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Outsourcing

Outsourcing in history

Economies of scale
Organizations have been dealing with how they can exploit their competitive advantage since the industrial Revolution to increase markets and their profits in these markets. The most important model in the 19th and 20th century was the large integrated organization. In the 50’s and 60’s corporate bases were more broadened to profit from economies of scale.
The large integrated organization diversified its product range and expansions required more layers of management. Because of technical development such as the internet, organizations were forced to complete more globally in the 80’s and 90’s and were handicapped by a lack of flexibility because of the bloated management structures. To increase agility, many large organizations developed a strategy focused on their core business and core processes.

 

Principal-agency problem

The focus on core processes started the discussion of which processes were core and critical for business continuity and which processes could be outsourced to external service providers. Processes or functions for which no internal resources were available were outsourced to specialized agency or service providers. Consequently, the principal-agency problem between user organization and service organization evolved and the principal-agency theory and the related information asymmetry increased in importance aligned with the growth of outsourcing. 

 

Outcourcing

 

Information asymmetry

The most common agency relationship in the financial domain occurs between investors (or shareholders) and management of a company. The principal might not be aware of the activities of an agent or is prohibited by the agent to acquire information. The result is an information asymmetry between the principal and the agent. For example, management desires to invest in emerging economies while the risk appetite of the principal is adverse. This strategy of management might sacrifice short-term profitability and increase risks of the company and might also lead to higher earnings in the future. However, the investors that desire high current capital earnings with low risks and may be unaware of these plans of management.  If the consequence of this strategy of management is that certain losses are incurred, management might be inclined not to disclose this information to shareholder. The evolvement of the accountancy profession was an important development in the worldwide mitigation of the agency problem.

Risk and resource planning

As indicated above, situations might exist where the agent is planning to commit certain resources of the investors for high risk investments. The agent is the decision-maker and is incurring little to no risk because all losses will be the burden of the principal. This situation might occur when shareholders contribute financial support to an entity that management use at their discretion. The agent might have a different risk tolerance than the investors because of the uneven distribution of risk. Or employees might decide to invest their energy in a project which has no long-term benefits for the organization. Management being responsible for the financial situation of the organization might not be aware of employees focusing on the wrong objectives.

 

Financial consequences

If the principal is an investor or shareholder of an organization the interests of the principal are focused on yield optimization of investments. Yields from investments are paid as dividends to investors in the short or long term. Principles are focused on optimizing (long term) dividend yields. Paying high dividends to principals leads to constraining of investment opportunities or might lead to cash flow difficulties for management of the organization. In this aspect, principals and agents have opposite financial interests.

The agency theory in this aspect is also relevant in the relation of management towards employees. Employees have an interest in increasing their personal salaries and personal pleasure at the least effort. Management has an interest in optimizing production or sales volumes against the lowest labor costs. In this relation the information asymmetry also exists in the form management not having full insight in the day-to-day activities of employees. Management will probably implement budgeting mechanisms and controls to optimize the employee’s activities for the purpose of the organization. The agency theory is also relevant in outsourcing situations.

 

Agency theory in outsourcing

In general terms, the agency theory relates to all relationships between two parties in which one party is the principal and the other party is the agent who represents the principal in transactions with third parties. Agency relationships occur when the principals hire the agent to perform a service on the principals' behalf. Principals commonly delegate decision-making authority to the agents. Because contracts and decisions are made with third parties by the agent that affect the principal, agency problems can arise.

In the situation outsourced activities to service organization by an user organization, the agency theory is relevant for all aspects described; information asymmetry, risk tolerance and resources committed. For example, a financial institution outsources IT services to a managed services provider. The managed service provider has no insight in the risk tolerance of the institution and might decide that a weekly backup is acceptable or that storage of data outside of the EU is acceptable. The service provider might not inform the organization of down-time of certain servers if this network outage is not identified by the financial institution.  The service organization might also be inclined to minimize resources performing activities while trying to increase the fees received. A service organization might also have a different tolerance towards fraud or might be the committer of fraud itself. In the pension industry asset managers can make profits by front running transactions of pension funds. Resulting in the principal-agency problem described above.

An information asymmetry, resource planning asymmetry and risk asymmetry might therefore exist between an user organization (the financial institution) and the service organization (the IT service provider).

Outsourcing brings many benefits but might also bring risks of which the principal-agency problem is the primary risk an organization faces. Recognized benefits of outsourcing include controlling costs, improving efficiency, hiring specific expertise or reducing risks. The agency theory concerns with the resolving of problems due to unaligned goals or different aversion level to risks between a principal and an agent. Outsourcing decisions are typically developed at senior levels in an organization and in the planning the outsourcing of activities, different phases can be identified.

 

Phases in outscourcing

Many organizations outsource ancillary services; hiring contractors, fulfillment or distribution. This first phase of outsourcing can be identified as the primary or baseline stage of outsourcing. The outsourced services have not been performed in the organization or the organization is not specialized in a certain field or function. OutsourcingPathManagers continued to seek opportunities to improve their finances by profit optimization. The easiest method for profit optimization is cost-saving. Outsourcing of support services because of cost-saving was the next phase in outsourcing. Services performed in the organization can be performed at lower costs and will lead to direct cost-saving. Hiring experts or outsourcing basic services was considered a more cost-effective approach than integrating specialized functions within the organization. Functions that were necessary for operational processes but not related specifically to the core of the business where outsourced to specialized services providers. These service organizations could realize economies of scale as a consequence of specializing in one or more functions and optimizing the processes of these services.

In general terms, the agency theory relates to all relationships between two parties in which one party is the principal and the other party is the agent who represents the principal in transactions with third parties. Agency relationships occur when the principals hire the agent to perform a service on the principals' behalf. Principals commonly delegate decision-making authority to the agents. Because contracts and decisions are made with third parties by the agent that affect the principal, agency problems can arise.

The most recent and current stage of outsourcing is outsourcing as strategic asset. Until mid-2000 it was axiomatic that organizations would not outsource their core competences, the functions that provide a competitive or strategic advantage to an organization.  Pension funds, for example, often outsource asset management, because performance of this functions is crucial for overall performance.