Very Close Paper- Refere It

8/4/2019 Very Close Paper- Refere It

1/19

Determinants of Information TechnologyOutsourcing: A Cross-Sectional A nalysisL A W R E N C E L O H A N D N . V E N K A T R A M A N

L A W RE N CE L O H is a doctoral candidate in the Sloan School of Management atMassachusetts Institute of Technology. He is also a senior tutor in the Faculty ofBusine ss Adm inistration at National University of Singapore. His current researchinterests include information technology outsourcing, corporate governance, anddiffusion of innovation. His research has appeared in the Journal of BusinessResearch and he has presented papers at the Academy of Management NationalMeeting and the TIMS/ORSA Joint National M eeting.N. VENKATRAMAN is Richard S. Leghorn Career Deveiopment Associate Professorof Management in the Sloan School of Management at Massachusetts Institute ofTech nolog y. His current research interests intersect strategic manag emen t and infor-mation technology. At Sloan, he teaches a course on strategic management andinformation technology and his research projects deal with the causes and effects ofelectronic integration and information technology strategy, especially the manage-men t of infonn ation technology outsourcing . His doctoral thesis was awarded the 1986AT Kearney Award for Outstanding Research in General Management by the Acad-emy of Management and his research papers have appeared in the Academy ofManagement Journal, Academy of Management Review. Information Systems Re-search, Journal ofManagement Information Systems, Management Science, StrategicManagement Journaly and he has presented pap ers at several professional me etings.He serves on the editorial boards of Academy of Management Review. Journal ofManagement Information Systems, Organization Science, and Strategic M anagementJournal.

A BST RA CT . Th is paper develops and tests a mode! of the determ inants of informationtechnology (IT) outsourcing by integrating both business and IT persp ectives. Specif-ically, we attempt to explain the degree of IT outsourcing using business and ITcompetences as represented by their cost structures and economic performances. Inaddition , we posit that outsourcing is dependent on b usiness gov em ance , particularlyfinancial leverage. Based on factor analyses and m ultiple regressions u sing data fromfifty-five major U .S. corporation s, we observed that the degree of IT outsourcing ispositively related to both business and IT cost structures. W e also established that thedegre e of IT outsourcing is negatively related to IT performance. Finally, we co ncludewith implications and future research d irections.Acknowledgments: Authors are listed alphabetically.Thisproject was supported by the researchconsortium on Managing Information Technology in lhe Next Era (MITNE) of lhe Center forInformation Systems R esearch (CISR) at the Massachu setts Institute of Tec hno logy . We tliankJohn R ockart. Judith Quillard, three journ al reviewers, and the Editor-in-Chief for co mm entson earlier versions of the paper.

Journal o/MaMogemginfii/bmaiioHSysttms/SwrmusT 1992. Vol. 9. No, 1, pp. 7-24


2/19

8 LOH A>a3 VENKATRAMAN

KE Y WORDS AND PHRASES: information technology outsourcing inform ation technol-ogy strategy.IT IS A TRUISM THAT INFORMATION TECHNOLOGY (IT) has transcended its establishedadm inistrative support function a nd has m oved toward playing a m ore central role ofbusiness operations (see, for instance, [1 4, 18 ,25 ,3 5] ). Within this tradition, researchefforts have focused on the use of IT to influence ihe boundaries of a firm with itssuppliers, buyers, and o ther intermediaries [6 ,8 ,21] . There is, how ever, a glaring lackof research emphasis on the role of IT infrastructure as a component of the firmboundary itself. In other w ords, while IT has been considered a critical m echanism ofmultiorganizational business relationships, the research stream has treated the gover-nance of IT infrastructure as if it were within one single firm's hierarchy. Such anapproach fails to recognize the recent trend toward managing a firm's IT infrastructurethrough a variety of governance mechanisms with otber firms.

Under con tractual arrangem ents popularly termed "o utsourc ing," firms are increas-ingly shifting specific components of their IT infrastructure away from a "hierarchi-cal" mode toward a "market" mode of governance. The well-publicized decision byEastman Kodak to hand over its entire data center to IBM, its microcomputeroperations to Businessland, and its telecomm unications and data netw orks to DigitalEquipm ent Corporation and IBM is a classic illustration [43,45]. Beside this particularcase, it appears that IT outsourcing is becoming a serious strategic option for manyfirms. The Yankee Group estimated that all Fortune 500 firms would evaluateoutsou rcing, that a fifth of them would sign outsourcing de als during the 1990s, andthat the outsourcing m arket would increase from $29 billion in 1990 to $49.5 billionin 1994 [7].

IT outsourcing can bo dependent on several factors across multiple levels. At thelevel of the econ om y, ilie temporal effects of trends and cycles may m otivate firmsto rationalize the management of the IT infrastnicture through arrangements likeoutsourcing. At an industry level, competitive pressures may induce firms toestablish "partnersh ip-based " relationships with key IT vend ors. At the firm level,the quest for competitive advantage may serve as a critical impetus to the IToutsourcing d ecision. Within the firm, the decision to outsourc e may be dep end enton several managerial factors. For instance, managers may like to build empiresby accumulating control over corporate resources [27] such as the IT infrastruc-ture. Further, the association of information with power [17] may inhibit theoutsourcing decision.

The practice of IT ou^wurcing has been extensively documented in the businessperiodicals, but there is scant attention provided to articulate its determinan ts. In otberwo rds, we know the phenomenon in some detail but we do not fully grasp the set offactors leading to the outsourcing dec ision. Our objective in this paper is to developa research model on the determinants of IT outsourcing. We recognize Ihc complexarray of factors discussed above; but as a first attempt at establishing an empiricalmodel, we focus on factors at \ht,firm level with appropriate controls for industry


3/19

DETERMINANTS OF IT OUTSOURCING 9

Frameworks of IT OutsourcingOUTSOURCING CAN BE FRAMED as a "make -versus-b uy" decision facing a firm. In itsgeneric form, it has been studied in several settings, such as the manu facturing of partsin the automo bile industry [30, 40 ], the sales function in the electronic industry [1],the procurement of components or services in the naval shipbuilding industry [23],and the distribution of equipment, componcnis, and supplies across a broad set ofindustrial firms 116].

W ithin lhe IT profession, lhe term "ou tsourcin g" is often viewed as a buzzw ord thatis confusing and often misunde rstood [44]. W e define IT outsourcing as the significantcontribution by external vendors in the physical and/or human resources associatedwith the entire or specific componen ts of the IT infrastructure in the user organization.Th is definition is consisten t with the conc eptualiza tion of the IT infrastructure in term sof "the intemal organization of people and resources devoted to computer-basedsystems . . . [involving] both the tangible equipme nt, staff and applications and theintangible organization, methods and policies by which the organization maintains itsability to provide system services" [22 , p. 148].

In the context of IT sourcing, vendors may co ntribute comp uter assets for the u ser.Alternatively, the ownership of certain co mp uter assets of the user may be transferredto the v endor. Sim ilarly, vendors may utilize Iheir personnel to provide the requiredservices, or existing staff of the user may he employed by the vendor. In figure 1 w edepict the distinction between outsourcing and insourcing based on the two dimen-sions central to our definition: (1) the degree of intemalization of physical reso urcesby the user, and (2) the degree of intemal ization of human resources by lhe user. Byintemalization, we mean the ownership of the computer assets or the employment ofthe system pers onn el. Several m odes of the IT infrastructure have heen co mm onlyoutsourc ed by firms. These include applications deve lopm ent, data center, systemsintegration, systems design/planning, telecommunications/network, and timeshar-ing. The mod es of IT outsourcing vary through the different levels of contributionof physical and human resources by the user and the vendor. We also illustrate inthis figure the typical location of each mode of outsourcing in the definitionalframework.

The various mod es of IT outsourcing also differ in the domain of influence withinthe corporation. D omain of influence refers to the extent to which IT is inherent in thebusiness processes as well as the administrative and functional coordination of theorganization. For instance, an application development outsourcing arrangementordinarily affects a specific dom ain of the firm, while a telecomm unications/nelworkoutsourcing arrangement may affect a more general domain of the firm. Further, anoutsourcing arrangement differs in terms of the contractual mode (i.e., the type ofrelationship between lhe user and the vendor as governed by the agreement). Forexam ple, a systems design/planning outsourcing contract may be project-based, whilea data center operations outsourcing contract may be period-based. In figure 2 weshow the characteristics framework and illustrate the various mod es of IT outsourcing


4/19

10 L O H A N D V E N K A T R A M A N

H.gh

Intemalizationof HumanResources

Low

INSOURCING

OUTSOURCINGI D a t a II Center I I ApplicationI Development

Low Intemalizationot' Phys icalResources

H.gh

Figure L Outsourdng versus Tnsourcing

The Research M odelIN THIS PAPER, WE DEVELOP A MODEL of ihc determinants of IT outsourcing, with aparticular emphasis on economic constructs from both the business and the ITcon texls. Our framework is based on an argumen t that managem ent should con stantlyreassess the scope of those activities that should be carried o ut with a firm's hierarchyand those that are best performed by extemal partners, including IT vendors. Theguiding considerations for such make-versus-buy decisions include: relative costadvan tage, and econo mies of scale and sco pe. Thu s, it is likely that in som e cases, anIT vendor may be a more appropriate entity to manage Ihe firm's IT infrastructurethan th e firm itself. This is becau se an outsourcing vendor being a specialistserve smu ltiple users simultaneously. To the extent that the know ledge, skills, and capacitycan be pooled across different cu stom ers, there ean be benefits of econ om ies of sca le,which are otherw ise absent when single users perform the same tasks. In addition, thewide variety of IT projects undertaken by the vendors permits the reaping of econo-m ies of scope. The lower costs attributable to the vendor also arise from the enhancedIT com petence and experience, both of which are absolutely crucial in m anaging the


5/19

DETERMINANTS OF rr OUTSOURCING U

General

CorporateDomain

Specific

Syslcms rteiPlan II ing

Telecoms/Network

Systems Integration

Center

Applicat ion DevelopmentDataProcess pg

Project-Based Period-BasedCo n t r a c l u a l Mo d e

Figure 2. CharacterisUcs of Different IT O ulsourcing M odes

We follow Henderson and Venkalraman's [12] model of aligning business and ITdomains to derive ihe specific constructs of the research model. Thus, business andIT strategies are viewed as involving the dime nsions of competence and governance.Further, we posit that IT governance (specifically, outsourcing) is dependent on thestructural c haracteristics of the user organization, especially business competence,business governance, and IT competence. We elaborate our rationale below.

Business CompetenceBusiness Cost StructureA well-accepted axiom in the strategy and eco nom ics literature is that a firm *s businesscost structure (the entire spectrum of costs directly associated w ith tbe actual produ c-tion and coordination of the firm's product line) is a significant source of businesscompetence given its role in explaining business profitability (see, for instance, [5,32]). Th us, firms try to produce their output below the average cost and are constantlyunder pressure in a competitive marketplace to reduce the relative cost of business


6/19

12 LOH AND VENKATRAMAN

transforming inputs into outputs [33], the costs associated with a particular ITgov em anc e include the direct technology cost and the indirect cost of suppo rting theadministration of the enterprise. Thus , a firm in a situation of high relative cost willseriously consider the available options to reduce its business cost structure, includingreassessing the positioning of its IT infrastructure within the scope of the firm'shierarchy.

Therefore we hyp othesize that a firm's business cost structure is a crucial determ i-nant of IT outsourcing;

Hypothesis 1: The firm's b usiness cost structure will be positively related to thedegree of IT outsourcing.

Business PerformanceAnother component of business competence is reflected by the level of businessperforman ce. As noted in a trade periodical: "Red uced profits . . . are causing m an-agement to look everywhere to increase margins" [9 ,p. 89]. Under conditions of po orbusiness perform ance, firms often seek to streamline their operations, including sellingoff or redeploying assets [10]. The traditional view of IT operation s as an investmen tcenter or a service center is rapidly giving way to an emergent notion of a profit center.Th us, the IT infrastructure is no longer off limits to the top ma nagem ent team seekingsuperior performance. In fact, "much of what is fanning the fire f o r . . . outsourcing isthat business is having to restructure to remain com petitive" [9, p. 90] . When the firmdoes not perform well vis-5-vis its com petition, the need to reevaluate the traditionalgovemance modes of all its major spheres of operations, including the IT arenabecomes even greater. We thus seek to test:

Hypothesis 2: The firm's business performance will be negatively related to thedegree of IT outsourcing.

Business GovemanceFinancial LeverageThe need to reduce reliance on debt financing has been one of the key impetus tooutsou rce the IT infrastructure. Indeed, as widely cited amon g practitioners, increaseddebt "has been a major reason for cutting costs in the IS area, thus supporting the useof outsourcing" [9, p. 90]. Within the context of an imperfect corporate financingenvironm ent (see [28]), financial leverage can result in problems relating to financialdistress or bankruptcy [3] as well as agency [15] . Furthe r, the cost of equity capitalincreases with financial leverage [13].

Deb t and equity have been argued to be more than altema tive financial instmm ents:they are different business g ovem ance stm ctures [4 7]. Accord ingly, it is posited that


7/19


which the funds are used. Debt gov em ance is more appropriate for financing rede ploy-able assets, wh ile equity gov em ance is more suitable for nonredeploya ble a ssets. Du eto the complex and customized nature of systems, applicalions, and staff, the degreeof redeployability of an installed IT infrastracture may be limited. Th us, debt gov er-nance is not the optimal foim of business govemance. A high level of debt henceresults in a need to reduce the non-redeploya ble assets which then gives rise to a greaterlevel of IT outsou rcing. Thus we test

Hypothesis 3: The firm'sfinancial leverage will be positively related to the degreeof IT outsourcing.

I T C o m p e t e n c e

rr Cost StructureInvestment in IT has recently escalated, and its importance is nowhere less evidentthan in its dramatic increase from $55 billion to $190 billion in the econom y; in fact,IT accounts for about balf of most large firms' capital expenditures [18]. Due to theenormous outlay associated with the IT infrastructure, firms have found it necessaryto adopt a better cost control approach to IT . In line with this notion , IT must be treatedas a capital investment and not just an overhead of lhe firm. Firms have been plaguedby the astronom ic rise of IT expenditure in many specific IT areas that are necessaryto run the business. For instance, in the area of application development, a criticalproblem has been the control of the cost of internally conceived software [11].Consequen tly, corporations arc rationalizing iheir capital outlay on IT. Where possible,drastic restructuring of the traditional inhouse mode of IT govemance is undertaken totrim the high costs of IT infrastniciurc. As Weizerand Associates [42] put it: "Outsourcingcan free capital tied up in data center hardware and save operating costs."

An extrem ely attractive option available to firms is to outsource their IT infrastruc-ture to value-added ven dors who are m ore efficient in terms of manag ing and operatingthe IT. In three often-cited early cases of IT outsourcing, A merican Standard report-edly saved $2 million per year for its financial and payroll operations, Copperweldcut its systems bud get from $8 m illion to $4 million, and Foodm aker slashed its dataprocessing costs by 17 percent [36]. Other recent cases are Wab co and Am ericanUliram ar, which trimm ed iheir annual processing costs from $3 million to S1.8 million,and from $3 million to $1.5 million respectively [46]. W e thus seek to verify:

Hypo thesis 4: The firm's IT cost structure will be positively related to the degreeof IT outsourcing.

IT PerformanceWith the elevation o fthe role of ITIrom the "backroom " to lhe "frontline" of business


8/19


overall corporate profitability. The profit-oriented posture imposed on the IT infra-stmc ture puts intense pressure on the technology to result in tangible econom ic returns.W ith the escalating level of IT investments needed to support business in the contem -porary mark etplace, there is a need to reconfigure the IT infrastructure in ways thatmake it possible to ascertain the benefits in a clear manner [38]. As IT expenditurehas risen rapidly over the last decade [41], it is not surprising that mana gers arc m orestringent than ever before in assessing the productivity of their IT infrasmicture. T hu s,when economic profits fall in relation to IT investments, management faces animmense need to reevaluate the roleo f IT . As efficiency of organizing is tied intimatelyto the mode of govemance, it is natural that there is a greater shift from the usualinhou se manag emen t to extemal involvem ent. Indeed, it has been the view w ithin thepracticing and consulting IT communities that "outsourcing is a key strategy thatenable [companies t o ] . . . improve retum on equity" [31]. Therefore, we test:

Hypothesis 5 : The firm's IT performance will be negatively related to the degreeof IT outsourcing.

Figure 3 is a schematic representation of the research model w ith the five hypotheses.

MethodsSampleW E BEGAN WITH A SAMPLE FROM THE U S T of comp anies in a study of 200 m ajor U.S.corporations carried out by G2 Research, Inc., which provided data on their level ofIT outsourcing [24]. W e also required that the level of total IT expenditure be availablefor operationalizing some of our independen t constructs. Data availability across thesetwo variables limited our study sample to fifty-seven firms (see the appendix for thelist of companies). We collected corresponding data on the independent constructspertaining to each firm in our sample for the fiscal year 1989 from Standard an d P oo r'sCom pustat II and Lo tus' CD /Corporate on CD-R OM .' Th us, our data represents theuse of both primary and secondary source s. During discussions with the manage rs ofG2 Research, we ascertained that the data on outsourcing expend iture are an integralpart of their professional service to their clients. Our overall assessment is that theirmethod of data collection and verification meets the standards of our researchpurposes. Further, the integrity of the secondary data sources for the independentconstmcts is widely accepted within accounting, economics, and finance research.

O p e r a t i o n a l i z a t io nW e need to operationalize four key constructs. For the degree of outsourcing (Y), we


9/19

DETERMINANTS OF FT OUTSOURCING 15

Business Governance

Compelence

/ ^ \/ Business \1 Cost Structure KV yf Business \( Perfurmance YKzzy H2(-)

f Financial \1 Leverage 1

^^

ITCompetenceH3(+)

^ Î IT \ Î Outsourcing 1

IT GovernanceII5(-)

4 CosI Slructuro IV y1 IT \T Performance 1

Figure 3. The Research Frameworkthe level of IT outsourcing is normalized by firm size. The business cost structure (X{)was computed as lhe sum of the cost of goods sold and the selling, general, andadministrative expen ses, divided by net sales and total assets.^ Bu siness performance(X^) was capttuêd by retum of assets and earnings per share (fully diluted andexcluding extraordinary items), representing the economic efficiency of lhe entirebusiness as measured by its assets or equity. For financing leverage (X^), we look theratios of long-term debt as well as of total liabilities with shareholder equity.

Ope rationalization of constructs in the IT context is mo re difficult given the paucityof prior research. The m etric used lo evaluate lhe effectiveness of IT has evolved fromcode analytic (1970-78), through design analytic (1978-84) and function analytic(19 84-9 0), to thecurr ent business directed (1990-present) measures [37]. In short, thecriteria used are shifting from metrics thai focus on IT output to those that focus onthe economic outcomes of IT activities. Further, it has been argued that the econom icbenefit of information systems can be best evaluated bymeasurements pertaining tothe company's entire IT expenditure level, as opposed to the economic benefitsderived from individual systems [4]. Thus, for IT cost structure (X4), we used (he ratioof IT expenditure with both gross plant, property, and equipmen t (i.e., before depre -ciation) and net plant, property, and equipment (i.e., after deprecia tion), which is analog ousto the extent to which the physical infraslructure of lhe firm is represented by the ITinfrastructure. IT performance (X5) was measured by ncl income and sales divided by IT


10/19


In addition, we specified two control variables, one for business siz e (X^) and anotherfor industry (X^). The size variables included net sales and total assets, while binarydum my v ariables werc formed for service and industrial sectors.

AnalysisDue to the possibility of multicollinearity among our independent measures, weperfonned a factor analysis using the principal components method and a varimaxrotation to discem the factor pattem inherent in the data structure. This procedureensure s thai the independent constructs used for our subsequ ent regression are orthog-ona l. We obtained the corresponding s cores associated with a prespecificd set of thefour factors for the business context and tw o factors for the IT contex t. In our m ul tipleregression, we used the ratio of IT outsourcing expenditure to total assets as thedependent variable and the set of factor scores for the business and the IT contextsand the industry sector dumm y variable as the independent variables. The econ om etricspecification for our analysis is as follows:(1) r = po + piXi -

where e represents the random error.

ResultsDesc riptive S tatistics and Factor StructureT A B L E I SUMMARIZES THE MEANS AND STANDARD DE VUTIO NS for all the individualindicators, while Table 2 provides the matrix of zero-order correlations. In Table 3,we dep ict the results of factor an alysis for the business and IT contexts. W ith a varimaxrotation, four factors in the business context can be interpreted: (1) business perfor-ma nce; (2) business cost stmcture; (3) business size; and (4) financing leverage . Twofactors extracted for the IT context can be interpreted as: (1) IT cost stm cture, and (2)IT performance.

Test of HypothesesThe results of estimating equalion (1) are shown in Table 4. The overall model hasan F-valu e of 2.10 (p < 0.06), and explains abou t 24 percent of the varian ce, which isacceptable for an exploratory research and a limited num ber of indepen dent v ariables.In the business context, we accept HI since the coefficient for business cost s tructureis significant at the 0.05 level with the expected sign. In the IT con text, we accept H4and H 5 since the coefficients for IT cost stmcture and IT performance are significant


11/19


Table 1 Means and Slandard D eviations

DescriptionOutsourcing Expenditure/ Total AssetsCost of Goods Sold-nSelling, General, &Administrative Expenses/ SalesCost of Goods Sold+Selling, General, &Administrative Expenses/ Total AssetsLons-Term Debt/ Shareholders' EquitvTotal Liabilities/ Shareholders' EquitvReturn on AssetsEarnings per Share ($)IT Expenditure/ Gross Plant, Property, &EquipmentIT Expenditure/ Net Plant, Property, &EquipmentNet Income/ IT Expenditure

Sales/ IT ExpenditureTotal Assets ($ million)Sales ($ million)Service SectorIndustrial Sector

VariableOSTACSSA

CSTA

LDSETLSEREOAEAPSITGP

ITNP

N U TSAITASSESALESERVINDU

M e a n0.002578

0.8336

0.6754

0.47835.138

0.026673.0890.1355

0.1522

2.38556.91210009405

0.59650.4035

Std Dev0.0040850.1555

0.6706

1.9897.005

0.067655.257

0.1748

0.1738

7.298

44.81265009877

0.49500.4950

H3) relating to business performance and financial leverage in the business contextare not supported. Further, the two control variables did not emerge as significant.

DiscussionTHE EMPIRICAL RESULTS PROVIDE GENERAL SUPPORT for our research model. First,HI was accepted, which suggests that the business cost structure is a critical determi-nant of IT outsourcing. A high level of business cost structure m ay m otivate a firm toreview its overall cost structure reflected in its costs of physical infrastructure (suchas plant and equip ment), including its IT infrastructure. S uch restructuring m ay signalto the capital markets the strong comm itment of corporate managemen t to improve itsbusiness efficiency. Further, as IT pervades the entire value chain of the business, the


12/19

18

IoU

oi

u

UJ

UJ

SUJ

Very Close Paper- Refere It

Documents