Outsourcing: Should you use suppliers or do it in-house?

Why your firm should combine both approaches for better results

Esade Entrepreneurship Institute

This article is based on research by George Chondrakis

Executives must frequently decide whether to outsource to suppliers or do things in-house. Esade Assistant Professor George Chondrakis has published evidence that suggests that executives should stop viewing this dilemma as a black-or-white decision.

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George Chondrakis: Economic theories tend to look at the in-house versus outsourcing dilemma as a binary relationship. If the cost of outsourcing is high, firms tend to do things in-house whereas if the cost of using external suppliers is low they tend to outsource more. Our research studies cases in which this relationship is actually not binary...

Why not?

For instance, if your company makes phones and you need a particular component, the standard theories would suggest that, if you have a competitive advantage over the market, then you should do it in-house. If you don't, or if the cost of using an external supplier is low, then you should outsource. So according to these theories, it's either one or the other.

Our findings question this black-or-white approach and reveal that, in practice, many firms actually use both options and exhibit important differences in designing their sourcing strategies.

If the cost of outsourcing is high, firms tend to do things in-house

What advice would you give to managers who are pondering whether to do something in-house or outsource?

There are many potential answers, but our research suggests that one idea to consider is what we call plural sourcing – that is, using in-house and external suppliers at the same time.

Using both options is not always applicable, and sometimes it won't be possible, but managers should stop thinking about this relationship in terms of in-house versus outsourcing. They should be thinking that under certain conditions there are benefits to using both options.

What type of benefits?

One of the main benefits of using in-house and external suppliers simultaneously is that it allows companies to better manage uncertainty. If you don't know what your needs are going to be in the future, combining both approaches can help you balance your resources more effectively.

Combining in-house and outsourcing helps firms to negotiate better

For instance, we analysed companies that filed patents frequently. Some months a company might need 20 lawyers, whereas other months it would only need 10 lawyers or fewer. As a manager, the last thing you want is to hire 20 lawyers and then have half of them sitting around with their arms crossed.

Another reason why firms combine in-house and outsourcing is that it helps them to negotiate better.

Let's say you're negotiating with a supplier how much they would charge you for a given product or service. If you have an in-house department, the supplier knows you can do it without their help. Therefore, you have more leverage to negotiate better conditions. You also gain more leverage by having a better understanding of the product or process being outsourced. This will help you avoid being 'outsmarted' during negotiations.

Using in-house and external suppliers simultaneously helps companies to negotiate better

How do firms choose how much to do in-house and how much to outsource?

This was the primary focus of our study. Some firms may do 50% in-house and outsource the other 50%, while others may do 80% in-house and outsource 20%, or vice versa. We show that this relative balance is based on the relationships firms develop with their suppliers.

What type of relationships?

The type of supplier your company has is a strong predictor of how much you will do in-house and how much you will outsource. We find that some firms have stronger relationships with their suppliers (what we call relational suppliers) while others have weaker relationships (what we call contractual suppliers).

When firms have weaker relationships with their suppliers, they tend to do more tasks in-house and outsource less. This is because working with such suppliers is comparatively costlier, so the in-house department becomes a more attractive option.

However, when companies use fewer suppliers, over time they tend to develop stronger relationships with them. The fact that you're working with fewer people makes these relationships stronger. They outsource more because it's easier to work with them, they build trust, and they reduce the costs of contracting because they have established standardised interfaces, billing systems and so on.

We also found that such benefits are even more pronounced when the suppliers are able to offer a diverse range of services. They can act as one-stop shops as their clients' needs change over time.

When firms have weaker relationships with their suppliers, they tend to do more tasks in-house and outsource less

How can managers choose what's best for them?

Depending on the relationship you want to develop with your suppliers, you might want to decide how much in-house investment you want to do versus outsourcing. If you prefer to work on a relational basis with your suppliers, it may make sense to increase your percentage of outsourcing and reduce your in-house workload.

But if, as a firm, you want to avoid being stuck with the same supplier, then you may want to consider having a stronger in-house department and approaching your suppliers in a more aggressive way in order to have more leverage for negotiation. Ultimately, there is a trade-off between developing strong relationships with your suppliers and maintaining flexibility in choosing them.

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