How firms decide to insource or outsource

Say you’re about to diversity your business, or venture into something new. What is the best way to configure your value chain? What you will do in-house and what you will outsource? How you answer that question, it turns out, is an important determinant for the success of your business. In recent research associate management professor Glenn Hoetker looked at the factors affecting firms’ decisions about what to insource and what to outsource in the value chain.

Say you’re a multinational energy company looking to capitalize on the clean energy movement. Or you’re a corn farmer looking to expand your market beyond just feed grain. You decide to move into the bioethanol business, turning corn into fuel to be used as an additive or alternative to gasoline. But what is the best way to organize this new business of yours — how do you decide how you’ll configure your value chain, what you will do in-house and what you will outsource?

How you answer that question, it turns out, is an important determinant for the success of your business — in bioethanol or any other industry. So in recent research, Glenn Hoetker, an associate professor of management at the W. P. Carey School of Business, looked at the factors affecting firms’ decisions about what to insource and what to outsource in the value chain.

In a study published in late 2012 in the journal Organization Science, Hoetker and two co-authors analyzed existing U.S. bioethanol firms that entered the industry between 1978 and 2009. The authors consider the experience of “diversifying entrants” (firms moving into bioethanol production from other industries, such as farming or oil production) as well as “new entrants” (start-ups). They concentrate on the four main activities in the bioethanol value chain: feedstock (corn) procurement; technology development; marketing and distribution of ethanol; and marketing and distribution of the co-product (leftovers that are turned into corn mash and used as feed stock).

Hoetker and his coauthors studied the bioethanol industry, but there is no reason to believe that their findings aren’t applicable to any other industry as well, Hoetker says. The practical implications of the work are important: in improving the understanding of why successful firms make the decisions they do, Hoetker’s findings can be used by businesses to optimize their own value chains — in other words, to run a better business.

Insource or outsource?

“Some activities are harder to outsource than others,” Hoetker explains. Activities with high transaction hazards (risks) that persist — like corn price volatility, for example — are typically kept in-house. But when risk is transient — when it dissipates as the industry matures — then it becomes less of a determining factor in a firm’s decision to keep the activity in-house.

Hoetker explains, “For example, when an industry is young, buying machinery can be risky; what if the machinery becomes obsolete in just a few years? But over time, those risks go away — the industry settles on one type of equipment, for example. And as the risks dissipate, they become less of a factor in firms’ sourcing decisions.”

Prior experience with a given activity in the value chain makes the firm more likely to keep that activity in-house. For example, the energy company (a diversifying entrant) has experience in technology development, and the start-up headed by the former corn farmer (a new entrant) has experience in feedstock procurement. Either kind of experience with a given activity makes a firm far more likely to keep that activity in-house.

But that prior experience matters less the more mature the industry is. Hoetker says, “When an industry first is born, there is a lot of uncertainty, so if you have experience you’re really going to use it. But after 25 years, it’s not hard to hire a consultant, read the trade press, hire people who have worked in industry before — so whether you have experience or not is less of a determining factor in your decision to keep the activity in-house or outsource it.”

Experience also mitigates the effect of a risk. Hoetker explains, “If I'm a brand new firm looking to do technology development, for example, my decision to insource or outsource will be heavily impacted by how risky the activity is. On the other hand, if I have prior experience I will be swayed a lot less by hazards because I've lived through them before — I know how to deal with them.”

Start-ups are sexy, but existing companies matter too

Hoetker’s work improves understanding of why successful firms make the decisions they do, helping firms optimize their value chains. But his findings also carry potentially significant policy implications: Who should get the money that the government spends to support clean energy technologies? Often the thinking is that government funding should favor start-ups. After all, the guy in his garage is, theoretically at least, more agile and innovative than the stodgy, century-old oil company.

Hoetker says that perhaps that’s true, but those stodgy old companies have strengths that start-ups don’t. “Existing companies diversifying into new industries are more likely to succeed at turning technology into product,” he explains. “So there is a reason you might want to support both start-ups and existing companies.”

Hoetker says that when he began his study he figured that differences between start-ups and diversifying entrants would dissipate as the industry matured; but they haven’t. “In fact, the more mature an industry is, the more likely start-ups are to outsource all but one activity in the value chain. Where there are lots of good external options, they take them, because the start-up is really focused on doing their one activity really well.”

Start-ups are often good at doing their one activity really well — whether it’s the farmer who has figured an innovative way to mitigate the risks of corn price volatility or the petroleum engineer who developed a new technology for turning corn into ethanol — diversifying entrants are often good at tying the pieces of the value chain together. “And that’s a real advantage,” Hoetker says.

The bottom line message, Hoetker explains, is to know who you are, where your strengths lie, and make sourcing decisions accordingly.

First featured in the Spring 2013 W. P. Carey magazine