In many ways outsourcing is as old as commerce itself. But what drives the decision to outsource - and more importantly how to outsource properly?

One might be surprised that much of the evolution of modern outsourcing can be tied to the study of economics. In fact, economic research stretching for more than 80 years is woven into the fabric of modern outsourcing.

The big thinkers focused on growth theory, transaction costs, game theory, property rights, deregulation and the nature of the firm. At least six Nobel Prizes have been awarded to economists that have something to teach us about outsourcing.

But what does this mean for the average practitioner in charge of outsourcing today? It means that the theories, lessons and wisdom of the brilliant economists can serve as validation and guideposts for outsourcing in the real world.

This article examines some of the best-known economists and how some of their findings can be applied to modern outsourcing. We've tried to take the essence of their work and distill it into a few sentences that can help you the next time you find yourself trying to develop your outsourcing strategy or structuring a deal.

            Ronald Coase, Coase Theorem: or Business is a Math Problem

The groundbreaking work of Ronald Coase, which stretched back to the 1930s, shed light on a concept known as transaction cost economics.

Coase advocated that it was not enough to include only production and transportation costs as the main costs of doing business; businesses needed to also consider the cost of entering into and executing contracts. This boils down to a mathematical analysis, and his breakthrough thinking was even given a mathematical name, the Coase Theorem.

That all seems obvious today, but Coase's inclusion of contracting and contracting costs into the mix of a firm's organizational structure and accounting helped him win the Nobel Prize in Economics in 1991 and created the conditions for outsourcing to become a normal and major part of a firm's strategy. Coase was probably scratching his head laughing at companies who rushed to offshore in the late 1990s only to find that the $1 they saved in manufacturing was offset by other costs.

Lesson for today's outsourcing firms: When outsourcing, think about the TOTAL COST - not just the price/budget of the work that is being outsourced. If you make your decisions solely on the price of the scope of work and not the total costs you will have a myopic and highly inaccurate view.

            John Nash, Game Theory: or Playing Nice is Good for Everyone

Is it a wild stretch then to move from the Coase Theorem and business as a math calculation to the famed bar scene in the movie A Beautiful Mind? Possibly, but let's do it anyway.

In the movie, the mathematician John F. Nash, as played by Russell Crowe, has a revelatory moment in a campus watering hole as he and his mates ponder the best ways to produce optimum results as they consider how to approach a beautiful blonde and her friends.

Nash's moment of inspiration and clarity was that Adam Smith's principle that the "best result comes from everyone in a group doing what's best for themselves" was incomplete and needed revision: The best result comes from everyone in a group doing what's best for themselves and the group.

Nash's pursuit and proof of that conclusion led to what is called the Nash Equilibrium. He demonstrated that companies that work together will discover that the sum of the parts can be better when combined effectively than if they work at cross-purposes.

Nash went on to win a Nobel Prize in 1994 for his work and the related work of two others that he shared the Nobel Prize with, John C. Harsanyi and Reinhard Selten. Their work spurred an entire branch of economics now known as Game Theory, or Behavioral Economics.

Game theorists have been studying the economics of playing non-zero sum games (aka win-win) games for more than 50 years to show that playing nice is indeed good for you.   Since Nash's Nobel Prize - there have been seven more Nobel Prizes awarded to Game Theorists.

Lesson for today's outsourcing firms: It's pretty easy to observe the seminal importance of game theory development in reaching equilibrium, or win-win solutions and outcomes, in outsourcing contracts. 

            Robert Solow, Technical Change: or Brains are Better than Brawn

More than 50 years ago Robert Solow showed that technology was the real driver of economic growth.

Solow's growth model was first presented in a 1956 article. His premise: Without "technological progress" growth rates for capital, labor and total production would all be about the same.  In fact, he found that about four-fifths of the growth in U.S. output per worker was attributable to technological progress. In short, brains matter more than brawn if you want to spur economic growth.

Solow won a  Nobel Prize for his work in 1987.

Lesson for today's outsourcing firms: Today most outsourcing agreements are transaction-based, meaning that a service provider gets paid for every activity - be it a rear-end in a seat to answer a call, two hands for packaging, or fingers for filing. This approach focuses on brawn, not brains. If economic growth is achieved from "technical change" then companies that outsource should focus their efforts around paying suppliers for their brainpower and not their brawn (or simply to perform an outsourced activity).

            Oliver Williamson and TCE: or Not Playing Nice Can Really, Really Cost You

Oliver Williamson, professor emeritus of business, economics and law at the University of California, Berkeley, is taking transaction cost analysis to a new level that he calls 'transaction cost economics' (TCE).

He applied TCE directly to outsourcing and the supply chain in an April 2008 article in the Journal of Supply Chain Management ("Outsourcing: Transaction Cost Economics and Supply Chain Management").

Williamson warns about potential "maladaptations" in the contract process that can develop if companies don't start by thinking cooperatively and proactively about "unanticipated disturbances" in order to preserve contract continuity.

His analysis of the three styles of contracting  -- muscular, benign and credible -- is particularly insightful. We are particularly fond of his quote, "Muscular buyers not only use their suppliers, but they often 'use up' their suppliers and discard them. The muscular approach to outsourcing of goods and services is myopic and inefficient."   

Oliver Williamson is the most recent economist to win a Nobel Prize. He shared the 2009 award with Elinor Ostrom, who received recognition for her work on how user associations can effectively manage common property.

Lesson for today's outsourcing company: Companies should think cooperatively upfront - because switching costs of vendors is very expensive. If your strategy is to "bid and transition" you are likely losing at the game of TCE. And for all those companies that have pit bull procurement professionals still on their staff - it is not only old school it is  "myopic and inefficient." If you aren't convinced by game theory, Williamson's work is the icing on the cake on why not playing nice can really, really cost you.

            Steven D. Levitt, Freakonomics and Superfreakonomics: or It's All About Incentives

Steven D. Levitt and his sidekick, the journalist Stephen J. Dubner, are the modern day rebels in economics with their work exploring "the hidden side of everything." Levitt points out, "One of the most powerful laws of the universe is the law of unintended consequences." 

While Levitt tells lively stories of how unattended consequences drive the behaviors of schoolteachers, realtors, crack dealers and expectant mothers, we contend this law also greatly affects outsourcing deals as well. In fact, an outsourcing deal that is not well thought out will likely suffer from one or more of the 10 Ailments of Outsourcing spelled out in the book Vested Outsourcing: Five Rules that will Transform Outsourcing.

Levitt has not won a Nobel Prize yet - but he does have two New York Times bestsellers and his lessons are well worth the read (and much easier to read than his peers).

Lesson for today's outsourcing company: In outsourcing, it's important to take Levitt's advice: "Morality is what people should do. Economics is what people do." For all those out there structuring an outsourcing deal - you always get what you pay for. So if you want more than a simple butt in a seat to do your work you need to consider an outsourcing business model that pays outsource providers for their brainpower to add value and solve your real problems and help you achieve your desired outcomes. We think Steven Levitt would be a supporter of the Vested Outsourcing concept that promotes aligning interest through the use of carefully crafted incentives.

            Thomas Friedman, The World is Flat: or why outsourcing is here is to stay

Thanks to Coase, Solow and their colleagues, outsourcing is now an intrinsic part of the business landscape. However, it has been popularized, debated and indeed lionized in the mainstream press by Thomas Friedman.

Friedman's big bestseller, The World is Flat: A Brief History of the Twenty-First Century (first released in 2005 and updated twice since then) stresses the importance of technology and outsourcing as major elements of the global economic structure.

The book describes 10 "flatteners" that have leveled the global playing field. The rise of outsourcing and related activities such as off-shoring and supply chain networks figures prominently on the list.

Friedman says outsourcing has allowed companies to split service and manufacturing activities into components that are subcontracted and performed efficiently on a global scale.  

The ease of offshoring today - if contracted correctly! - means that a company can locate manufacturing and other processes to a foreign locale to take advantage of less-costly labor and operations.

The emergence of sophisticated supply chain networks and the role of technology is another flattener, according to Friedman, because companies can now use the Internet, sophisticated software (including workflow programs and open source software) to coordinate and streamline items such as sales, distribution, shipping and risk management in real time.

Lesson for today's outsourcing company: The world is getting flatter all the time, and if you have not heard, outsourcing can be good for your company's health. Management guru Peter Drucker sums it up best with his advice in 2004: "Do what you do best, and outsource the rest."

We add one caveat: Do it right, because if you simply outsource and don't follow the economic lessens of outsourcing you will not maximize your results. For a primer on how to do outsourcing right, pick up a copy of Vested Outsourcing: Five Rules that will Transform Outsourcing.

            Conclusion

We've come a long way thanks to thought leaders such as Coase, Nash, Solow and Williamson.  But the outsourcing phenomenon is really just getting started.  Outsourcing is poised to achieve new levels of sophistication and efficiency, especially if it becomes the cooperative exercise benefiting all parties that it should be and companies play by the rules. 

Vitasek (kvitasek@utk.edu) is the lead researcher and faculty on the topic of Vested Outsourcing for the University of Tennessee's Center for Executive Education.  She is also the founder of Supply Chain Visions and is the lead author of Vested Outsourcing: Five Rules that will Transform Outsourcing.

Manrodt is an associate professor in the Department of Management, Marketing and Logistics and Georgia Southern University. 

DiBenedetto (wrdforward@earthlink.net) is a Seattle-based business writer and editor.

Source: Supply Chain Visions