the impact of outsourcing on the transaction costs and boundaries of manufacturing

Int. J. Production Economics 88 (2004) 61–71

The impact of outsourcing on the transaction costs andboundaries of manufacturing

Ian McCarthya,*, Angela Anagnostoub

aSFU Business, Management of Technology, Simon Fraser University, 515 West Hastings Street,

Vancouver, BC V6B 5K3, CanadabBrasenose College, University of Oxford, Oxford, UK

Received 15 April 2003; accepted 16 May 2003

Abstract

This paper discusses the concept of outsourcing, along with an account of the economic benefits that are achieved by

reconfiguring the organization and reducing the transaction costs of providing products and services. With the practice

of outsourcing experiencing exceptional growth, this paper examines the corresponding change (decline) in UK

manufacturing as an economic activity, and considers how the economic benefits of outsourcing alter the contribution

that an organization makes to a sector’s gross domestic product. To assess this issue, an input–output methodology for

measuring economic restructuring in UK manufacturing is presented.

r 2003 Elsevier B.V. All rights reserved.

Keywords: Outsourcing; Input–output methodology; Manufacturing; Boundary; Configuration

1. Introduction

All businesses exist because they perform value-adding processes that consist of transformationfunctions. Service, transportation and retail orga-nizations perform processes that focus on infor-mation, geographical distance and availability,respectively. Manufacturing organizations focus,by definition, on processing raw material, but sincethe industrial revolution they have evolved intobusinesses that also deal with significant amounts

of information processing (design, marketing,R&D, customer service, etc.) geography proces-sing (distribution and logistics) and availability(retail outlets).

Pioneered in the 1930s by organizations such asthe Ford Motor Company, which was ferventabout control, rationalization and the eliminationof uncertainty, many corporations since then havesought growth and power by conglomeration, andvertical and horizontal integration. The FordMotor Company altered the boundary of itsorganization by acquiring and integrating busi-nesses that were parts of its supply chain. Theseincluded mining companies, shipping companies,railway companies and rubber plantations. Thisstrategy, not only provided ownership and

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*Corresponding author. SFU Business, Simon Fraser Uni-

versity, 515 West Hastings Street, Vancouver, BC V6B 5K3,

Canada. Tel.: +1-604-291-5298; fax: +1-604-291-5153.

E-mail address: [email protected] (I. McCarthy).

0925-5273/03/$ - see front matter r 2003 Elsevier B.V. All rights reserved.

doi:10.1016/S0925-5273(03)00183-X

enhanced control of the supply chain and market,but as reported by Lonsdale and Cox (2000) itoffered organizations the potential for economiesof scale and the opportunity to exercise greatermarket power.

Manufacturing organizations are complex sys-tems that consciously evolve in response to marketneeds, competition and innovation. Directing thisevolution is a key management responsibility thatinvolves making decisions about the configurationand boundary of an organization, to ensurecompetitiveness relative to market demands andstability. This concept is central to the transactioncost perspective (see Section 2.2), which assertsthat organizations seek to reduce costs (directcosts and associated support costs) by formingalliances or selecting structures and practices thatlead to efficiency improvements. This cost mini-mization hypothesis has underpinned the purchas-ing function and is a key issue in both defining anorganization’s boundary and understanding thebenefits of outsourcing. For instance, in the early1990s, many manufacturing organizations hadevolved into businesses that were no longer justconcerned with material processing and assembly.They had extended their boundaries and remit tofocus on converting an idea or need into amarketable product, along with the provision ofappropriate product support and service. Theconglomeration and vertical integration activitiesof the previous 60 years had helped manufacturingorganizations achieve this change in focus, but atthe expense of burdening the organization withexcess and inefficient processes and services, anduncompetitive transaction costs.

With this development in organizational focus,the need and trend for outsourcing emerged.It was based on the assumption that a competitiveadvantage would be gained if external supplierswere contracted to carry out non-core processesmore efficiently and effectively. To achievemore proficient and profitable functions in areassuch as accounting, logistics, catering, design,production, IT support and customer service,manufacturing organizations began to utilizethe core-competencies of other manufacturing,service and transportation organizations. Today,manufacturing is the industry sector most likely

to outsource, with durable goods manufacturersaccounting for 39% of all activity and non-durablegoods manufacturers accounting for 25% (Zhuet al., 2001). In addition, with a global outsourcingmarket estimated at d188 billion in 1998, andwith annual growth rates of 15% (Coombs &Battaglia, 1998), the distinction between eco-nomic activities in different sectors has becomeblurred.

With the practice of outsourcing experiencingexceptional growth, this paper examines a possiblecorresponding and related change, a decline inmanufacturing as an economic activity, andconsiders how outsourcing alters the perceivedcontribution that an organization makes to acountry’s GDP. The conclusion is that theboundaries of manufacturing activity have altered,changing the ownership of certain aspects of theeconomic activity. Thus, to properly understandand measure the economic value of manufacturingrequires an approach that recognizes the highlyintegrated and codependent set of activities thatconstitute the modern economic system of manu-facturing.

To review and assess this notion, this paperwill proceed as follows. Section 2 reviews theeconomic benefits and drivers that motivatemanufacturing organizations to outsource. Section3 provides an introductory account of the macro-economic decline that has occurred in UKmanufacturing and asserts that the decline hasbeen influenced by the practice of outsourcing,which has shifted activities and employment frommanufacturing to services. Section 4 examines thisclaim by using an input–output methodology andmore specifically the decomposition approach(Dietrich, 1999) to investigate the impact thatoutsourcing has had on the boundaries andoutputs of the manufacturing sector. This methodcan be used to analyze the flow of goods andservices from every sector to every other sector inthe UK economy at a specific point of time. Thus,flows of goods and services can be traced betweensectors and their relative contributions to econom-ic output, value added or productivity can beestimated. The methodology is demonstrated usinga range of UK input–output data. Section 5provides a conclusion.

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2. The case for and against outsourcing

2.1. What is outsourcing?

Outsourcing has become an important businessapproach, whereby a competitive advantage maybe gained when products or services are producedmore effectively and efficiently by outside suppli-ers. It is an agreement in which one companycontracts-out a part of their existing internalactivity to another company. As a managementpractice it has probably been in existence for over200 years, but during the last 15 years, with thesupport of academics, consultants and industryforums, it has developed into a popular strategicmanagement initiative. During this 15-year period,the economic value, strategic importance andcomplexity of the outsourced function (whenconsidering manufacturing organizations) has in-creased; evolving from routine and non-value-adding functions, such as security, cleaning andcatering, to key support and value-adding func-tions, such as information technology, logisticsand accounting, to core manufacturing-relatedfunctions, such as design and certain productionprocesses.

Outsourcing not only purchases products orservices from sources that are external to theorganization, but also transfers the responsibilityof the physical business function and often theassociated knowledge (tacit and codified) to theexternal organization. It is this adaptation, drivenby transaction cost rewards, functional competi-tiveness, strategic development and the businesspressures of globalization and technologicalchange, that has altered the configuration (howthe organization is designed managed and oper-ated) and boundary of the modern manufacturingorganization. These changes not only affect anorganization’s performance, but also the perceivedcontribution of an organization and its industrialsector to an economy.

2.2. The case for and against outsourcing

There have been several studies that haveexamined the motivations for and benefits ofoutsourcing. Abraham and Taylor (1993) identi-

fied three reasons for outsourcing: (i) savings onwage and benefit payments, (ii) transfer of demanduncertainty to the outside contractor, and (iii)access to specialized skills and inputs that theorganization cannot itself possess. Kakabadse andKakabadse (2000) report that the main reasons foroutsourcing are: (i) economic—greater specializa-tion in the provision of services, as outsourcingallows economies of scale and the longevity ofdemand for the activity; (ii) quality—access toskills, the competency and focus of potentialsuppliers and geographical coverage is increased;and (iii) innovation—improvements in qualitythrough innovation, and the development of newservice products, can lead to new demands.Bendor-Samuel (1998) also asserts that outsour-cing provides certain power that is not availablewithin an organization’s internal departments.This power can have many dimensions: economiesof scale, process expertise, access to capital, accessto expensive technology, etc. The combination ofthese dimensions creates the cost savings inherentin outsourcing, because the outsourcing supplier(the organization specializing in a particularbusiness function) has the economy of scale, theexpertise and the capital investments in leadingtechnology to perform the same tasks moreefficiently and effectively than the internal depart-ments of the outsourcing ‘buyer’.

Another possible benefit is that outsourcingprovides companies with greater capacity forflexibility, especially in the purchase of rapidlydeveloping new technologies, fashion goods, or themyriad components of complex systems (Carlson,1989; Harrison, 1994). Companies can buy tech-nology from a supplier that would be tooexpensive to replicate internally. A network ofsuppliers could provide an organization with theability to adjust the scale and scope of theirproduction capability upward or downward, at alower cost, in response to changing demandconditions and at a rapid rate. As such, out-sourcing claims to provide greater flexibility thanthe vertically integrated organization (Carlson,1989; Harrison, 1994; Domberger, 1998). Further-more, outsourcing can decrease the product/process design cycle time, if the client uses multiplebest-in-class suppliers, who work simultaneously

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on individual components of the process (Quinnand Hilmer, 1994).

The case against outsourcing is based onarguments such as loss of management control,reduction in flexibility and increased costs. Forinstance, competitive outsourcing requires a highstandard of supplier management to avoid thepitfalls of transferring critical functionality, orbecoming too dependent on a supplier for day-to-day performance of vital business functions. Inaddition, outsourcing can generate new risks, suchas the loss of critical skills, developing the wrongskills, the loss of cross-functional skills, and theloss of control over suppliers (Domberger, 1998;Quinn and Hilmer, 1994). The possible loss offlexibility is connected to the typical long-termcontractual relationship that is formed as part ofan outsourcing agreement, and that during thecontract term, the customer’s business, the avail-able technology, and the competitive and regula-tory environment may change dramatically. Thus,this inflexibility is mostly linked to an unyieldingand inappropriate contract. Although outsourcingis undertaken by many organizations to control orreduce costs, there is some evidence that it doesnot decrease costs as expected, and in some cases,costs increase. For instance, when an item isoutsourced, the assumption is that the supplier’scosts and required contribution is less and willcontinue to be less than the cost of internalprovision. A survey based on 1000 managersworldwide by the PA Consulting Group (PACG)revealed that only 5% of organizations gained‘‘high’’ levels of economic benefit from outsour-cing (PA Consulting Group (PACG), 1996) andthat 39% of organizations admitted ‘‘mediocre’’economic benefit. Also, as outsourcing leads to are-definition of organizational boundaries and, byimplication, structural adjustments involving hu-man resources, these changes incur social as wellas financial costs. Although the social costs aretransitory and can be mitigated by facilitating theadjustments through the re-training and re-deployment of staff within the organization, theirtransfer to the supplier organization and ensuingredundancy payouts can still be considerable(Domberger, 1998; Hall and Domberger, 1995).Also, outsourcing can lead to industrial disputes

between employers and employees, which in turncan damage morale, trust and productivity.

In summary, the rationale for practicingoutsourcing is to exploit external suppliers’ invest-ments, innovations, and specialized professionalcapabilities. This helps an organization to reduceits operating costs, whilst achieving an increasedfocus on its core competencies. This obvious andimportant benefit is consistent with transaction

cost economics, which was largely developedby Coase (1937) and Williamson (1975, 1979).Transaction cost analysis integrates economictheory with management practice and organiza-tion science to study why organizations exist,what are their configurations and what determinestheir boundaries based on the assumption thattransaction costs are minimized. Transaction costsare the full cost of providing products or servicesincluding negotiating, monitoring and enforcingthe contractual agreement. Therefore, regardlessof whether the motivation for outsourcing isstrategic, operational, political, innovative orstructural, transaction cost analysis asserts thatthe properties and economic benefits of businessfunctions, whether internal or external, influencethe configuration and boundary of the organiza-tion. How this effects the economic impact ofoutsourcing on structure and perceived size ofindustrial sectors is not clear. Yet, outsourcingis a management process that alters the boundaryof an organization and therefore changes theeconomic contribution that an organizationmakes to its industrial sector and thus to theeconomy.

3. The changing context and boundaries of UK

manufacturing

Although manufacturing is essential to success-ful industrialization and has been regarded as oneof the most important elements of the UKeconomy up until the late 1960s, it no longeroccupies that status. The period from the early1970s to the early 1990s was one of many changeswith recessions and recoveries. In particular, theoil crises of the early 1970s and the recession of1979–1981 had a severe impact on the structure of

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the UK industry. The UK economy underwenta prolonged period of expansion in the 1980s. Thisrepresented recovery from a deep recessionand entailed considerable structural change,particularly in manufacturing. Output fell at theturn of the decade and only returned to its 1979level in 1987. Much effort in recent years has beendevoted to comparisons of the UK’s industrialperformance with that of other industrializedcountries.

For a sustained period, UK manufacturing lostshare in world markets and within the domesticeconomy. Manufacturing gross value added(GVA) as a percentage of total national grossvalue added fell, from 26.5% in 1980 to 18.8% in1999. This was accompanied by significant changesin employment in the manufacturing industry. Inthe 1969 manufacturing provided over 8.1 millionjobs in the UK (Yearbook of Industrial Statistics,1974) whereas in 1999 it provided four million jobs(Yearbook of Industrial Statistics, 2001).

This relative reduction in manufacturing, andparticularly in manufacturing employment, wasaccompanied by substantial changes in the relativesize of other sectors. In essence, there are definablestages of economic development and the finalstages are characterized by a growing and healthytertiary sector (i.e. transport, construction, dis-tribution and services) with growing preferencesfor service products. In addition, the contributionof value added from the services to national grossvalue added has been rising gradually from 59.9%in 1980 to 70.2% in 1999 (see Table 1), whichsuggests that the UK appears to be a service-dominated economy.

When considering this competitive and structur-al change in UK manufacturing, it is important torecognize that organizations are open systems.They have permeable and changing boundariesthat reflect the domain of an organization’sactivities and functions. Outsourcing has encour-aged manufacturing organizations to alter theirboundaries and become extended enterprises (seeFig. 1) by setting up partnerships, and bycollaborating and trading with other manufactur-ing, service and transportation organizations. Thishas increasingly resulted in a nebulous manufac-turing sector, with indistinct manufacturing orga-

nizations creating wealth through the governanceof knowledge and physical production activities.The result is that the conventional boundaries of

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Table 1

Value added (VA) as a percentage of gross value added (GVA)

and employment analyzed by industry over the period of 1980–

1999

GVA Employment (1000s)

1980 1990 1999 1980 1990 1999

Agriculture 2.1 1.9 1.2 654 592 525

Mining and

quarrying

4.4 2.7 2.3 361 208 107.8

Manufacturing 26.5 23.0 18.8 7081 5398 3936

Utilities 5.3 2.3 2.3 2343 1820 1886

Construction 6.1 6.9 5.3 1617 1559 1767

Services 59.9 67.1 70.2 14,937 14,547 20,718

Source: UK National Accounts, 2000; National Statistics:

Monthly Digest of Statistics, 2000.

Traditional Single Organization Approach

PrimaryValue AddingEnvironment

(PVAE)

Flow of marketneeds or idea

Flow of resource

Products andservices

Waste

An Extended Enterprise based on a ValueAdding Network of Organizations

S

T

OM

OEM

S

T

Flow of marketneeds or idea

Flow of resource

Products andservices

Waste

PVAE

OEM =original equipment manufacturerS = service organizationT = transportation organizationOM = other manufacturer

Fig. 1. Traditional and extended enterprise.


manufacturing value are not appropriate. Themanufacturing sector has been restructured andextended into non-manufacturing sectors, thuschanging the contribution that this industrialsector makes to a sector’s gross domestic product(GDP).

The significance of these differences is indicatedin Table 2 where manufacturing value added andgross production are compared with that of abroadly defined private tertiary sector (transport,construction, distribution and services). As man-ufacturing has reduced in value added and grossproduction (23.8–20% and 31.8–25%, respec-tively), the tertiary sector has increased in termsof both value added and gross production overthe period 1989–1998 (69–78.3% and 44.3–69.4,respectively).

Using the input–output methodology and morespecifically the decomposition approach explainedbelow, the next section examines the impact thatoutsourcing has had on the boundaries and outputof the manufacturing sector. The UK input–output tables between 1984 and 1998 show thatthere has been a significant increase in the grosspurchases that UK manufacturing makes fromnon-manufacturing sectors (services and transportin particular).

4. A methodology for measuring economic

restructuring

Based on the assumption that supply equalsdemand, the input–output methodology permitsstudy of the structural changes in an economy byseparating economic activity into four categories:intermediate deliveries, final demands, primary

inputs and final demands of primary inputs.Basically, supply or sectoral output must equalfinal demand plus intermediate demand; and onthe production side, intermediate inputs andprimary inputs are combined to produce the levelof output. Thus, the standard input–outputmethodology for input–output data is based onthe following identity:

xi ¼ zi1 þ zi2 þ?þ zij þ?þ zin þ fi; ð1Þ

where the total output of any industry can bedisaggregated into amount bought by industryfrom industry j and the output from industry i (zij)supplying final demand fi: For all n industries, inmatrix notation,

x ¼ Zþ f: ð2Þ

The intermediate deliveries Z denote transac-tions between economic (manufacturing) sectors.The manufacturing sectors use commodities ofother sectors as inputs in production of their owncommodity. An element zij of the n � n matrix Z

denotes the intermediate deliveries from sector i tosector j: A large part of the production is useddirectly for consumption as raw material forproducts or as a technology investment. The finaldemand f consists of the output of productionsectors used for consumption, investment, govern-ment expenditures, changes in stocks and exports.An element fig of the matrix f denotes the deliveriesfrom sector i to final demand category g: Amanufacturing sector also requires inputs that arenot produced solely by one of the sectors. Suchinputs include payments for labor, capital, im-ports, indirect taxes minus subsidies, and profits.Hence, primary inputs consist of value added andimports, and factor inputs may be used directly forconsumption, investment, etc.

From the UK input–output tables, severalrelationships and coefficients have been derived.

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Table 2

Value added and gross output (d millions), 1989–1998

Manufacturinga

share of total

Tertiary share of

totalb

1989

Value added 23.8 69.0

Gross outputc 31.8 44.3

1992


Gross output 27.1 65.6

1997



1998



Source: UK National Accounts, 2000.aManufacturing value added divided by total value added.bTertiary value added divided by total value added.cConstant price estimates of gross output by industry.


The matrix with intermediate deliveries can beexpressed as a matrix of input coefficients with theelements of the vector of total inputs on its maindiagonal:

Z ¼ A #x; ð3Þ

where which A is defined as

A � Z #x�1; ð4Þ

#x denotes the digitalized matrix of the vector x.The matrix A consists of input coefficients aij asthe amount of product x required per unit ofproduct j: Therefore, the input coefficients are theelements of the intermediate deliveries part of theinput–output table divided per column by the totalinputs of that sector:

aij ¼zij

xj

; ð5Þ

which represents the direct requirements of theoutput of any sector i per unit of any otherpurchasing sector j ði; j ¼ 1; 2;y; nÞ: FromEqs. (3) and (2) yields

x ¼ Axþ f ð6Þ

or

x ¼ ðI� AÞ�1f ¼ Lf; ð7Þ

where I is the n � n identity matrix and L is theLeontief inverse derived from the input coefficientmatrix A. Leontief inverse matrix represents thedirect and indirect requirements of sector i per unitof final demand for the output of sector j:

A sufficient condition for the existence of theLeontief inverse is that no column sum is largerthan 1 while at least one column sum is smallerthan 1 (Nikaido, 1970; Takayama, 1985).

Changes in the input–output data can be used todescribe the extent to which restructuring, invol-ving outsourcing and related activities such ascontracting out, and subcontracting has occurred.Suppose that changes in total output x aredecomposed into the contributions of two fac-tors—the Leontief inverse and the final demandf—and if the value of total output is known attimes t and t þ 1; the change in total output Dx isgiven by

Dx ¼ xtþ1 � xt ¼ Ltþ1ftþ1 � Ltft: ð8Þ

By rewriting Eq. (7) it is possible to decomposethe growth of total output (Dx) in terms of changesin the Leontief inverse (DL) and changes in thefinal demand Df:

Dx ¼ ðLtþ1 � LtÞftþ1 þ Ltðftþ1 � ftÞ

¼DL ftþ1 þ Lt Df ð9Þ

or

Dx ¼ ðLtþ1 � LtÞft þ Ltþ1ðftþ1 � ftÞ

¼DL ft þ Ltþ1 Df: ð10Þ

In both equations, changes are weighted withfigures of a different period. This raises a timeinconsistency in the weights of the changes. Tosolve this inconsistency the decomposition can berewritten as

Dx ¼Ltþ1ftþ1ð�Ltft þ Ltþ1ftÞ � Ltþ1ft

þ Ltftþ1ð�Ltftþ1 þ LtftÞ � Ltft

¼ DL ft þ Lt Df þ DL Df ð11Þ

or as

Dx ¼Ltþ1ftþ1ð�Ltft þ Ltþ1ftÞ � Ltþ1ft

þ Ltftþ1ð�Ltftþ1 þ Ltþ1ftþ1Þ � Ltþ1ftþ1

¼ DL ftþ1 þ Ltþ1 Df þ DLDf: ð12Þ

Taking the arithmetic average of Eqs. (11) and(12), changes in output can be expressed as

Dx ¼ 12DLðft þ ftþ1Þ þ 1

2ðLt þ Ltþ1ÞDf; ð13Þ

which is another possible method of decomposition.The second part of the right-hand side (RHS) of

Eq. (13) captures that part of the change in grossoutput which is attributable to the change in thetechnical coefficients, keeping final demand at itssecond period level, while the first term capturesthe change in final demand, keeping the technicalcoefficients fixed at the first period level. The firstterm on the RHS is the change in technicalcoefficients evaluated using the first period’s levelof final demand and the second term is the changein final demand evaluated using second periodtechnical coefficients.

Thus, Eq. (13) separates the total change ingross output into final demand and inter-industryeffects, i.e. changing demand with given input–output relationships and changing input–outputrelationships with given demand.

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For purposes of empirical measurement, we canrewrite Eq. (13) as follows:

Dxav ¼ 12ðD1þD2Þ þ 1

2ðS1þ S2Þ; ð14Þ

where

D1 ¼ Lt�1ft � Lt�1ft�1 ¼ Lt�1 Dft;

D2 ¼ Ltft � Ltft�1 ¼ Lt Dft;

S1 ¼ Ltft � Lt�1ft ¼ DLt ft;

S2 ¼ Ltft�1 � Lt�1ft�1 ¼ DLt ft�1: ð15Þ

The first term on the RHS of Eq. (14) is theaverage demand-induced change in output. Thesecond term defines the average supply-led changein output. Hence, it is possible to analyze thesignificance of this compositional effect by exam-ining the relationship between demand changesand the extent to which industries use servicesactivities. The latter can be measured by theaverage (input–output) coefficient for each manu-facturing industry’s purchase of services. If thiscompositional effect is significant there should be apositive relationship between industry demandsand service coefficients. It is clear from Eqs. (11)and (12) that if ft > ft�1; then final demand as aproportion of gross value is increasing, whereas ifLt > Lt�1 intermediate use of resources as aproportion of gross value is expanding, thusoutsourcing is increasing.

Based on the definition that outsourcing is anagreement in which one company contracts-out apart of their existing internal activity to anothercompany, outsourcing can be quantified formeasurement purposes as the proportion ofbought-in goods and services in gross output,where gross output is calculated as bought-ingoods and services plus value added. This indi-cator can be used for single companies, manufac-turing sectors, or the whole economy, dependingon the level of aggregation and boundary ofanalysis. In the following section, the input–outputmethodology and more specifically the decomposi-tion approach explained above (Eq. (13)) are usedto examine the impact that outsourcing has had onthe boundaries and outputs of the UK manufac-turing and service sectors.

4.1. Empirical investigation

Input–output tables explicitly account for theinterdependence of different economic activities byincorporating the size and composition of thevarious industries’ mutual input demands (mea-sured by interdependent coefficients of the Leon-tief inverse), this permits analysis of both directand indirect interactions. With the practice ofoutsourcing experiencing significant growth, it ispossible to gauge how this management initiativemay have altered the contribution that an indus-trial sector makes to GDP; thus, distorting thedefinition and boundaries of manufacturing sec-tor. As the effect of outsourcing is not recognizedby national economic accounts, input–outputtables were used to assess if there is a significantincrease in the gross purchases that the tradition-ally defined manufacturing sector makes fromnon-manufacturing sectors (services transport inparticular). It should be noted that the data wereconverted to 1995 prices using sector-specific pricedeflators.

Annual input–output tables for 1984 and 1989–1998 were obtained from the UK Office ofNational Statistics (ONS). The 1998 tables at thetime of writing were the latest available andprovide the most up-to-date information aboutthe inter-industry relations. Since the aim is tostudy the impact of outsourcing on the boundariesof manufacturing, a higher degree of aggregationis adopted to focus on the relationship between themanufacturing sector as a whole and other sectors.Thus, the following sectors were considered:agriculture, energy, manufacturing, construction,distribution, transportation, communication, andservices. This aggregation creates a potentialdifficulty, as the supply-side effects may not beoperating at industry level for specific industries.Instead, certain industries may make more inten-sive use of bought-in services and these industriesmay have become more important over time bygrowing more rapidly than the average. However,it is possible to analyze the significance of thiscompositional effect by examining the relationshipbetween demand changes and the extent to whichindustries use services activities. The latter can bemeasured by the average (input–output) coefficient

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for each manufacturing industry’s purchase ofservices. If this compositional effect is significant,there should be a positive relationship betweenindustry demands and service coefficients.

In this section, the use of input–output tables forthe period 1989–1998 is presented to illustrate thedecompositions proposed by Eq. (13). The resultsare shown in Table 3.

In Table 3, the decomposition of gross output isused to identify what part of the changes in grossoutput of manufacturing can be attributed to shiftsin the final demand. In addition, what can beattributed to supply-side changes (i.e. changes inthe technical coefficients). For any period, thechange in gross output of the manufacturing sectorcan be attributed to the change in technicalcoefficients. Also, for each period, there is a highincrease in the demand-side and a significantsupply-side effect captured by the change intechnical coefficients. For example, during theperiod 1992–1993, manufacturing could have hadrecorded d34,668 million more output if thesupply-side effect had been accounted for. Also,for the period 1997–1998, it appears that manu-facturing’s gross output should have been somed9,229 million higher, suggesting that the totaldomestic output for 1998 from manufacturing,instead of being the d376,090 million as listed inTable 4, would have been the d388,080 million aslisted in Table 5. The largest outsourcing outperiods between 1984 and 1998 occurred during

1990–1991 and 1992–1993. This suggests that thecontribution of manufacturing output in 1993 tobe 28.8% instead of 25.6%, thus 2.2 percentagepoints higher. In addition, in 1998 it would be25.4% instead of 23.5%, i.e. 1.9 percentage points

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Table 3

Supply-side and demand-side effects in the manufacturing

sector

Dxda Dxs Dx

1989–1990 — — —

1990–1991 54,212 �37,747 16,465

1991–1992 51,526 �10,990 40,536

1992–1993 85,081 �34,668 50,413

1993–1994 78,302 �23,715 54,587

1994–1995 70,741 �25,670 45,071

1995–1996 50,149 �20,900 29,249

1996–1997 40,973 �25,712 15,261

1997–1998 54,212 �9229 16,465

aDxd ¼ 0:5ðD1þD2Þ and Dxs ¼ 0:5ðS1þ S2Þ as defined in

Eq. (15).

Table 4

UK’s domestic manufacturing and total output (d million),

1979–1998

Manufacturinga

(d millions)

Total

outputa

(d millions)

Share of

manufacturing

to total output

1979 136,778 342,688 25.0

1984 180,467 547,026 33.0

1989 296,776 1,017,919 29.2

1990 259,897 894,859 29.0

1991 277,506 1,027,824 27.0

1992 282,896 1,101,705 25.7

1993 299,060 1,168,193 25.6

1994 326,554 1,271,305 25.7

1995 350,739 1,359,593 25.8

1996 368,154 1,450,016 25.4

1997 378,851 1,526,371 24.8

1998 376,090 1,601,222 23.5

Source: UK National Accounts, 1980–2000.aDomestic manufacturing and total output of products at

basic prices, i.e. total supply of products at purchasers’ prices

less imports, distributors’ trading margins, less taxes less

subsidies on products.

Table 5

UK’s outsourcing in manufacturing (d millions), during 1979–

1998

Outsourcing

(d millions)

Contracting

out plus

manufacturing

domestic output

(d millions)

Share of

manufacturing

and outsourcing

to total domestic

output

1979–1984 6930 187,397 34.3

1984–1989 6322 303,098 29.8

1989–1990 — 259,897 29.2

1990–1991 37,747 297,644 33.3

1991–1992 10,990 288,496 28.1

1992–1993 34,668 317,564 28.8

1993–1994 23,715 322,775 27.6

1994–1995 25,670 352,224 27.7

1995–1996 20,900 371,639 27.3

1996–1997 25,712 393,866 27.2

1997–1998 9229 388,080 25.4

Source: Input–Output Tables, 1979–1998; UK National Statis-

tics, 1979–2000.


higher. These results support the notion thatoutsourcing has altered the configuration andboundary of manufacturing organizations in termsof value added and that true manufacturingoutput is underestimated.

5. Conclusions

There are several compelling reasons to out-source, but the underlying rationale is consistentwith the principle of transaction cost economics,i.e. to achieve economic improvement in theperformance of business functions. This involvescontracting out a function to a specialist supplierin an attempt to reduce costs and to benefit fromcompetitive knowledge and practices. Thus, theeconomics of outsourcing alter the configurationand boundary of an organization and thereforechange the economic contribution that an organi-zation makes to its industrial sector and theeconomy. This suggests that even though areduction in the economic contribution of theUK manufacturing sector has taken place, therehave been important structural changes in thecomposition of UK manufacturing at the enter-prise level which should provide a basis forstronger performance in the future. This isreflected by the input–output data presented for1992–1998, that shows a significant increase in thegross purchases that manufacturing makes fromnon-manufacturing (services and transport inparticular).

In conclusion, it is argued that conventionaleconomic views of UK manufacturing activityunderestimate its importance and contributionto GDP. This is because existing macroeconomicdata do not acknowledge that UK manufacturingorganizations, in pursuing greater efficiency,have outsourced many functions such as logistics,IT, accounting telecommunications and legalservices. This practice is the reverse of verticalintegration and has led to a significant extension ofthe boundary of manufacturing organizations,which in turn has shifted transaction costs andassociated economic value into other sectors, mostnotably the service sector. Thus, to recognize thereal value that manufacturing makes to an

economy, it is necessary to understand andmeasure the significant purchases it makes fromother sectors, using a method such as the input–output methodology that analyzes the flow ofgoods and services between sectors. The servicesector by definition serves other sectors, andinitiatives such as outsourcing have helped todevelop and grow this sector. The input–outputdata shows that manufacturing is a key customerof the service sector, and through its purchasescreates a significant and additional contribution toa nations GDP.

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