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WORKING PAPER
ALFRED P. SLOAN SCHOOL OF MANAGEMENT



DETERMINANTS OF INFORMATION TECHNOLOGY
OUTSOLUCING: A CROSS-SECTIONAL ANALYSIS



Lawrence Loh

and
N. Venkatraman



Working Paper No. 3382-92BPS



February 1992



MASSACHUSETTS

INSTITUTE OF TECHNOLOGY

50 MEMORIAL DRIVE

CAMBRIDGE, MASSACHUSETTS 02139



DETERMINANTS OF INFORMATION TECHNOLOGY
OUTSOURCING: A CROSS-SECTIONAL ANALYSIS



Lawrence Loh

and
N. Venkatraman



Working Paper No. 3382-92BPS February 1992



M.I.T. LIBRARIES

FEB 2 1 1992

RFCc.vcL)



Determinants of Information Technology Outsourcing:
A Cross-Sectional Analysis



Lawrence Loh

Massachusetts Institute of Technology

and

National University of Singapore



N. Venkatraman

Massachusetts Institute of Technology



August 1991
Final Version: January 1992



Authors are listed alphabetically. Please address all correspondence to Professor N.
Venkatraman at Sloan School of Management, Massachusetts Institute of Technology, 50
Memorial Drive E52-537, Cambridge, MA 02139; Phone: (617) 253-5044; Bitnet: NVENKATR
@ SLOAN. This project was supported by the research consortium on Managing
Information Technology in the Next Era (MITNE) of the Center for Information Systems
Research (CISR) at the Massachusetts Institute of Technology. We thank John Rockart,
Judith Quillard, three journal reviewers, and the editor for comments on earlier versions of
the paper.



Forthcoming in the Journal of Management Information Systems



Determinants of IT Outsourctni;



Determinants of Information Technology Outsourcing:
A Cross-Sectional Analysis

Abstract

This paper develops and tests a model of the determinants of information
technology (IT) outsourcing by integrating both business and IT perspectives.
Specifically, we attempt to explain the degree of IT outsourcing using business and
IT competences as represented by their cost structures and economic performances.
Additionally, we posit that outsourcing is dependent on business governance,
particularly financial leverage. Based on factor analyses and multiple regressions
using data from 55 major U.S. corporations, we observed that the degree of IT
outsourcing is positively related to both business and IT cost structures. We also
established that the degree of IT outsourcing is negatively related to IT performance.
Finally, we conclude with implications and future research directions.



Keywords: Information technology outsourcing; information technology strategy.



Deicrmir.ar.ts o^ IT Outsouran^



Introduction

It is a truism that information technology (IT) has transcended its estabUshed
administrative support function and has moved toward playing a more central role
of business operations (see for instance, [14, 18, 25, 35]). Within this tradition,
research efforts have focused on the use of IT to influence the boundaries of a firm
with its suppliers, buyers and other intermediaries [6, 8, 21]. There is, however, a
glaring lack of research emphasis on the role of IT infrastructure as a component of
the firm boundary itself. In other words, while IT has been considered a critical
mechanism of multi-organizational business relationships, the research stream has
treated the governance of IT infrastructure to be within one single firm's hierarchy.
Such an approach fails to recognize the recent trend towards managing a firm's IT
infrastructure through a variety of governance mechanisms with other firms.

Under contractual arrangements popularly termed as 'outsourcing,' firms are
increasingly shifting specific components of their IT infrastructure away from a
'hierarchical' mode toward a 'market' mode of governance. The well-publicized
decision by Eastman Kodak to hand over its entire data center to IBM, its
microcomputer operations to Businessland, and its telecommunications and data
networks to Digital Equipment Corporation and IBM is a classic illustration [43, 45].
Beside this particular case, it appears that IT outsourcing is becoming a serious
strategic option for many firms. The Yankee Group estimated that all Fortune 500
firms would evaluate outsourcing, and a fifth of them would sign outsourcing deals
during the 1990s and that the outsourcing market would increase from $29 billion in
1990 to $49.5 billion in 1994 [7].

IT outsourcing can be dependent on several factors across multiple levels. At
the level of the economy, the temporal effects of trends and cycles may motivate
firms to rationalize the management of the IT infrastructure through arrangements
like outsourcing. At an industry level, competitive pressures may induce firms to



Determinants of IT Outsourcing



establish 'partnership-based' relationships with key IT vendors. At the firm level,
the quest for competitive advantage may serve as a critical impetus to the IT
outsourcing decision. Within the firm, the decision to outsource may be dependent
on several managerial factors. For instance, managers may like to build empires by
accumulating control over corporate resources [27] such as the IT infrastructure.
Further, the association of information with power [17] may inhibit the outsourcing
decision.

The practice of IT outsourcing has been extensively documented in the
business periodicals, but there is scant attention provided to articulate its
determinants. In other words, we know the phenomenon in some detail but we do
not fully grasp the set of factors leading to the outsourcing decision. Our objective in
this paper is to develop a research model on the determinants of IT outsourcing. We
recognize the complex array of factors discussed above; but as a first attempt at
establishing an empirical model, we focus on factors at the firm-level with
appropriate controls for industry sector effects.

Frameworks of IT Outsourcing

Outsourcing can be framed as a 'make-versus-buy' decision facing a firm. In
its generic form, it has been studied in several settings such as: the manufacturing of
parts in the automobile 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, components, and supplies across a broad set
of industrial firms [16].

Within the IT profession, the term "outsourcing" is often viewed as a
buzzword that is confusing and often misunderstood [44]. We define IT outsourcing
as the significant contribution by external vendors in the physical and/or human
resources associated with the entire or specific components of the IT infrastructure



D€tcrrjnKi2Kt> of IT Outsourcing



in the user organization. This definition is consistent with the conceptualization of
the IT infrastructure in terms of "the internal organization of people and resources
devoted to computer-based systems... [involving]... both the tangible equipment,
staff and applications and the intangible organization, methods and policies by
u^hich the organization maintains its ability to provide system services" [22, p. 148].
In the context of IT sourcing, vendors may contribute computer assets for the
user. Alternatively, the ownership of certain computer assets of the user may be
transferred to the vendor. Similarly, vendors may utilize their personnel to provide
the required services, or existing staff of the user may be employed by the vendor. In
Figure 1, we depict the distinction between outsourcing and insourcing based on the
two dimensions central to our definition: (1) the degree of internalization of
physical resources by the user; (2) the degree of internalization of human resources
by the user. By internalization, we mean the ownership of the computer assets or
the employment of the system personnel. Several modes of the IT infrastructure
have been commonly outsourced by firms. These include applications
development, data center, systems integration, systems design/planning,
telecommunications /network, and timesharing. The modes of IT outsourcing vary
through the different levels of contribution of physical and human resources by the
user and the vendor. In Figure 1, we also illustrate the typical location of each mode
of outsourcing in the definitional framework.



Insert Figure 1 here



The various modes of IT outsourcing also differ in the domain of influence
within the corporation. Domain of influence refers to the extent in which IT is
inherent in the business processes as well as the administrative and functional
coordination of the organization. For instance, an application development



Determinants of IT Outsourcing;;



outsourcing arrangement ordinarily affects a specific domain of the firm, while a
telecommunications /network outsourcing arrangement may affect a more general
domain of the firm. Further, an outsourcing arrangement differs in terms of the
contractual mode (i.e., the type of relationship between the user and the vendor as
governed by the agreement). For example, a systems design/planning outsourcing
contract may be project-based, while a data center operations outsourcing contract
may be period-based. In Figure 2, we show the characteristics framework and
illustrate the various modes of IT outsourcing along the two above dimensions.

Insert Figure 2 here

TJie Research Model

In this paper, we develop a model of the determinants of IT outsourcing, with
a particular emphasis on economic constructs from both the business and the IT
contexts. Our framework is based on an argument that management should
constantly reassess the scope of those activities that should be carried out with a
firm's hierarchy and those that are best performed by external parmers including IT
vendors. The guiding considerations for such make-versus-buy decisions include:
relative cost advantage, economies of scale and scope. Thus, it is likely that in some
cases, an IT vendor may be a more appropriate entity to manage the firm's IT
infrastructure than the firm itself. This is because an outsourcing vendor — being a
specialist ~ serves multiple users simultaneously. To the extent that the knowledge,
skills, and capacity can be pooled across different customers, there can be benefits of
economies of scale, which are otherwise absent when single users perform the same
tasks. In addition, the wide variety of IT projects undertaken by the vendors permits
the reaping of economies of scope. The lower costs attributable to the vendor also
arise from the enhanced IT competence and experience, both of which are absolutely



Dt'tcryntnants of IT Outuiurcin>^



crucial in managing the IT infrastructure in the complex and rapidly changing
information era.

We follow Henderson and Venkatraman's [12] model of aligning business
and IT domains to derive the specific constructs of the research model. Thus
business and IT strategies are viewed as involving the dimensions of competence and
governance. Thus, we posit that IT governance (specifically, outsourcing) is
dependent on the structural characteristics of the user organization, especially
business competence, business governance, and IT competence. We elaborate our
rationale below.
Business Competence

Business Cost Structure. A well-accepted axiom in the strategy and
economics literature is that a firm's business cost structure (the entire spectrum of
costs directly associated with the actual production and coordination of the firm's
product line) is a significant source of business competence given its role in
explaining business profitability (see for instance, [5, 32]). Thus, firms try to produce
their output below the average cost and are constantly under pressure in a
competitive marketplace to reduce the relative cost of business operations. Given
the ubiquitous nature of IT that pervades the entire process of transforming inputs
into outputs [33], the costs associated with a particular IT governance include the
direct technology cost and the indirect cost of supporting the administration of the
enterprise. Thus, a firm in a situation of high relative cost will seriously consider
the available options to reduce its business cost structure including reassessing the
positioning of its IT infrastructure within the scope of the firm's hierarchy.

Therefore we hypothesize that a firm's business cost structure is a crucial
determinant of IT outsourcing:

Hypothesis 1: The firm's business cost structure will be positively related to the
degree of IT outsourcing.



Determinants oHT Outsourcing^



Business Performance. Another component of business competence is
reflected by the level of business performance. As noted in a trade periodical:
"Reduced profits. ..are causing management to look everywhere to increase
margins" [9, p. 89] Under conditions of poor business performance, firms often seek
to streamline their operations, including selling-off or redeploying assets [10]. The
traditional view of IT operations as an investment center or a service center is
rapidly giving way to an emergent notion of a profit center. Thus, the IT
infrastructure is no longer off-limits to the top management team seeking superior
performance. In fact, "much of what is fanning the fire for... outsourcing is that
business is having to restructure to remain competitive" [9, p. 90]. When the firm
does not perform well vis-a-vis its competition, the need to re-evaluate the
traditional governance modes of all its major spheres of operations, including the IT
arena becomes even greater. We thus seek to test:

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

Business Governance

Financial Leverage. The need to reduce reliance on debt financing has been
one of the key impetus to outsource the IT infrastructure. Indeed, as widely cited
amongst practitioners, increased debt "has been a major reason for cutting costs in
the IS area, thus supporting the use of outsourcing...." [9, p. 90]. Within the context
of an imperfect corporate financing environment (cf. [28]), financial leverage can
result in problems relating to financial distress or bankruptcy [3] as well as agency
[15]. Further, the cost of equity capital increases with financial leverage [13].

Debt and equity have been argued to be more than alternative financial
instruments: they are different business governance structures [47]. Accordingly, it is
posited that the choice between debt and equity depends on the characteristics of the
assets in which the funds are used. Debt governance is more appropriate for



Determinants of IT Out?ourdn


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