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Toward a model of strategic outsourcing

Tim R. Holcomb *, Michael A. Hitt 1

Texas A&M University, Mays Business School, Department of Management,

College Station, TX 77843-4221, United States

Available online 16 June 2006

Abstract

Acknowledging efficiency motives, firms have increasingly turned to outsourcing in an effort to capture cost savings.Transaction cost theory (TCT) has been the dominant means of explaining outsourcing as an economizing approach whereby

cost efficiencies are achieved by assigning transactions to different governance mechanisms. Recent research has used the resource-

based view (RBV) to examine the role of specialized capabilities as a potential source of value creation in relationships between

firms. Although research in supply chain management has expanded substantially, only limited applications of TCTand the RBVare

available, especially in the field of operations management. We extend both perspectives to explain conditions leading to strategic

outsourcing.

# 2006 Elsevier B.V. All rights reserved.

Keywords: Strategic outsourcing; Operations strategy; Resource-based view; Transaction cost theory; Resource management; Value creation;

Operations management; Supply chain management; Capabilities; Vertical disintegration; Intermediate markets

1. Introduction

Understanding how firms establish firm scope has

interested management scholars for some time, and a

body of research has explored the boundary conditions

firms consider when choosing to source activity from

the marketplace (e.g. Fine and Whitney, 1999; Gilley

and Rasheed, 2000; Quinn, 1999). In particular, this

research highlights the complex choices firms make

when deciding whether to internalize or outsource

production. On the one hand, internalization requires

firms to commit resources to a course of action, which

may limit strategic flexibility and be difficult to reverse

(Leiblein et al., 2002). On the other hand, internaliza-

tion may be required by firms to more effectively carry

out production. The complexity of these boundary

decisions has intensified in recent years stimulated by

increased competitive pressures, the rapidity of tech-

nological change, and the dispersion of knowledge

across different organizations and geographic markets

(Hoetker, 2005; Teece, 1992). Accordingly, a variety of

outsourcing arrangements has emerged. We rely on both

transaction-based and resource-based logics to explain

the emergence of one such arrangement strategic

outsourcing in which firms rely on intermediate markets

to provide specialized capabilities that supplement

existing capabilities used in production.

What determines firm scope? A well-developed

approach for boundary decisions associated with firm

scope is transaction cost theory (TCT). According to

this perspective, firms integrate production to minimize

costs from opportunism and bounded rationality of

www.elsevier.com/locate/jomJournal of Operations Management 25 (2007) 464481

* Corresponding author. Tel.: +1 979 845 4852;

fax: +1 979 845 9641.

E-mail addresses: tholcomb@mays.tamu.edu (T.R. Holcomb),

mhitt@mays.tamu.edu (M.A. Hitt).1 Tel.: +1 979 458 3393; fax: +1 979 845 9641.

0272-6963/$ see front matter # 2006 Elsevier B.V. All rights reserved.

doi:10.1016/j.jom.2006.05.003

mailto:tholcomb@mays.tamu.edumailto:mhitt@mays.tamu.eduhttp://dx.doi.org/10.1016/j.jom.2006.05.003http://dx.doi.org/10.1016/j.jom.2006.05.003mailto:mhitt@mays.tamu.edumailto:tholcomb@mays.tamu.edu

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firms and their suppliers, the uncertainty and frequency

of market exchange, and asset specificity that arises

from supplier-firm or firm-customer relationships

(Coase, 1937; Williamson, 1985). This theory holds

that certain types of governance mechanisms manage

exchanges with particular characteristics more effi-

ciently than others; cost economizing therefore reflectsa firms efforts to minimize costs arising from the

governance of market exchanges.2 Accordingly, the

decision to outsource often rests on economizing

motives related to the fit between firms governance

choices and specific attributes about an economic

exchange (Grover and Malhotra, 2003; Silverman et al.,

1997).

Recently, however, scholars have presented

resource-based perspectives of integration that augment

transaction-based views and sharpen the focus on firms

relative advantages (Combs and Ketchen, 1999;Leiblein and Miller, 2003; Poppo and Zenger, 1998).

This growing body of work, which is based on the

original work of Penrose (1959) and uses Barneys

(1991) more recent translation of the resource-based

view (RBV) of the firm, emphasizes the importance of

resources in guiding firm activity and the management

of a firms portfolio of capabilities as central to

competitive advantage.3 More specifically, this research

contends that the reasons for internalization extend

beyond the cost of transacting through the market to the

conditions that enable firms to establish, maintain, anduse capabilities more efficiently than markets can do

(Conner, 1991; Ghoshal and Moran, 1996; Teece et al.,

1997).

The resulting convergence between these two

theories has stimulated a number of empirical studies,

which has created a more effective understanding of

what drives strategic outsourcing. For example, in

recent years, transaction cost scholars have accepted

that transaction-based and resource-based perspectives

deal with partly overlapping phenomena, often incomplementary ways and that capability endowments

matter to boundary decisions (Williamson, 1999, p.

1098). Combs and Ketchen (1999) found evidence that

firms often place resource-based concerns ahead of

exchange economies when deciding on potential

interfirm cooperation. Complementary to this view,

Madhok (2002) pursued the question of how firms

should organize production given certain resource-

based conditions (e.g. pre-existing strengths and

weaknesses). He suggested that boundary decisions

depend not only on the conditions surrounding thetransaction, but also on capability attributes, and the

governance context that it creates. Thus, substantial

empirical support exists for the proposition that

capability considerations trade-off with economizing

constraints in the decision to outsource (e.g. Hoetker,

2005; Jacobides and Winter, 2005; Poppo and Zenger,

1998).

Our work contributes to this stream by extending

earlier conceptualizations of outsourcing based on

economizing conditions, such as asset specificity, small

numbers bargaining, and technological uncertainty, toinclude factors that influence the selection and

integration of capabilities from intermediate markets

(Argyres and Liebeskind, 1999; Jacobides and Winter,

2005). In particular, we consider the complementarity

of capabilities, strategic relatedness, relational cap-

ability-building mechanisms, and cooperative experi-

ence as four important conditions that establish a

resource-based context for strategic outsourcing.

According to this perspective, in the decision regarding

the strategic outsourcing of production, firms evaluate

internally accessed capabilities and those capabilities

available externally from intermediate markets, andconsider how they might best be integrated to produce

the greatest value.

Therefore, this work goes beyond the question of

governance mechanisms to enrich our understanding of

capability selection and use, providing a more mean-

ingful understanding of strategic outsourcing. Whereas

transaction-based perspectives typically confine out-

sourcing to more specialized, repetitive activities such

as manufacturing, logistics, and facilities management,

resource-based theory provides a context to explain

strategic outsourcing arrangements for more visible and

T.R. Holcomb, M.A. Hitt / Journal of Operations Management 25 (2007) 464481 465

2 There are multiple sources and aspects of transaction costs. Coase

(1937), for example, emphasized the frictional costs, such as those

costs that arise from negotiating, drafting, and monitoring contracts.

Williamson (1975, 1985) expanded this perspective by focusing

attention on the costs of transactional hazards (e.g. difficulties) and

governance mechanisms to limit such hazards. Whereas Williamson

focuses on the tendency of transaction difficulties to emerge as a

function of the exchange, Coases frictional costs are a feature of

economic conditions that occur independent of deliberate calculation

or motives (see also Jacobides and Winter, 2005).3 Resources, broadly defined, have often been used in the literature

in a generic sense to include capabilities (e.g. Barney, 1991). Other

scholars have claimed that capabilities represent how firms manage

resources (e.g. Dutta et al., 2005; Helfat and Peteraf, 2003) or that

capabilities represent a unique combination of resources that enable

firms to pursue specific actions that create value (Sirmon et al. in

press). For purposes of this paper, we use resources to represent

tangible or intangible assets owned or controlled by firms (Barney,

1991; Grant, 1996) and capabilities to represent organizational

routines that allow firms to effectively integrate and use resources

to implement their strategies (Lavie, 2006; Winter, 2003).

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potentially sensitive functions such as research and

development (R&D), engineering design, and customer

support. This trend is evident in the personal computer

(PC) and communications equipment sectors, where

growing demand for new product offerings has driven

the market for third-party R&D and design. As a result,

the volume of outsourced R&D, design, and manu-facturing services in these two sectors is expected to

grow almost two-fold between 2004 and 2009, from

$179 billion to $345.5 billion (Carbone, 2005).

Despite the dramatic increase in strategic out-

sourcing in recent years, few systematic studies of

strategic outsourcing have been completed (Gilley and

Rasheed, 2000). In fact, this topic has received only

limited exposure in the fields of healthcare management

(e.g. Billi et al., 2004; Roberts, 2001), economics (e.g.

Chen et al., 2004a; Shy and Stenbacka, 2003), and

strategic management (e.g. Fine and Whitney, 1999;Quinn, 1999; Quinn and Hilmer, 1994). Accordingly,

this work represents an early attempt to frame and

provide a theoretical understanding to the strategic

outsourcing concept in operations and supply chain

management research using both transaction-based and

resource-based logics.

This work follows Grover and Malhotras (2003)

call for more research by operations management

scholars that integrate strategic management and

organizational theory into the study of interfirm

relationships. In particular, our work contributes tothe stream of research synthesizing TCT and the RBV

by integrating them to extend earlier conceptualiza-

tions of outsourcing. We also make three important

contributions to the outsourcing literature. First, we

offer a more concise definition of strategic outsourcing

that extends transaction-based logics and considers

value created when firms more effectively leverage the

specialized capabilities these relationships provide.

Second, we explain how developing a capabilities

view better informs the discourse about the out-

sourcing choices that firms make. Prior work has

established a relationship between outsourcing andcost economies from the selection of more efficient

governance mechanisms (e.g. Cachon and Harker,

2002; Walker and Weber, 1984). However, to date,

there has been little understanding provided of the role

that internal and external capabilities play in strategic

outsourcing decisions. Herein, we shift the focus on

value creation from different exchange conditions to

value chain structures and to theprocess by which firms

produce goods and services. Thus, we provide

managers with a richer framework to understand the

trade-offs between internalization, past relationships

and experience, and capabilities that guide their

decision to internalize or outsource. Third, we high-

light the expanded role that boundaries serve in the

formation of strategic outsourcing relationships.

Establishing firm boundaries requires understanding

more than how internally- and externally-sourced

production activities affect performance (Araujo et al.,2003). It also requires a better understanding of the

bridging function that boundaries perform in linking

firms production activity with intermediate markets

(McEvily and Zaheer, 1999). Accordingly, we argue

that a more complete understanding of the organization

of economic activity requires a greater sensitivity to the

interdependence of capabilities, production activity,

and interfirm relations that emerge from boundary

decisions, as suggested by Coase (1988).

Fig. 1 summarizes our model for strategic out-

sourcing. This model depicts conditions for valuecreation integrated with economizing arguments for

strategic outsourcing. These theoretical arguments are

examined in the following sections. We begin with a

concise review of the literature and derive a more

complete definition of strategic outsourcing. Next,

transaction-based and resource-based arguments for

outsourcing are reviewed. Building on these two

perspectives, we present a model of strategic out-

sourcing that uses transaction- and capability-based

factors to examine a firms decision to outsource.

Finally, we discuss opportunities for future research.

2. Theoretical foundation

Whereas transaction-based perspectives explain

different governance mechanisms, resource-based

theory considers the relative capabilities of focal

firms and exchange partners as important in vertical

integration decisions (e.g. Afuah, 2001; Argyres,

1996). According to this view, firms are largely

heterogeneous in terms of their resources and

capabilities (e.g. Barney, 1991; Wernerfelt, 1984),

and thus often carry out the same activity withdifferent production efficiencies and costs. As a result,

separate firms that display different ways of accom-

plishing the same task achieve different cost effi-

ciencies and performance outcomes.

2.1. Strategic outsourcing defined

We define strategic outsourcing as the organizing

arrangement that emerges when firms rely on inter-

mediate markets to provide specialized capabilities that

supplement existing capabilities deployed along a

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firms value chain.4

Further, we suggest that strategicoutsourcing creates value within firms supply chains

beyond those achieved through cost economies. As

explained later, intermediate markets that provide

specialized capabilities emerge as different industry

conditions intensify the partitioning of production. As a

result of greater information standardization and

simplified coordination, clear administrative demarca-

tions emerge along a value chain (Jacobides, 2005).

Partitioning of intermediate markets occurs as the

coordination of production across a value chain is

simplified and as information becomes standardized,making it easier to transfer activities across boundaries

(Richardson, 1972). Accordingly, an orientation toward

strategic outsourcing evolves, as specialized capabil-

ities emerge, resulting in a greater dependence on

intermediate markets for production (Fine and Whitney,

1999; Quinn, 1999).

The decision to outsource existing production

represents the simplest form of strategic outsourcing.

Gilley and Rasheed (2000) refer to this organizing formas substitution-based outsourcing. With substitution,

firms discontinue internal production (e.g. the produc-

tion of goods or services) and replace existing activities

and/or factors of production (e.g. resources) with

capabilities provided by intermediate markets. Accord-

ingly, applying a capabilities perspective, we suggest

that firm scope is partly determined by considering the

performance differential between existing internal

capabilities and those available in intermediate markets

for substitution. By contrast, firms can also decide to

outsource production a priori. Gilley and Rasheed referto this form as abstention-based outsourcing, which

occurs when firms acquire capabilities from inter-

mediate markets, rather than incur the necessary

investments to internalize production. Thus, firm scope

is also determined by examining the differential

between the costs of internally developing new

capabilities against accessing these capabilities in

intermediate markets (Argyres, 1996; Langlois and

Robertson, 1995).

Research indicates that economizing firms often

consider the value of their capabilities in decisions

about internalizing an activity or conducting itthrough intermediate markets (e.g. Argyres, 1996;

Combs and Ketchen, 1999; Hoetker, 2005). Specifi-

cally, in deciding whether or not to internalize, firms

often compare their capabilities with those of other

firmsas signaled by the price and quality terms that

exchange partners are prepared to provide (Jacobides

and Winter, 2005). However, due in part to ambiguity

that emerges based on imperfections in the market,

boundedly rational agents are often unable to foresee

potential synergies from the integration of distinctive

capability combinations.

T.R. Holcomb, M.A. Hitt / Journal of Operations Management 25 (2007) 464481 467

Fig. 1. A theoretical model for strategic outsourcing.

4 Avaluechain, as definedherein, consists ofthe set of value-adding

activities within a supply chain that may be undertaken for a product

to be made or a service to be rendered. The concept of the value chain

was originally used to conceptualize the set of productive activities

that occur within the boundaries of any given firm, such as research

and development, engineering design, inbound/outbound logistics,

marketing, etc. (see Porter, 1985). Our definition of the term is

consistent with the general use (e.g. Porter, 1985) to mean a structured

set of activities associated with a firms productive output, regardless

of whether they take place within the boundaries of a single integrated

firm or occur externally using intermediate markets. Focusing on

distinct activities that firms perform provides an efficient way of

examining how boundaries change and how specialized capabilities

from intermediate markets can be leveraged to accommodate some or

all of the activities within a value chain.

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An important distinction introduced herein is how

resource-based logics influence the decision to strate-

gically outsource more effective specialized capabilities

along a value chain, beyond that which we know by

examining different governance mechanisms. More

effective capabilities can enable firms to increase

inventory turns, shorten product development cycles,and reduce the time-to-market for new products (Clark

and Fujimoto, 1992; Petersen et al., 2005). Stated

differently, we contend that strategic outsourcing not

only creates cost economies by shifting production

activity from a focal firm to intermediate markets, but

also creates economic value, especially when produc-

tion involves the use of potentially more valuable

specialized capabilities (Fine and Whitney, 1999;

Mowery et al., 1996). Argyres (1996) was one of the

first to provide qualitative evidence on the role of

capabilities in internalization decisions, observing thatcapabilities are a significant driver of firm scope in the

cable connector industry. When comparing transaction-

and firm-level influences on firm scope, Leiblein and

Miller (2003, p. 854) found that firm-level capabilities

independently and significantly influence firms

boundary decisions. Jacobides and Hitt (2005, p.

1222) examined how capability differences shape the

make-versus-buy decision concluding that, productive

capabilities can and do play a major role in the

determination of vertical scope, and account for mixed

governance modes.

2.2. Specialized capabilities and the emergence of

intermediate markets

A stream of research originally characterized as

vertical disintegration (Stigler, 1951) helps explain

strategic outsourcing by developing a capabilities

view (e.g. Langlois and Robertson, 1995; Leiblein and

Miller, 2003). According to this perspective, the

emergence of new intermediate markets is driven

largely by the desire of firms to pursue gains from the

trade of specialized production. Richardson (1972) wasone of the first to suggest that boundaries were

contingent on the different activities in which firms

engage, the capabilities such activities require, and the

selection and use of those capabilities along a value

chain. Jacobides (2005) examined conditions leading to

increased specialization. He explained the emergence of

new intermediate markets on the basis of gains from

intrafirm specialization that condition a market, divid-

ing previously integrated value chains among different

sets of specialized firms and shifting the focus on value

creation from the final market for goods or services to

the value chain structure and the process by which the

good or service is produced (2005, p. 490).

In the automobile sector, for example, advances in

engineering and production technologies have led

manufacturers to decouple supply chain capabilities

giving up parts of the value chain to newly formed

specialists in intermediate markets (Fine and Whitney,1999). Similar trends are evident in the PC and

communications sectors, with the emergence of electro-

nics manufacturing services (EMS) and original design

manufacturing (ODM) firms, such as Flextronics, Hon

Hai, Sanmina, and Compal Communications, and the

corresponding growth of original equipment manufac-

turersinthesesectorsthatonlymarket,butdonotdesignor

manufacture their own equipment. In the banking sector,

standardization and advances in information technology

led to significant specialization of production activities

such as application development and data processing,which enabled non-financialfirms such as IBM, EDS, and

Accenture to become key participants in the intermediate

market for information services. Accordingly, given

advances in technology and standardization, new inter-

mediate markets emerge, decomposing the value chain,

allowing firms to acquire valuable yet specialized

capabilities cost-effectively via the market. As a result,

firm boundaries shift as activities that were carried out

internally are transferred to newly formed intermediate

markets.We thereforearguethat strategicoutsourcing not

only allows firms to reducecosts, butalso to enhance theirportfolio of capabilities, and value creation potential,

especiallywhenfirmsproduceuniquecombinationsusing

capabilities provided by these markets.

We suggest that three assumptions underlie resource-

based views about strategic outsourcing. First, selection

determines gains available to firms from capabilities

accessed in the intermediate markets and then

intensifies the effect of these capabilities on firm

performance. Complementarity and relatedness creates

uniquely valuable synergy, especially when specialized

capabilities are effectively combined and when no other

combination can replicate the resulting value chainactivities (Harrison et al., 1991, 2001; Prahalad and

Bettis, 1986; Richardson, 1972; Tsai, 2000). To the

extent that intermediate markets have superior cap-

abilities that complement a firms existing capabilities,

selection processes will combine the specialized

internal and external capabilities. By contrast, if a firm

possesses superior capabilities that are already inte-

grated, selection will accommodate internalization.

Second, strategic outsourcing relationships form

within a social context. Ties, both direct and indirect,

with firms in intermediate markets create a network

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(Uzzi, 1997), and become an important source of

information about the reliability and performance of

current and future exchange partners (Granovetter,

1985). Such information helps a focal firm to learn

about capabilities available in intermediate markets.

Repeated ties improve trust in current and potential

exchange partners and increase the likelihood of futurecooperation (Gulati, 1995). Accordingly, cooperative

experience forges close bonds over time and increases

confidence that exchange partners will pursue mutually

compatible interests thereby reducing the probability of

opportunism (Das and Teng, 1998), and facilitating the

exchange of capabilities crucial for performance (Combs

and Ketchen, 1999; Uzzi, 1996). Because strategic

outsourcing involves coordinating the actions of two or

more firms, cooperative experience is vital to its success.

Third, firms enhance their ability to leverage

specialized capabilities by developing and refiningmechanisms that strengthen the synergies such cap-

abilities provide. We refer to these mechanisms as

relational capability-building mechanisms (Dyer and

Singh, 1998; Makadok, 2001), which allow firms to

enhance the potential value of specialized capabilities

deployed along a value chain. When purposefully

developed, relational capability-building mechanisms

allow firms to accumulate, integrate, and leverage

experience over time; they are derived from previous

capability-building actions, the results of those actions,

and the future actions firms pursue (Fiol and Lyles,1985). From a transaction-based perspective, these

mechanisms reduce coordination and integration costs

and enable firms to exploit new opportunities in the

market, especially when they develop the mechanisms

to more effectively manage the portfolio of capabilities

they acquire from intermediate markets. These mechan-

isms also create causal ambiguity, obscuring the use of

capabilities deployed across a value chain and making it

difficult for competitors to determine a priori the

sources of value within firms supply chains.

In sum, we contend that specialized capabilities

accessed by strategic outsourcing may allow firms toachieve greater performance gains. In the following two

subsections, we briefly describe several economic

incentives behind strategic outsourcing and contrast

this organizing arrangement with two related concepts:

strategic purchasing and strategic alliances.

2.3. Economic motives and incentives behind

strategic outsourcing

Although previous empirical studies of outsourcing

have produced equivocal results, there is increasing

evidence that certain economic motives may prompt a

firms decision to pursue this organizing form. We

provide three possible economic motives behind strategic

outsourcing. First, strategic outsourcing potentially

reduces bureaucratic complexity. As firms grow, infor-

mation asymmetries emerge (Hitt et al., 1996). Asym-

metries produce information deficits. Informationdeficits add to the administrative demands of organizing

transactions. Excessive bureaucratic costs associated

with governance oversight reduce firm performance

(DAveni and Ravenscraft, 1994; Rothaermel, Hitt and

Jobe,inpress). In turn, these demands distract managerial

attention from important sources of innovation and

growth and add to the costs of internalization (DAveni

and Ravenscraft, 1994). As transaction volumes increase,

mobility and exit barriers form reducing strategic

flexibility and often trapping firms in obsolescent tech-

nologies (Harrigan, 1985). Thus, strategic outsourcinghelps firms align competing priorities, focus manage-

ment attention on growth and innovation opportunities,

and target resources to those tasks firms do best.

Second, strategic outsourcing improves production

economies, especially when firms fail to achieve

sufficient production scale to overcome cost disadvan-

tages (Teece, 1980). Because decisions about price and

production are made before actual demand is observed,

as transaction volumes vary, firms may find it difficult to

make optimal use of available capacity or may ration

production when existing production scale limitsactivity (Green, 1986). Strategic outsourcing allows

firms to avoid or reduce rationing and meet production

requirements by relying on intermediate markets as

demand varies over time; it also provides a mechanism

for firms to reduce uncertainty, transfer risk, and share

scale economies with specialized firms from these

markets. As a result, overhead is reduced, production

costs decline, and investments in certain facilities and

equipment are eliminated, which in turn reduces firms

break-even points.

Based on the considerations noted above, financial

advantages evolve in three ways. First, firms pursuingstrategic outsourcing through substitution (Gilley and

Rasheed, 2000) benefit from financial capital (cash)

exchanged for internal factors of production (e.g.

facilities, equipment, management and production

personnel, etc.) when assets are transferred or sold to

firms in intermediate markets. The nature and size of

this financial capital-factor exchange often has sub-

stantial effects on the total value of strategic out-

sourcing deals. Second, with strategic outsourcing,

firms can reduce or eliminate longer-term capital

outlays to fund future investments related to the

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outsourced production. This allows firms to partly

shift specific internal costs, including fixed charges,

such as amortization and depreciation costs, to

intermediate markets. Finally, strategic outsourcing

can buffer firms by providing access to resources (Miner

et al., 1990). Thus, firms reduce their exposure as

capacity and costs are more directly linked to actualproduction output (e.g. the number of units produced).

This allows firms to transfer the risk of changes in

production as well as responsibility for future capital

outlays to intermediate markets.

Third, increases in bureaucratic complexity increase

the coordination costs associated with different factors

of production, especially when specialization reduces

the degrees of freedom (Rothaermel et al., in press).

Diminishing returns result when the loss of strategic

flexibility and the increase in administrative costs

outweigh the benefits of integration (Jones and Hill,1988). Accordingly, when increased specialization

simplifies coordination across a value chain (Jacobides,

2005), or when internal production is more efficient

through intermediate markets, firms are more likely to

integrate and use specialized capabilities.

2.4. Strategic outsourcing and related concepts

We draw a distinction between strategic outsourcing

and strategic purchasing. Strategic purchasing refers to

the ongoing process of soliciting, negotiating, andcontracting for the delivery of goods and services from

suppliers (Chen et al., 2004b; Murray and Kotabe,

1999). Key activities include procurement, supplier and

contract management, and other related supply chain

management actions (Salvador et al., 2002) that involve

arms-length transactions with suppliers (Chen and

Paulraj, 2004). Firms regularly purchase products or

services from suppliers on a frequent or recurring

basisfrom the procurement of production inputs to

the purchase of supplies for office and administrative

use (Walker and Weber, 1987). Accordingly, these

decisions tend to be more routine and rarely involve thetransfer of resources (Chen et al., 2004a). By contrast,

strategic outsourcing is less common, and may involve

the transfer or sale of resources to firms in intermediate

markets. Moreover, strategic outsourcing reflects a

primary relational view involving linkages with

exchange partners that provide access to specialized

capabilities. This relational view explains performance

gains that arise when these capabilities are configured

along the value chain to create value that cannot be

realized through internalization (Das and Teng, 1998;

Sirmon et al., in press). Equating strategic outsourcing

with the purchase of goods and services fails to capture

full nature of this organizing form.

We also differentiate strategic outsourcing from

strategic alliances. Strategic alliances represent colla-

borative arrangements that firms establish to achieve

common goals in which benefits are ultimately shared

by alliance partners (Inkpen, 2001). As such, inalliances, individual firm performance is a function

of both the total value generated by the alliance and the

share of this value each firm appropriates (Alvarez and

Barney, 2001; Hamel, 1991). Alliances also allow

partners to share risks and resources (Ireland et al.,

2002), to gain access to new knowledge (Dyer and

Singh, 1998), and to obtain access to new product

markets (Hitt et al., 2000). By contrast, strategic

outsourcing arrangements generally involve a focal

firms decision to deploy specialized capabilities along

its value chain thereby linking firm performancedirectly to the productive activities it controls. While

alliances infer joint decision-making and shared

residuals, strategic outsourcing primarily benefits firms

that originate the action (Insinga and Werle, 2000) by

allowing them to appropriate directly the residual value

such actions create. Accordingly, outsourcing decisions

are not based on appropriation logic per se, rather on

economic terms defined by a focal firm after consider-

ing the different cost/performance trade-offs.

3. Transaction-based arguments for strategicoutsourcing

Efficiency assumptions in TCT drive the classical

reasoning for strategic outsourcing. With this view,

difficulties that emerge from market-based exchanges

generate transaction costs. Such costs include negotia-

tion, contracting, monitoring, and enforcement costs, as

well as costs incurred when resolving disputes. Based

on this perspective, the performance implications of

outsourcing and thus the decision criteria firms apply

are based on the alignment of different governance

structures with attributes of the exchange and theunderlying contracting environment. For example, a

firm that selects a simple governance structure lacking

adequate safeguards and controls is exposed to moral

hazard and hold-up risks when the contracting

environment is complex or when it involves transac-

tion-specific investments (Leiblein et al., 2002). By

contrast, selecting an excessively complex governance

structure for a simple contracting environment unne-

cessarily intensifies bureaucratic complexity, which

reduces decision-making speed, decreases strategic

flexibility, and increases overall costs (Williamson,

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1985). Accordingly, cost economies as a consequence

of effective governance structures represent important

criteria in the decision to strategically outsource. We

briefly describe three transaction-based considerations

for strategic outsourcing: asset specificity, small

numbers bargaining, and technological uncertainty.

3.1. Asset specificity

Among the exchange conditions originally identi-

fied by Williamson (1975), asset specificity has been

perhaps the most robust empirically. Specific assets, in

contrast to general purpose assets, are considered an

obstacle to market efficiency, because they are costly

to redeploy to alternative uses (Williamson, 1991).

Thus, asset specificity is the principal factor giving

rise to transaction costs. Williamson (1985) defined

asset specificity as durable investments that are made

in support of particular exchange transactions.

Specific assets are investments made in specific,

non-marketable resources and reflect the degree to

which an asset can be redeployed to alternative uses

and by alternative users without sacrificing productive

value (Williamson, 1991, p. 281). Highly specific

supply chain assets, for example, might include

investments in facilities, equipment, personnel, and

firm- or process-specific training associated with the

production of goods or services that have little or no

use outside the exchange relationship (Grover and

Malhotra, 2003).With strategic outsourcing, one of the principal

challenges in deciding whether to make a specific

investment concerns the possibility that exchange

partners might act opportunistically. Asset specificity

creates a bilateral interdependency between the firms

(Carney, 1998; Jones, 1983). As such, conditions of

outsourcing often lead to one or more firms being

locked in and increasingly vulnerable. Trading

hazards created by the structure of the market exchange,

in turn, produce transactions costs. Diseconomies

related to weak incentives and monitoring costs emerge.Under these conditions, asset specificity exposes

outsourcing firms to potential opportunism, when

exchange partners advance their own self-interest.

Contracting in such situations is difficult, expensive,

and often counter-productive. Consequently, where

resource investments by focal firms are idiosyncratic to

an exchange relationship, interfirm cooperation is likely

to involve internalization. Thus, we propose that:

Proposition 1a. Requirements for firm-specific invest-

ments by a focal firm in exchange-specific assets

between the firm and specialized firms from intermedi-

ate markets negatively affect the likelihood a firm will

pursue strategic outsourcing.

Under certain conditions, however, asset specificity

may serve as a catalyst for interfirm cooperation. When

firms involved in outsourcing relationships are required

to invest collectively in the development of specificassets or new capabilities, such collaboration can form a

reciprocal interdependency that increases the level of

cooperation and reduces the incentive to engage in

opportunism. These conditions reduce the costs of using

capabilities from intermediate markets (Combs and

Ketchen, 1999; Teece, 1992). Accordingly, in contexts

that involve mutual investments in capabilities, colla-

boration may encourage mutual gain, even when such

investments result in exchange-specific assets, and thus

increase the likelihood a firm will pursue strategic

outsourcing. Thus, we propose that:

Proposition 1b. Requirements for collaborative invest-

ments in exchange-specific assets between a firm and

specialized firms from intermediate markets positively

affect the likelihood a firm will pursue strategic out-

sourcing.

3.2. Small numbers bargaining

TCT scholars also argue that small numbers

bargaining situations create market inefficiencies that

create higher switching costs and increase the like-lihood of opportunistic behavior (e.g. Klein et al., 1978;

Williamson, 1975). The possibility of opportunistic

behavior arises when the number of specialized firms in

intermediate markets is small, resulting in small

numbers bargaining (Williamson, 1975). Moreover,

the likelihood of opportunistic behavior is most severe

when focal firms are required to make significant

exchange-based investments because such investments

may be subject to hold-up by external partners (Klein

et al., 1978). Small numbers bargaining affects the

distribution of bargaining power in outsourcing

relationships. Bargaining power is defined as the abilityto influence the outcomes of negotiated relations

(Bacharach and Lawler, 1981; Schelling, 1956). Firms

with more bargaining power can obtain more favorable

outcomes. In this case, bargaining power is important

because it can lead specialized firms to act opportu-

nistically in order to gain an advantage in outsourcing

relationships. Thus, small numbers bargaining reduces

the likelihood firms will pursue outsourcing.

Moreover, when the degree of competitiveness

within intermediate markets is low (e.g. small number

of specialized firms), specialized firms acting oppor-

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tunistically may be less willing to share costs caused by

changes in production volume or design specifications,

thereby increasing transaction costs for a focal firm

(Walker and Weber, 1987). By contrast, the higher the

degree of competitiveness in an intermediate market,

the more likely that partners will collaborate to share

scale economies by leveraging adjustment costs acrosscustomers (Walker and Weber, 1984). Such economies

dampen opportunistic bargaining, reduce potential

transaction costs, and therefore provide a stronger

incentive for firms to outsource. Accordingly, the

greater the density of specialized firms, the lower a focal

firms exposure to small numbers bargaining, and the

more likely that strategic outsourcing will emerge.

Thus, we propose that:

Proposition 2. The number of specialized firms from

intermediate markets is positively related to the like-

lihood a firm will pursue strategic outsourcing.

3.3. Technological uncertainty

Technological uncertainty refers to unanticipated

changes in circumstances surrounding technology, i.e.,

new generations of technology that render existing

technology obsolete (Folta, 1998; Robertson and

Gatignon, 1998). Broadly defined, technology repre-

sents theoretical and practical knowledge, skills,

production and supply chain systems, and relatedartifacts that can be deployed along a firms value chain

to develop goods and services (Burgelman et al., 1996).

Changes in technology create new complexities for

structuring value chain activities, especially when new

knowledge is applied at a faster rate reducing the time

between innovations (Song and Montoya-Weiss, 2001).

In the presence of technological uncertainty, greater

resource commitments produce more exposure to

negative shocks. Thus, relative to arrangements that

provide on-demand access to capabilities through

intermediate markets, technological uncertainty may

serve as a disincentive to internalize because it oftenrequires greater resource commitments.

These conditions may prompt firms to pursue

strategic outsourcing to reduce their exposure to

unforeseen contingencies and to improve financial

and operational stability and predictability. Schoon-

hoven (1981, pp. 355356) found that destandardiza-

tion and decentralization of task execution had

positive effects on firm performance under conditions of

technological uncertainty. Harrigan (1985, 1986)

argued that increases in technological uncertainty

may lead firms to use less firm-specific resources. As

a consequence, internalization is likely to decrease in

the long-run, because strategic outsourcing allows firms

to partly transfer the risk of task variability to the

intermediate markets. Specialized firms in these

markets may be better able to achieve cost efficiencies

that are difficult for focal firms to achieve by balancing

task requirements across multiple customers. Astechnological uncertainty increases, internal economies

of specialization deteriorate in relation to the external

economies of specialized firms (Teece, 1980). As such,

strategic outsourcing not only can provide scale

economies during periods of technological uncertainty,

but may also act as a coping strategy helping to deal

with risk. From this perspective, strategic outsourcing

provides more predictable and orderly patterns of

exchange within and between firms.

However, at higher levels of technological uncer-

tainty, larger information deficits increase the likelihoodfor opportunism, making it costly to handle exchanges

through intermediate markets. These asymmetries

reduce the ability to foresee potential contingencies

that may occur in the future making it costly to write,

monitor, and enforce complete contracts (Grossman and

Hart, 1986). As a result, parties to such exchanges are

more likely to regularly renegotiate the terms of their

relationship, which increases the likelihood of oppor-

tunism. At increasingly higher levels of uncertainty,

greater information deficits emerge, reducing cost

economies and increasing the difficulty of interfirmcollaboration. Reductions in cost economies lead to

diminishing returns. At higher levels of technological

uncertainty, firms find it difficult to accurately predict a

priori the combination of possible events and outcomes

that are likely to emerge from production (March and

Simon, 1958). Thus, beyond a certain level of

technological uncertainty, we expect this relationship

to be negative. Specifically, we propose that:

Proposition 3. Technological uncertainty will have a

non-linear (inverse U-shaped) effect on the likelihood a

firm will pursue strategic outsourcing, with the slopepositive at low and moderate levels of technological

uncertainty but negative at high levels of technological

uncertainty.

3.4. Critique of transaction-based arguments for

strategic outsourcing

While providing a number of important insights

regarding the most efficient means to govern a

particular economic exchange (Grover and Malhotra,

2003), TCT generally involves a set of restrictive

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assumptions that ignore the potential influence of a

firms extant governance forms, its portfolio of

exchange transactions, and other firm-specific capabil-

ities on value created through value chain activities.

Thus, in equilibrium, TCT implies that all firms facing a

similar set of exchange conditions and transactional

attributes will reach similar conclusions regardingwhich activities to internalize and which activities to

outsource (Leiblein and Miller, 2003). However, this

proposition is untenable. Comparisons of internaliza-

tion decisions across firms in the same industry suggest

that the internalization decisions often differ dramati-

cally. For instance, while companies such as IBM and

Nokia have remained historically integrated, other

companies such as Dell, HP, Ericsson, and Motorola

outsource a variety of production functions ranging

from R&D and engineering design to manufacturing

and logistics. Moreover, variance in performance withinand between these two groups of firms suggests a more

complex set of factors affect the decision to outsource.

Thus, using economizing motives alone limits the

quality of discourse about the decision to outsource. In

the following section, we extend the conceptual

orientation of strategic outsourcing to consider

resource-based factors.

4. Resource-based arguments for strategic

outsourcing

Drawing on the RBV, we extend transaction-based

perspectives of strategic outsourcing by focusing

attention on the role of specialized capabilities obtained

through intermediate markets. This approach, however,

requires a refinement in the traditional role of

boundaries. In particular, while conventional

approaches to boundary conditions emphasize bound-

aries as an economizing buffer to environmental

contingencies (Araujo et al., 2003), boundaries also

act as a bridge to intermediate markets through

relationship ties formed by a focal firm. In other

words, boundaries integrate as well as separate a firmfrom its environment. In this work, we define bridging

as the process by which firms establish linkages with

intermediate markets, suggesting that new capabilities

may be obtained through relationships established

within and across a firms relationship network (e.g.

Burt, 1992; Granovetter, 1973). Herein, our focus is on

the specialized capabilities provided through these

relationships.

The ability to access new and potentially more

valuable capabilities is a critical driver of strategic

outsourcing because these actions can fundamentally

alter a firms capability endowments (Morrow et al.,

2005), making it easier to pursue new opportunities in

the market. We maintain that different conditions affect

the value of capabilities sourced from intermediate

markets. In particular, we briefly describe four resource-

based considerations for strategic outsourcing: com-

plementarity of capabilities, strategic relatedness,relational capability-building mechanisms, and coop-

erative experience.

4.1. Complementarity of capabilities

Beginning with Penrose (1959), strategy scholars

have proposed that firms enhance value chain perfor-

mance when they align with exchange partners in order

to access complementary capabilities (e.g. Harrison

et al., 1991; Rothaermel, 2001; Teece, 1986). Applied to

strategic outsourcing, this argument suggests that firmsseek ties with specialized firms that possess capabilities

beneficial to and needed by a focal firm. Such

capabilities may be required to replace existing

capabilities deployed along a value chain (e.g.

substitution-based outsourcing) or to fulfill a specific

need not currently available in a firm (e.g. abstention-

based outsourcing).

Capability complementarity reflects a situation in

which specialized capabilities enhance the value

creation potential of a focal firms own capability

endowments. Complementary capabilities are differ-ent, yet mutually supportive (Luo, 2002a; Hitt et al.,

2001). Richardson (1972) suggests that capabilities

are complementary when they represent different

phases of production and require in some way or

another to be coordinated in order to create

maximum value (Richardson, 1972, p. 889). Where

complementarities exist, the integration of internal

and external capabilities enhances the potential

performance gains firms realize, especially when

economies of scope in production increase their

market power (Mahoney and Pandian, 1992). When

complementary capabilities are idiosyncratic andindivisible, and thus not otherwise available in the

factor markets (Barney, 1986), strategic outsourcing

can provide access to them.

When complementary capabilities are linked

together, they are especially difficult for competitors

to duplicate because imitation not only requires

obtaining the capabilities from intermediate markets,

but also duplicating their deployment along a value

chain (Holcomb et al., 2006). Barney (1988) suggested

that acquiring firms gain above normal returns from

acquisitions only when private or uniquely valuable

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synergies can be realized. Private and uniquely valuable

synergy is created when information about the

combination is obscured from rivals and when no other

combination of firms could produce the same value.

Research suggests that firms participating in exchange

relationships that involve complementary capabilities

perform better than firms with relationships that areformed to achieve cost economies (Harrison et al.,

2001; Holcomb et al., 2006). Chung et al. (2000) also

found the likelihood of alliance formation was

positively related to the complementarity of investment

banks capabilities. Similarly, other research suggests

that firms consider the potential for complementarity an

important partner selection criterion (Hitt et al., 2000,

2004).

Different but complementary resources can help a

firm improve scale economies, enhance responsiveness

and innovative potential, and increase quality. Further-more, because complementary capabilities are gener-

ally relationship-specific (Dyer and Singh, 1998), the

value created may be unavailable to rivals through

alternative sources (e.g. private; Barney, 1988), which

may create a sustainable competitive advantage. Thus,

strategic outsourcing relationships are more important

to value-creating activities when these relationships

provide specialized capabilities that are complementary

to those currently held by a firm, especially when the

integration of those capabilities across a value chain

create private and uniquely valuable synergy. From theresource-based perspective, firm scope then is deter-

mined by the limits in specialization and the need to

maximize gains from the combination of complemen-

tary capabilities along a value chain.

By applying this logic, we argue that strategic

outsourcing is a likely alternative when benefits from

specialized capabilities accessed from intermediate

markets are based on complementarity. A complemen-

tarity perspective for strategic outsourcing suggests that

a firm will ally with partners in whom the greatest

complementarity exists between the firms capability

endowments and those held by partners in intermediatemarkets. Thus, we conclude that the complementarity of

capability endowments between a firm and its exchange

partners has a positive effect on the likelihood the firm

will pursue strategic outsourcing. Specifically, we

propose that:

Proposition 4. The extent of complementarity that

exists between a firms existing capability endowment

and capabilities available from intermediate markets

positively affects the likelihood a firm will pursue

strategic outsourcing.

4.2. Strategic relatedness

Strategic relatedness characterizes the degree to

which firms are strategically similar; it reflects the

extent to which firms produce similar goods and

services, serve similar markets, utilize similar produc-

tion and supply chain systems, or rely on similartechnologies. Relatedness provides a rationale for

capability-sharing between firms (Prahalad and Bettis,

1986; Rumelt, 1974; Tsai, 2000). We expand this view

of relatedness to include goal congruence and the

commonality of knowledge-sharing routines. A high

degree of relatedness between a firm and its exchange

partners implies that they share common goals and are

able to transfer knowledge between them more

effectively. Accordingly, strategic relatedness is an

important factor in a firms decision to pursue strategic

outsourcing.Goal congruence is the degree to which firms

operational, strategic, and performance objectives

overlap and/or reinforce one another. When firms

goals are not congruent, performance considered

satisfactory to a focal firm may not be satisfactory to

exchange partners and vice versa. Likewise, behavior

promoting the interests of a focal firm may not promote

the interests of those partners (Luo, 2002b). The

presence of congruent goals helps to resolve these

potential concerns. Despite the importance of goal

congruity for success in exchange relationships (Luo,2002a), evidence suggests a lack of goal congruity in

many such relationships. As profit-maximizing goals

are aligned, strategic outsourcing not only reduces

monitoring and enforcement costs associated with the

arrangement but also increases synergies as well. When

goals are aligned, specialized firms are more likely to

share common interests with a focal firm and thus be

more supportive of exploiting new opportunities, even if

such opportunities require these firms make additional

investments. These synergies enable firms with com-

mon goals to more quickly exploit competitive

imperfections observed in the market (Mahoney andPandian, 1992), and thus hold the potential to create

value beyond cost savings alone.

Goal congruency also reduces conflict and

encourages cooperative behavior (Parkhe, 1993). Thus,

firms with exchange partners that share congruent goals

find it easier to collaborate thereby enhancing the value

of these relationships. Moreover, congruent goals

improve the quality of relationships with exchange

partners, which reduce the probability of opportunism

(Granovetter, 1985; Uzzi, 1996). With the threat of

opportunism reduced, exchange partners may be more

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willing to make additional resources available. Finally,

congruent goals can reduce the need for formal

contractual arrangements (Dyer and Singh, 1998).

These informal agreements in turn promote adaptability

and reduce the need for formal governance mechanisms

(Uzzi, 1997). Thus, costs are reduced to the extent that

less monitoring and enforcement is required.By contrast, incongruent goals often lead to the

development of sub-goals, which exchange partners

may pursue at the expense of a focal firm (Williamson,

1975). Incongruent goals also impede cooperation, limit

the exchange of resources between exchange partners

(Luo, 2002a), and can lead to early termination of these

relationships. Furthermore, in the presence of incon-

gruent goals, the time and energy spent resolving

disputes detract from developing and implementing

innovative strategies and can prevent valuable strategies

from emerging. Incongruent goals therefore make itdifficult to leverage specialized capabilities accessed by

firms through strategic outsourcing. Thus, we argue that

goal congruency affects the likelihood a firm will

pursue capabilities from intermediate markets through

strategic outsourcing. Specifically, we propose that:

Proposition 5a. Goal congruency between a firm and

specialized firms from intermediate markets positively

affect the likelihood a firm will pursue strategic out-

sourcing.

A high degree of strategic relatedness also results

when focal firms and specialized firms share common or

similar knowledge-sharing routines (Dyer and Singh,

1998). We define knowledge-sharing routines as regular

patterns of interactions that permit the transfer,

assimilation, and integration of new knowledge (Grant,

1996). The advantage of such routines lies in the ability

to economize effort, which reduces coordination costs

and affords greater capacity for knowledge-sharing

between firms.

Common knowledge-sharing routines may emerge

as new intermediate markets are formed by increasing

specialization within an industry (Jacobides, 2005). Forexample, with the emergence of intermediate markets

specializing in information services, firms have

increasingly transferred in-house computing systems

resourcesi.e., programming and data center opera-

tions personnel, computer hardware, and enterprise

application software as well as software design and

programming processes and methodologiesto firms

in these markets (e.g. EDS, IBM, and Accenture) who

integrate and use these resources. As a result of these

transfers, focal firms commonly share routines with

their partners, which facilitates knowledge-sharing.

Further, because firms within an industry often share

common knowledge structures, the emergence of

vertically specialized markets in an industry increases

the likelihood they will share common knowledge-

sharing routines. Accordingly, the emergence of

intermediate markets increases the diffusion of knowl-

edge and thus increases the probability of strategicoutsourcing in an industry.

Various scholars have argued that interorganizational

learning is also critical to competitive success, noting

that firms partners are, in many cases, the most

important sources of new knowledge (Powell et al.,

1996; Von Hippel, 1988). Common knowledge-sharing

routines between a firm and its exchange partners

enable more efficient absorption and use of acquired

knowledge (Cohen and Levinthal, 1990). Absorptive

capacity includes relationship-specific capabilities,

such as knowledge-sharing routines, that arise whenfirms develop mutually specialized ways of exploiting

each others capabilities. Dyer and Singh (1998) define

partner-specific absorptive knowledge as a function of

(1) the extent to which firms develop overlapping

knowledge bases, and (2) the extent to which partners

develop routines that maximize the benefit of their

interactions. In sum, we conclude that effective

knowledge-sharing routines are crucial to the exploita-

tion of intermediate markets and thus affect the

likelihood firms will pursue strategic outsourcing.

Thus, we propose that:Proposition 5b. Commonality of knowledge-sharing

routines between a firm and specialized firms from

intermediate markets positively affects the likelihood

a firm will pursue strategic outsourcing.

4.3. Relational capability-building mechanisms

Evidence suggests that firm performance is affected

by its abilities to integrate, build, and reconfigure

resources. This process is referred to as dynamic

capabilities (Teece et al., 1997). According to Loasby(1998, p. 139), managing capabilities is itself a

capability; that is, firms develop capabilities over time

that help them develop and link productive capabilities

across a value chain. In particular, dynamic capabilities

have been used to explain why firms in the same industry

perform differently. For example, Helfat and Peteraf

(2003) suggest that dynamic capabilities are embedded

within firms and consist as a set of specific and

identifiable strategic and organizational routines. We

usethe work on the dynamic capabilities(e.g.Teece et al.,

1997; Helfat and Peteraf, 2003) to define relational

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capability-building mechanisms as routines that allow

firms to synthesize and leverage specialized capabilities

(Dyer and Singh, 1998; Makadok, 2001). Our view of

these mechanisms also complements recombinatory

(e.g. Galunic and Rodan, 1998; Grant, 1996; Kogut and

Zander, 1992) views of capabilities, which emphasize the

manipulation of competences residing within the firm.Accordingly, these mechanisms improve a firms ability

to accumulate, integrate, and leverage specialized

capabilities across a value chain, and affect its ability

to pursue new opportunities in the future.

Relational capability-building mechanisms also act as

a focal point for learning andleveragingexperiencesfrom

past capability-building actions, the results of those

actions, and the firms future actions (Fiol and Lyles,

1985). They represent a more systematic and routine

implementation of dedicated processes that support

production activity involving the use of specializedcapabilities. For example, Kale et al. (2002) found that

firms with a dedicated capability to manage interfirm

relationships generated substantially higher market value

than firms without such capability. Stated differently,

firmsthatsystematicallyinvestindevelopingtheabilityto

manage interfirm relationships consistently perform

better than others that choose not to make such

investments. Zollo and Singh (2004)found that dedicated

processesinwhichfirmsaccumulateandexplicitlycodify

acquisition experience significantly improved overall

acquisition performance by counteracting the coordina-tion problems that future contingencies create. Accord-

ingly, we expect investments in development of relational

capability-buildingmechanisms willreduce coordination

andintegration costs, andimprove the synergistic benefits

available through strategic outsourcing.

In sum, relational capability-building mechanisms

not only enable firms to generate greater value

(Mahoney and Pandian, 1992; Makadok, 2001), but

also create additional ambiguity that allow firms to

sustain certain advantages over time (Rumelt, 1984).

Under these conditions, we expect relational capability-

building mechanisms to directly affect the likelihoodfirms pursue strategic outsourcing. Accordingly, we

propose that:

Proposition 6. Relational capability-building mechan-

isms positively affect the likelihood a firm will pursue

strategic outsourcing.

4.4. Cooperative experience

Strategic outsourcing relationships are formed

within a social context that influences selection

decisions and the pattern of interfirm linkages that

emerge. We represent cooperative experience as

repeated ties, direct and indirect, formed with specia-

lized firms from intermediate markets. Repeated ties

with these firms create a pattern of relationships in

which focal firms can access information about the

reliability and performance of current and futurepartners (Granovetter, 1985; Uzzi, 1997). These ties

reduce information asymmetries, heighten awareness

about specialized capabilities and firms from inter-

mediate markets, and establish a basis for trust. In turn,

trust enhances the potential benefits of strategic

outsourcing by reducing the risk of adverse selection

and improving the level of collaboration once such

relationships are established. Herein, we define trust as

a firms confidence in the reliability of a specialized firm

to fulfill its obligations and act fairly when the

possibility for opportunism is present. Zaheer et al.(1998) found that organizational trust formed by

repeated market exchanges is an important driver of

interfirm relationships because it enhances overall

performance, decreases the complexity and costs of

negotiation processes, and reduces conflict. Examining

international joint ventures (IJVs), Luo (2002b) found

that cooperation had a linear effect on IJV performance,

especially at higher levels of contract term specificity

and contingency adaptability, which represents the

extent to which unanticipated contingencies are

accounted for and the guidelines for handling suchcontingencies are specified in a contract. We suggest

that a focal firms cooperative experience with

specialized firms reduces information asymmetry and

opportunistic behavior, and thus enhances the potential

benefits of strategic outsourcing. Accordingly, coop-

erative experience increases the likelihood that addi-

tional outsourcing arrangements will be pursued with

these firms in the future.

Whereas, according to the transaction-based view,

interfirm cooperation occurs only when the costs of

governing production can be minimized, the resource-

based perspective suggests that firms share capabilities inorder to stimulate growth (Combs and Ketchen, 1999).

As such, cooperation represents the willingness of a

partner firm to pursue mutually compatible interests . . .

ratherthan act opportunistically (Das andTeng, 1998, p.

492). Because market exchanges are embedded in a

social context, the governance of interfirm exchanges

involve more than contracts; they depend on the level of

cooperation between the firm and its partners (Luo,

2002b). For such relationally-governed exchanges, the

enforcement of obligations, promises, and expectations

involves social processes that promote norms of

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adaptation and information exchange. The significance

of cooperative experience is reflected in the paradox that

results: firms are expected to pursue strategies and

programs that best serve their interests; however,

interfirm relationships require simultaneous investment

and restraint in order for each party to gain maximum

value from the relationship (cf. Das and Teng, 1998).The pattern of cooperation that emerges when

intermediate markets form around specialized capabil-

ities (Jacobides, 2005; Richardson, 1972) encourages

firms to engage in repeated exchanges, especially as these

markets mature improving accessibility to specialized

capabilities. Repeated ties with specialized firms

improve trust and increase the likelihood of future

cooperation (Gulati, 1995). This pattern of connections

broadens the firms scope and also affects the nature of

ongoing capability development processes (Araujo et al.,

2003; Jacobides and Winter, 2005), i.e., the way in whicha firm shapes or improves its value chain over time.

Changes in capabilities then reshape intermediate

markets, allowing additional firms to participate. These

changes facilitate growth in the number of potential

suppliers but also increase the complexity of the selection

and coordination process. Cooperative experience

provides knowledge that helps in selecting and coordi-

nating specialized capabilities in which relationship ties

serve as a valuable conduit for rich information.

Previous cooperation, defined in terms of both the

length and quality of the exchange relationship, fostersa climate of trust, openness and confidence. Repeated

interactions or cycles of exchange between parties

strengthen their willingness to trust each other and to

expand the boundaries the relationship (Rousseau et al.,

1998). Over time, such relationships become integrated

into the social context that develops between firms,

which fosters knowledge-sharing, supports adaptability,

and deters opportunism. In so doing, the synergy from

exchange relationships is magnified. Specifically,

exchange relationships based on trust are more likely

to exploit market opportunities requiring access to

resources from exchange partners. Such relationshipsare more likely to result in collaborative efforts to

exploit emerging opportunities in the market. We

conclude that cooperative experience affects the like-

lihood firms will pursue strategic outsourcing. Thus, we

propose that:

Proposition 7. Cooperative experience between a firm

and specialized firms from intermediate markets,

defined by the length and the quality of previous rela-

tionships, positively affects the likelihood a focal firm

will pursue strategic outsourcing.

5. Discussion and conclusion

The dominant goal most often cited for strategic

outsourcing is cost efficiency. According to this

perspective, firms internalize value chain activity to

minimize costs from opportunism and bounded

rationality, the uncertainty of frequent marketexchanges, and specific assets that may arise from this

organizing arrangement. This rationale, in part, holds

that specific governance mechanisms used to manage

certain exchanges are more efficient and reflects the

view of firm boundaries as the point at which resource

owners relinquish control over access and use.

Accordingly, transaction-based perspectives develop

logic for strategic outsourcing on the basis of

economizing motives linking governance choices to

attributes of an exchange.

The restrictive assumptions offered by TCT suggestthat, in equilibrium, firms with similar exchange

conditions will make the same decisions about strategic

outsourcing. However, the arguments presented herein

show this proposition to be incomplete. Strategic

outsourcing enables firms to bridge boundaries and

access capabilities from intermediate markets that are

subsequently deployed along the value chain. Accord-

ing to the RBV, resource heterogeneity leads to

otherwise similar firms displaying significantly differ-

ent ways of accomplishing the same set of value chain

activities, emboldened by the use of different capabil-ities. We argued that by linking value chain activities

with intermediate markets for the purpose of gaining

access to valuable specialized capabilities, firms can

accrue value beyond the cost economies available

through more efficient governance mechanisms. Thus,

we augmented transaction-based arguments with

resource-based perspectives to sharpen the focus on

conditions that might favor the use of specialized

capabilities.

The purpose of this work has been to extend our

understanding of strategic outsourcing by integrating

transaction-based and resource-based logics. First, weoffered a more concise definition of strategic out-

sourcing and extended the focus on cost economies

resulting from more efficient governance mechanisms

to consider value that is created when firms more

effectively leverage the specialized capabilities that

outsourcing relationships provide. An important dis-

tinction introduced herein is how firms understanding

of their capabilities and those of specialized firms affect

their decision to strategically outsource. We also

showed how the emergence of new intermediate

markets (e.g. vertical disintegration; Jacobides, 2005;

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Richardson, 1972) provides a theoretical framework

explaining the logic for a capabilities view of strategic

outsourcing. In particular, we shift the focus on value

creation from different exchange conditions to value

chain structures and to the process by which firms

produce goods and services. Accordingly, intermediate

markets that maintain specialized capabilities emerge asconditions within an industry intensify the partitioning

of production activity. As a result, boundaries shift to

accommodate access to specialized capabilities that are

then deployed along a firms value chain.

Second, we extended the view of boundaries as

providing a bridge between firms and intermediate

markets (Araujo et al., 2003) to explain how value chain

linkages are enabled through strategic outsourcing. On

the one hand, boundaries provide a space for the

development of valuable and difficult-to-imitate cap-

abilities within the firmthe buffering function. On theother hand, boundaries provide a bridge to access

specialized capabilities outside the control of the firm.

While TCT generally establishes firm boundaries on the

basis of anticipated efficiencies, our extended model of

strategic outsourcing accommodates a view of bound-

aries in which firms join with exchange partners to

create synergies they cannot realize alone.

This extended model of strategic outsourcing

suggests several research questions worthy of further

investigation. First, we still know very little about the

process by which specialized capabilities are deployedand integrated along a value chain. For example, how do

firms integrate specialized capabilities along the value

chain? What performance measures best reflect

synergies created by the use of specialized capabilities

across the value chain? Although exchange transactions

through the market can often be economized, value

derived from strategic outsourcing lies more in the

combinative value of specialized capabilities available

through intermediate markets. Thus, scholars should

closely examine the underlying processes involved with

integration and measurement of specialized capabilities

along a value chain.Second, our understanding of the sources of value

creation is limited. Do focal firms pursuing outsourcing

benefit more by selecting valuable capabilities from

intermediate markets or by more effectively integrating

these capabilities in difficult-to-imitate ways? Using our

model of strategic outsourcing, for example, scholars

can evaluate Makadoks (2001) assertions regarding

synergies from the two main sources of rent genera-

tionresource-picking and capability-building

within a strategic outsourcing context. According to

this perspective, specialized capabilities affect firm

performance by enhancing the productivity of other

capabilities that firms possess.

Finally, as strategic outsourcing arrangements con-

tinue to expand in scope and complexity, scholars

should more closely examine specific attributes of

outsourcing deals, especially when such deals involve

the divestment of assets by a focal firm as part of theexchange. In some cases, these arrangements involve

the exchange of substantial financial considerations for

assets controlled by a focal firm. Where is value created

(and lost) by focal firms and intermediate markets? How

do financial considerations affect focal firms decision

to outsource? What are the implementation challenges?

How do investors view these arrangements? Thus,

research that provides a more comprehensive view of

strategic outsourcing deals and anticipates aggregate

economic considerations is needed.

The value-creating potential of the firm is at the heartof the theory of the firm. Adopting a model of strategic

outsourcing can help scholars and practitioners to

understand the strategic, operational, and financial

motivations and incentives behind this organizing

arrangement. If outsourcing is pursued strategically,

firms can achieve above normal returns. Examining the

different conditions in which value creation occurs can

extend managements view of strategic outsourcing and

provide a new paradigm for supply chain practitioners

to demonstrate the practical benefits of strategic

outsourcing.

Acknowledgements

We thank David Ketchen, Tomas Hult, and the two

anonymous reviewers for their helpful suggestions. We

also benefited from valuable comments and suggestions

by Sharon Alvarez, Lorraine Eden, and Michael Holmes

on earlier drafts of this article.

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