, for example, scholars can evaluate Makadok’s (2001) assertions regarding synergies from the two main sources of rent generation—resource-picking and capability-building— within a strategic outsourcing context. According to this perspective, specialized capabilities affect firm

performance by enhancing the productivity of other capabilities that firms possess. Finally, as strategic outsourcing arrangements continue to expand in scope and complexity, scholars should more closely examine specific attributes of outsourcing ‘deals,’ especially when such deals involve the divestment of assets by a focal firm as part of the exchange. In some cases, these arrangements involve the exchange of substantial financial considerations for assets controlled by a focal firm. Where is value created (and lost) by focal firms and intermediate markets? How do financial considerations affect focal firms’ decision to outsource? What are the implementation challenges? How do investors view these arrangements? Thus, research that provides a more comprehensive view of strategic outsourcing deals and anticipates aggregate economic considerations is needed. The value-creating potential of the firm is at the heart of the theory of the firm. Adopting a model of strategic outsourcing can help scholars and practitioners to understand the strategic, operational, and financial motivations and incentives behind this organizing arrangement. If outsourcing is pursued strategically, firms can achieve above normal returns. Examining the different conditions in which value creation occurs can extend management’s view of strategic outsourcing and provide a new paradigm for supply chain practitioners to demonstrate the practical benefits of strategic outsourcing. Acknowledgements We thank David Ketchen, Tomas Hult, and the two anonymous reviewers for their helpful suggestions. We also benefited from valuable comments and suggestions by Sharon Alvarez, Lorraine Eden, and Michael Holmes on earlier drafts of this article. References Afuah, A., 2001. Dynamic boundaries of the firm: are firms better off being vertically integrated in the face of a technological change? Academy of Management Journal 44 (6), 1211–1228. Alvarez, S.A., Barney, J.B., 2001. How entrepreneurial firms can benefit from alliances with large partners. Academy of Management Executive 15 (1), 139–148. Araujo, L., Dubois, A., Gadde, L.E., 2003. The multiple boundaries of the firm. Journal of Management Studies 40 (5), 1255–1277. Argyres, N., 1996. Evidence on the role of firm capabilities in vertical integration decisions. Strategic Management Journal 17 (2), 129– 150. Argyres, N.S., Liebeskind, J.P., 1999. Contractual commitments, bargaining power, and governance inseparability: incorporating

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