Journal of World Business 44 (2009) 250–261

Understanding offshoring: A research framework based ondisintegration, location and externalization advantages

Ben L. Kedia a,*, Debmalya Mukherjee b,1

a The University of Memphis, Department of Management, Wang Center for International Business Education and Research, 220 Fogelman Executive Center,

330 Innovation Drive, Memphis, TN 38152, USAb Department of Management, College of Business Administration, The University of Akron, Akron, OH 44325, USA

A R T I C L E I N F O

Keywords:

Offshoring

Offshore outsourcing

Externalization

Disintegration advantages

A B S T R A C T

We present an analytical framework explaining offshoring in this paper. We address the

question: why do firms offshore their business functions? Given the growing prevalence of

offshoring as a dominant business practice in the world of global business, this question

merits further research attention. We propose that firms embark on offshoring when they

perceive three sets of interrelated advantages: disintegration advantages (D), location-

specific resourcing advantages (L) and externalization advantages (E). Theories from

multiple disciplines form the foundation of Disintegration–Location–Externalization

(DLE) framework. Implications for managers, government policy makers and recommen-

dations for future research are explored.

� 2008 Elsevier Inc. All rights reserved.

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Journal of World Business

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1. Introduction

Globalization and rapid improvements in informationand communication technologies (ICT) have resulted in aclosely integrated global labor and capital market(UNCTAD, 2004) where firms have greater access tohuman capital scattered around the globe (Lewin, 2005;Volberda, 2006). Accordingly, offshoring has emerged as aneffective strategic practice whereby firms relocate theirbusiness functions (that were previously performed in-house) to overseas locations. Firms can either embark onoffshoring internally, by setting up their own centers orsubsidiaries in foreign countries while maintaining fullownership and control (captive offshoring) or externally,by handing over business functions to independent foreign

* Corresponding author. Tel.: +1 901 678 4044; fax: +1 901 678 3678.

E-mail addresses: bkedia@memphis.edu (B.L. Kedia),

mukherjee.debmalya@gmail.com (D. Mukherjee).1 Tel.: +1 330 972 6086; fax: +1 330 972 6588.

1090-9516/$ – see front matter � 2008 Elsevier Inc. All rights reserved.

doi:10.1016/j.jwb.2008.08.005

providers (offshore outsourcing).2 Interest is growingamong the strategy and international business (IB)scholars to better understand how offshoring can be usedas a strategic device and sometimes as a strategy itself tocreate value (Kedia & Lahiri, 2007; Kedia, Lahiri, & Lovvorn,2005; Lewin & Peeters, 2006). Increasingly, standardized ITand business processes as well as high-valued-addedactivities, for instance engineering, R&D and productdesign, are being offshored (Lieberman, 2004; UNCTAD,2005). While offshoring of manufacturing activities hasbeen practiced for decades, a recent study predicts servicesoffshoring to increase from US$ 1 billion in 2002 to aboutUS$ 24 billion by 2007 (UNCTAD, 2004). The growth ofoffshoring offers a wide gamut of opportunities for IBscholars to formulate new frameworks or revisit extant IBtheories. Given the importance of offshoring as a ubiqui-

2 Outsourcing refers to handing over activities that were performed in-

house to external providers, who are located in the same country

(domestic outsourcing) or in offshore locations (offshore outsourcing).

B.L. Kedia, D. Mukherjee / Journal of World Business 44 (2009) 250–261 251

tous phenomenon in the global business world, why dofirms contemplate offshoring is a crucial question thatneeds to be examined both for theoretical and practicalpurposes (Doh, 2005). The existing conceptualization ofoffshoring lacks depth, and despite its present andanticipated future growth, many scholars have bemoanedthat it has not received adequate systematic researchattention (Bunyaratavej, Hahn, & Doh, 2008; Mol, Tulder,Rob, & Beije, 2005; Niederman, Kundu, & Salas, 2006). Onecan reasonably argue that this research domain needs acoherent theoretical framework that can be empiricallytested to trigger further scientific enquiries. We offer atheoretical framework pertaining to offshoring decisions offirms. More specifically, we ask the question why do firmshand over part or parts of their value chain activity(ies) toproviders located in foreign countries? This question isimportant and very much relevant to the IB and strategyfields as externalization of existing value chain functions asopposed to internalization, and migrating functions toforeign providers rather than to domestic providers,represent a major departure from the traditional strategicthinking. To address this question, we draw on differenttheoretical research strands and argue that the decision toembark on offshoring is contingent on three types ofinterrelated advantages as perceived by the firms. Parti-cularly,

(1) W

3

whi

hen a firm perceives disintegration advantages vis-a-vis integrated firms serving in the same industries.3

(2) A

ssuming condition (1) is satisfied, it must be moreadvantageous for the firm to procure resources fromoutside the country (offshore) to perform certainfunctions than executing the same in the country(onshore).

(3) A

ssuming condition (2) is satisfied, it must beadvantageous for the firm to externalize those func-tions to foreign providers (offshore-outsourcing/direct-offshoring) or internalize those functions to beperformed in-house in the foreign land by setting upcenter (captive offshoring).

These interrelated conditions are similar to thetheoretical arguments put forward by Dunning (1979, p.275). John Dunning’s eclectic paradigm, meant forexplaining the foreign direct investment (FDI) decisionsby multinational enterprises (MNEs), since its inception inthe 1970s, has spurred a prolonged scientific conversation(Dunning, 1977). This paradigm advanced the argument of‘Ownership–Location–Internalization’ (OLI) related advan-tages that encourage or discourage firms to engage in FDI.Doh (2005) however argued, in the context of offshoring,ownership and internalization advantages are somewhatless pertinent because these two advantages are dimin-ished through the transfer and disintegration of produc-tion stages to other countries, while location advantagesremain equally relevant. By taking a somewhat similarapproach (and we have been inspired by Dunning’s work)

Disintegration for the purpose of this paper refers to the process by

ch firms unbundle activities from their value chain.

to explore a different phenomenon (offshoring), this articleaims to provide a coherent and integrative analyticalframework to better understand the offshoring practice offirms. The analysis of this framework can be applied to alloffshoring activities as long as business functions or valuechain activities can be ‘disintegrated’ or ‘decoupled’, andcan be relocated in offshore locations.

The remainder of the paper unfolds as follows. First, weoutline the important macro-environmental forces that arechanging the nature and rules of IB, thereby fuelling thegrowth of offshoring and elaborate on the need for acoherent theoretical framework for better conceptualiza-tion of the phenomenon. Next, we delineate the proposedresearch framework that attempts to explicate the centralresearch question. In the subsequent section, we show howdifferent types of sourcing activities can be explained withthe help of our proposed analytical framework. The finalsection concludes with a reiteration of the majorcontributions and implications of this research along withsome possible future research directions.

2. Macro-environmental changes, growth of offshoringand need for a coherent framework

Globalization, accelerated technological advancementsand the entrance of new international players fromemerging markets have increased competition creating amore turbulent environment where businesses compete.Though these pervasive traits of today’s competitivelandscape are conceptually distinct, they are interrelatedand thus having challenging effects on business opera-tions. In response, more firms in various industries arerestructuring their value chain activities in order toredeploy crucial resources in core areas while gainingmuch needed flexibility. A more globalized world providesopportunities for a large number of potential markets,suppliers of raw materials and components and businesspartners available to organizations. Globalization, coupledwith technological advancements, has made sourcing ofhuman capital possible ‘anywhere and anytime’ therebyfacilitating offshoring activities (Lewin, 2005). The barriersassociated with physical, geographical, cultural or tem-poral dispersion have been largely conquered by theongoing technological revolution. Clearly, this changingnature of work reflects a major shift in the way work hastraditionally been done. To remain competitive and toensure continued survival amidst such ‘hypercompetitiveenvironment4’ firms are attempting to devise newstrategies. Research has found that under such circum-stances firms disintegrate their business functions andincrease outsourcing (McLaren, 2000).

Concurrently, following major economic reforms,countries such as India, China, Brazil, Russia, Hungary,Ireland, etc. have opened their markets (Kedia, Lahiri, &Mukherjee, 2006). These countries have huge ‘‘human

4 ‘Hypercompetition’ refers to the rapidly changing business landscape

where firms position themselves aggressively against one another and

seek to disrupt the competitive advantages of industry leaders (D’Aveni,

1995).

B.L. Kedia, D. Mukherjee / Journal of World Business 44 (2009) 250–261252

capital’’ resources that can be leveraged to a great extent.The shift from production to service-related businesses inthe Western economies has spawned a new generation ofextremely mobile knowledge workers in these countries.Furthermore, companies from emerging economies, suchas Mittal Steel, Infosys, Wipro, Tata Consultancy Services(TCS) are increasingly engaging in alliances with theirWestern counterparts (Kedia, Mukherjee & Lahiri, 2006).On one hand, this implies increased competition forresources and consumer markets; on the other hand,there are opportunities for Western firms to utilize theunique resources and capabilities of these companies. Tosummarize, these changes in the global economic envir-onment have altered the ‘‘ground rules’’ of IB creating a‘‘leveled playing field’’ for all players (Friedman, 2005).

Fig. 1. Schematic diagram of changing internalization advantages, global resource

Migration away from confrontation and a shift towardco-operation at various interorganizational levels seems tobe the new norm (Danskin, Dibrell, & Kedia, 2005; Luo,2007). This trend is reflected in the increasing use ofstrategic alliances, joint ventures and other forms ofinterorganizational co-operative relationships. These orga-nizational design changes have affected strategies of thefirms worldwide. The effectiveness of a firm strategy thatallows a firm to internalize exchanges under its ownhierarchy that would otherwise be conducted in openmarkets has been questioned by some scholars (e.g.,Balakrishnan & Wernerfelt, 1986; Holcomb & Hitt, 2007).This stream of literature has argued that hierarchicalgovernance may not add value in the changed environment.Fig. 1 depicts the effect of these macro-environmental

market and changing firm strategy (inspired by Narula & Dunning, 2000).

Table 1

The DLE advantages that spur the growth of offshoring

Type of advantage Theoretical basis Nature of advantages

Disintegration-related

advantages

Theory of core competencies

and modularity

Advantages related to increased focus on core competencies

� Innovation

� Superior capabilities through resource reallocation

� Increased quality of products and services

Advantages related to modularity

� Increased flexibility

� Increased speed

� Cost reduction

Location-specific

resourcing advantages

Geographic location theory,

human capital theory

Country level

� Infrastructure

� Government policy

Human capital level

� Labor arbitrage

� Knowledge arbitrage

� Time arbitrage

Externalization advantages Social exchange theory,

organizational capability and

organizational learning theory

� Advantages related to relationship capital

� Advantages related to co-specialization

� Advantages related to mutual organizational learning

B.L. Kedia, D. Mukherjee / Journal of World Business 44 (2009) 250–261 253

changes on the advantages related to internalization (adominant firm strategy), on the global resource marketplace and a subsequent shift in firm strategy towardincreased disintegration of value chain activities andaggressive offshoring.

According to a study by Gartner Dataquest, the globalmarket for Business Process Outsourcing (BPO, which is onlya segment of offshoring) is growing at a compounded annualgrowth rate of 9.5% and is expected to reach US$ 173 billionin 2007 (Pfannenstein & Tsai, 2004, p. 79). The impact ofoffshoring may be gauged from the widely quoted ForresterResearch statistic that as many as 1.6 million US jobs will be‘‘offshored’’ by 2010 (Maher, 2004). Industry leaders such asAT&T, Boeing, Citibank, General Electric, Morgan Stanley,Philips, Reebok, Sony, Swissair, Wal-Mart, etc. are usingoffshoring as a strategic tool. The practice is not onlyrestricted to the US Fortune 500 or large European orJapanese multinationals, but is also common in many smalland mid-size businesses (Carmel & Nicholson, 2005).

Despite the current and predicted growth of offshoring,this research domain has yet to develop a suitable researchagenda (Stack & Downing, 2005). The empirical research inthe realm of offshoring is also in its infancy (Mol, Pauwels,Matthyssens, & Quintens, 2004). In an attempt to partiallyfulfill this paucity, we take the initial steps towardsframing a broader analytical framework based on Disin-tegration–Location–Externalization (DLE) advantages thataspires to stimulate coherent empirical research. Toaccomplish our goal, we draw on multiple strands ofliterature. The DLE framework posits that firms contem-plate offshoring when they have disintegration advan-tages, location-specific resourcing benefits andexternalization-based incentives. The next section dis-cusses these advantages in greater detail.

3. The DLE advantages

To better conceptualize why firms embark on off-shoring activities, we need to account for advantages and

conditions that are relevant to offshoring. A configurationof DLE advantages is proposed to address the centralquestion of this article, i.e. why firms embark on the practice

of offshoring? To achieve this end, we first explicate thedisintegration-related advantages as perceived by thefirms. Table 1 encapsulates the proposed DLE advantages.

3.1. Disintegration-related advantages

A stream of research has argued that organizations needto be more flexible, leaner and more focused on their corecompetencies in order to stay competitive and responsivein hypercompetitive environments (Achrol, 1997; Jaco-bides, 2005; Schilling & Steensma, 2001).

Another body of research has noted that structuring ofan organization should be compatible with the design of itsvalue chain (Dess, Rasheed, McLaughlin, & Priem, 1995;Porter, 1980; Prahalad & Ramaswamy, 2004). Never-theless, both streams have agreed that the reconfigurationof value chain activities by disintegrating non-coreactivities and subsequently increasing focus on core areaswill generate value for firms and the customers. Achrolputs it more succinctly:

Large-scale downsizing, vertical disaggregation andoutsourcing, and elimination of layers of managementhave gutted the mighty multidivisional organizations ofthe 20th century. Replacing them are leaner, moreflexible firms focused on a core technology and process,laced in a network of strategic alliances and partner-ships with suppliers, distributors, and competitors. Themagnitude of the socioeconomic change that networkorganization portends may be as great as the IndustrialRevolution. (1997, p. 56, 57, 61)

Intraorganizational partitioning and disintegrationoccurs when firms perceive managerial benefits fromuntying ‘‘parts of the production process [or serviceprocess], due to reliance on different knowledge bases

B.L. Kedia, D. Mukherjee / Journal of World Business 44 (2009) 250–261254

or requisite managerial styles and incentive structures ineach part of the value chain make organizationalspecialization attractive’’ (Jacobides, 2005, p. 477). Disin-tegration includes unbundling or decoupling of differentsupport business functions, or services, e.g., payroll,finance and accounting, claims processing, etc. Disintegra-tion, when related to support functions, does not affect thevertical scope of the firm.

Three distinct sets of advantages may arise from thedisintegration of value chain activities. First, it reduces thecoordinating costs associated with hierarchical govern-ance. Second, it allows firms to focus on their corecapabilities and reallocate valuable resources for thatpurpose. Third, it gives rise to modular structures thatconfer flexibility, speed, and increased responsiveness inhypercompetitive environment. While cost-related advan-tages are important, we focus mainly on the increasedfocus and modularity-related advantages in the presentcontext as these advantages may influence the firm’sstrategy in the long run.

3.1.1. Advantages related to increased focus on core

Jacobides and Winter (2005) contended that usage ofoutsourcing and/or offshoring as a strategic device hasbeen predicated on the idea that certain functions (datahandling, customer relation management, informationprocessing, etc.) are generic activities among differentindustries and can be decoupled from their respectivevalue chains. Consequently, firms can focus on their corecompetencies to develop superior capabilities in order tooutcompete other firms in the same industries whileexternalizing the decoupled or disintegrated functions(Adler, 2003; Jacobides & Winter, 2005). In addition, firmscan also deploy their scarce resources on the areas wherethey possess competitive advantage (Dess et al., 1995;Peng, 2006, p. 17). In a related vein, Brown and Wilson(2005, p. 46) argued that following the decoupling ofsupport activities from their value chains, firms canredirect their limited but valuable resources (e.g., humanresources) to core areas where they can generate value fortheir customers. Well-developed core competencies createa barrier against competitors thus protecting the strategicadvantages of the firm’s market share. For example, Applefocuses its best resources on Apple DOS (disk operatingsystem) and the support macro software while disinte-grating other functions to external suppliers. Apple thusleveraged its limited capital resources to its maximum andenjoyed three-fold capital turnover and the highest marketvalue versus fixed investment ratio to outcompete itsmajor competitors (Quinn & Hilmer, 1994).

3.1.2. Advantages related to modularity

Organizational systems become increasingly modularwhen firms disintegrate certain support functions fromtheir value chains and begin to substitute loosely coupledforms for tightly integrated, hierarchical structures. Thisway, by shedding of peripheral non-core functions, firmsbecome specialized modular forms and substitute externalservice-providers for inferior in-house activities (Afuah,2001). The disintegrated, leaner and more modularorganizational forms allows for increased flexibility.

Organizational flexibility refers to a firm’s ability toperform new things quickly (Schilling & Steensma,2001). Management literature has stressed the significanceof being ‘flexible’ in the new competitive landscape. Forexample, Hitt, Keats and DeMarie (1998) contended thatgreater use of external contingent workers and increasedlevel of outsourcing delivers more flexibility which helpsfirms to respond quickly to unanticipated threats andopportunities of the market. There are abundant examplesin the computer and apparel industries, where industryleaders such as Microsoft, Dell Computers, and Reebokhave established the advantages of outsourcing peripheralfunctions while gaining flexibility and speed through theirflatter organizational forms. Likewise, US–Dutch profes-sional publishing giant Wolters Kluwer shifted theirsoftware development and editorial work to India andthe Philippines, which helped the company to generate agreater array of books, journals, and Web-based contentmore rapidly (Business Week, 2006). In another instance,OnStor Inc., a Los Gatos (California) developer of storagesystems, allied with Bangalore-based HCL TechnologiesLtd. that enabled to get customized products to clientstwice as fast as its competitors (Business Week, 2006). Inshort, modularity-related advantages enable firms to bemore responsive, meeting external demands, with greaterflexibility and speed.

3.2. Location-specific resourcing advantages

In the IB literature, location has been an importantconsideration for foreign investment activities (Buckley &Casson, 1976; Nachum, 2000). The OLI paradigm asproposed by Dunning (1977) attempted to address thelocation decision of firms and offered a framework fordetermining the extent and pattern of FDI. Location-specific advantages, in this framework, are based on theresources, networks, institutional structures, or otheradvantages that are specific to a country, and thus, areexternal to the firm (Dunning, 1988, 1993; Singh & Kundu,2002). These advantages typically include Ricardian typeresource endowments and institutional environments inwhich the endowments are used (Dunning, 1988; Singh &Kundu, 2002). Dunning (1988) identified three categoriesof factors that impact the location decision made by firms:infrastructure, country risk factors and government policy.

Subsequent research in this domain has identified anumber of potential country-specific advantages: inputcost advantages, such as low wages and the availability oflow cost natural resources; labor productivity; market sizeor potential; transport costs; and the psychic distance fromthe market to the home base of the MNE. Other factors suchas, tariff barriers, taxation structure, political and legalenvironment, attitudes toward FDI and the structure ofcompetition have also been considered (Delios & Beamish,1999; Dunning, 1988; Root, 1994). Recently, Doh (2005)argued that in the context of offshoring, these advantagesmay include human capital (educated workforce), softinfrastructure (such as business and telecommunication),as well as cultural similarity. In fact, research has foundthat services and manufacturing offshoring has differentdeterminants, and the abundance and quality of human

B.L. Kedia, D. Mukherjee / Journal of World Business 44 (2009) 250–261 255

capital, cultural similarity and telecommunication infra-structure are the main locational drivers for servicesoffshoring (Bunyaratavej, Hahn, & Doh, 2007, 2008). Grafand Mudambi (2005) also added the human capitaldimension to the traditional locational drivers of off-shoring in their analysis.

Consistent with this line of research, we argue thatfirms perceive mainly two types of advantages related to‘location-specific resourcing’. Country level advantagesrelated to the factors identified by Dunning’s eclecticparadigm and the human capital-specific advantages.

3.2.1. Country level advantages

Emerging economies have traditionally suffered frommarket deficiencies (characterized by a less developedproduct, capital and labor markets). In the last decade orso, economic liberalization and deregulation usheredthrough various policy reforms brought about broadchanges in the economic landscape of these economies.The simultaneous emergence of a huge human capital baseand new economy firms has caught the attention ofresearchers, practitioners and business leaders alike.Naturally, the surfacing of these factors has widened thebreadth and depth of the global resource pool and has acrucial effect on the international supply chain. Firms nowhave more complementary resource choices than everbefore. Similar arguments have been forwarded by Peetersand Lewin (2006) who explained how the increasingcapabilities and resources of service-providers in variouslocations around the globe constitute a major pull factortowards the increasing practice of venturing overseas.Furthermore, many of these countries (e.g., China, India)have excellent IT infrastructures and slowly but steadilydeveloping a superior transport systems. For example,following the economic reforms initiated in the early1990s, telecommunication costs in India have decreasedsharply (Kedia, Lahiri et al., 2006; Kedia, Mukherjee et al.,2006). The Indian and the Chinese governments areactively promoting their respective IT industries. India,for example has a separate ministry for its IT sector and thegovernment has definitely helped in the process ofindustry creation. In a related vein, China joined WorldTrade Organization (WTO) in 2001, and since haswitnessed a FDI boom in its domestic sector (Friedman,2005, p. 139). The trade and tariff barriers have beenreduced to a great extent. Overall, investment-friendlypolicies, improving infrastructures, and possession ofinexpensive but quality human capital have turned thesecountries to appealing centers for offshoring.

3.2.2. Human capital-related advantages

With the shifting of the economy from manufacturingto services, organizations are now attempting to competethrough people (Lepak & Snell, 1998). The reduction incommunication costs has considerably diminished trans-action costs associated with cross-border activities. Intoday’s world, it is relatively easier to reap the benefits of ahuman capital pool spread around the globe. The nature ofhuman resources and capabilities vary across nations. Forexample, Indian offshoring workers are generally inex-pensive but highly proficient in English (Lewin & Couto,

2007). However, Chinese service-providers compete on thebasis of their wide pool of university graduates existing inthe country. Their prior experience in manufacturingoutsourcing acts as an added bonanza. Advantages relatedto human capital can be classified into three broadcategories. Labor arbitrage, which is mainly associatedwith the cost of human capital, knowledge arbitrage,associated with better quality stemming from superiorcapabilities of human capital and time arbitrage, related towork that can be performed around the clock due to timedifference in different time zones.

3.2.3. Advantage of labor arbitrage

Cost reduction remains one of the strongest motivatingfactors for offshoring business functions to the far-flungcountries (Lewin, 2005). The cost of labor encompasses amajor portion of operational cost for any firm. The huge,educated but inexpensive labor pool available in countriessuch as India, China, Philippines, Hungary, etc. offers firman attractive opportunities to offshore business functionsat considerable cost savings. In a recent survey of USoffshoring firms, most of the respondents indicated thatcost reductions were the primary reason for offshoring(Lewin & Couto, 2007). A wide array of administrative andtechnical functions such as, programming, coding, tran-scripting, X-ray plate reading, and auditing are performedin offshore locations at a fraction of costs payable in the US.For example, the US banking industry has saved a US$ 6billion to US$ 8 billion per year by migrating their businessfunctions to India (Pfannenstein & Tsai, 2004). ClaimpowerInc., a New Jersey-based medical billing service-provideroffshored some of their routine functions. As a result, thecompany achieved cost leadership by charging US doctorsless than what its competitors managed to do. In just overtwo years, the firm’s client list of doctors rose from 10 to41, and the firm’s annual revenue increased seven-fold(Karmin, 2004).

Cost-related labor arbitrage erodes in the long run. Forexample, the labor cost in Ireland has been rising (Frost &Sullivan, 2007). Under such circumstances, companiesincreasingly move up the value chain to source high valueadded activities (e.g., R&D or sales and marketing) therebyshifting from labor to knowledge arbitrage (Bunyaratavejet al., 2007).

3.2.4. Advantage of knowledge arbitrage

Globalization has effectively democratized the intel-lectual capital scattered around the globe (Friedman,2005). The practice of offshoring not only entices the userfirms to get access to inexpensive labor but also can addvalue in the form of knowledge arbitrage (Pfannenstein &Tsai, 2004). Kedia and Lahiri (2007) noted that most of theemployees in provider firms generally possess qualifica-tions higher than those of their US/European counterparts.For example, most call-center employees in India areUniversity graduates. In a recent interview Michael Porterobserved that US-based engineers of a large software firm,when given a specific competence test which is vital forusing the particular technology, scored significantly lowerthan their Bangalore counterparts, situated in India(Snowdon & Stonehouse, 2006). Many argue that the

B.L. Kedia, D. Mukherjee / Journal of World Business 44 (2009) 250–261256

advanced nations such as the US, the UK, and otherWestern European countries are already facing a defi-ciency of skilled professionals in knowledge-intensivesectors (Lewin & Couto, 2007). One way to mitigate theseskills shortage is to source superior human capital fromlow-wage emerging economy nations. For example, Indiaalone produces 441,000 technical graduates and more than300,000 postgraduates every year (London, 2006).

In short, the emergence of nation-specific humantalents has thus enabled firms to have their servicefunctions and processes accomplished by better educatedand trained personnel at much cheaper rates.

3.2.5. Time arbitrage

Apart from cost and quality gained from labor andknowledge arbitrage, time is also an important dimension.Regulations prevailing in some advanced countries pre-vent their employees from working 24/7/365 (Graf &Mudambi, 2005). Employees in offshore locations whohave the advantage of being in a different time zone cancontinue working during US nighttime. This processsubstantially increases the overall productivity and speedof work. Thomas Friedman elaborates on how exactly itmay work:

‘‘Another factor, added Rozman, was that multina-tionals that were depending on Indian firms alone torun their backrooms 24 hours a day were getting thethird team for eight hours, since the best Indianengineers didn’t want to work the late-night shift—the heart of America’s day. By creating an outsourcingcenter in Montevideo, Tata could offer its clients its bestIndian engineers during India’s day (America’s night)and its best Uruguayan engineers during America’s day(India’s night).’’ (Friedman, 2006).

3.3. Externalization-related advantages

So far we have argued that offshoring of non-coresupport activities (which includes administrative andtechnical work) by a firm will be contingent on itsperception of advantages stemming from disintegrationof those support activities from its value chain andsubsequent global resourcing advantages as perceivedby that firm. The third strand of the DLE framework isconcerned with the externalization (to the independentforeign service-providers) versus internalization aspect ofthose activities (captive centers).

The internalization theory in the IB literature contendsthat MNEs or other firms internalize markets due to theirperception of structural and transactional market failures(Buckley & Pearce, 1979; Rugman & Verbeke, 1992). Inother words, firms prefer internalizing activities withintheir own boundaries to externalizing those activities toforeign providers owing to their perception of risk anduncertainty associated with the international market(Dunning, 1988). These conceptualizations, mainly basedon TCE posit that organizations opt for the most efficientapproach between the firm and the market (Coase, 1937;Williamson, 1971, 1991). Stated otherwise, markets(externalization) and hierarchies (internalization) arealternative approaches to completing a set of transactions

with economic actors choosing the structure that result inlower costs. Externalization of these transactions cangenerate economic value within the supply chain throughreduction of costs by tapping into specialized suppliercapabilities (Dyer & Ouchi, 1993). However, there are oftensignificant transaction costs associated with the contrac-tual interorganizational relationships between the firmand its external suppliers. These costs include, search costsfor potential partners, bargaining and negotiation costs,the costs of designing contracts, monitoring costs and costsassociated with measuring attributes. These costs canmagnify manifold especially when a firm is operating in aforeign country.

From these arguments we can postulate that valuecreation in offshoring largely depends on whether thebenefits, generated from disintegration and the superiorcapabilities of specialized foreign market firms, offset orexceed transactions costs. We posit that firms willexternalize the non-core support activities to the inde-pendent foreign service-providers when the perceivedeconomic value of such inter-firm relationship will out-weigh the costs and risks associated with such transac-tions. How that may happen? The economic value ofexternalization primarily stems from reducing transactioncosts by constraining opportunism through informalmechanisms such as mutual trust, co-operative norms,and shared values (relationship capital) as opposed to closemonitoring (transaction cost). An enlightened relationshipbetween the service-provider and the offshoring firm willlead to two types of externalization advantages, (1) co-specialization by harnessing the specialized resources andcapabilities of the provider and (2) organizational learningby harnessing information/resources, through sociallyembedded relationships. Under these circumstances afirm considers direct third-party offshoring. In simpleterms, firms consider externalization as opposed tointernalization when incentives are present in the formof co-specialization and organizational learning. Thetransaction costs and other risks associated with externa-lization are reduced and the advantages related to co-specialization and organizational learning can be reapedwhen the relationship is based on mutual trust and co-operation.

3.3.1. Relationship capital-based advantages

Social exchange theory posits that social exchangeoccurs within structures of mutual dependence, in whichactors are dependent on each other for valued outcome(Blau, 1964). Social exchange theorists have viewed trustas a central feature, mediating and maintaining suchrelationships (Molm, Takahashi, & Peterson, 2000; Zaheer,McEvily, & Perrone, 1998). In the literature on interorga-nizational relationship, there is a general consensus amongresearchers that the existence of relationships based onmutual trust between partner organizations has a positiveimpact on the ability of partners to adjust to changingenvironmental demands or unintended problems thatmight arise (Young-Ybarra & Wiersema, 1999). Trust-worthiness has been argued to be a source of competitiveadvantage (Barney & Hansen, 1994). When perceived risksof market failure are abundant (for example in the

Fig. 2. A DLE explanation of different sourcing models.

B.L. Kedia, D. Mukherjee / Journal of World Business 44 (2009) 250–261 257

knowledge-intensive offshoring sectors where data secur-ity and dissipation of knowledge are considered as fatalrisks) mutual trust can mitigate the risk related to possibleopportunistic behavior of the service-providers. We arguethat the perceived benefits associated with externalizationwill be based on the solid foundation of relationship capital(defined as having mutual trust and shared values betweenthe offshoring firms and their service-providers).

3.3.2. Co-specialization and organizational learning-related

advantages

If a market functions well for externalization, it may bebeneficial for the firms to select best external service-providers than relying on inferior in-house activities. Theconcept of co-value creation or resource complementarityin the context of alliances has been emphasized by manymanagement researchers (e.g., Wu & Cavusgil, 2006). Theproponents of RBV consider a firm as a collection ofimperfectly imitable resources and capabilities that formsthe basis of its successful competition against other firms(Barney, 1991; Wernerfelt, 1984). By utilizing physical,human, or organizational resources and capabilities, firmsare able to exploit environmental opportunities, outper-form rival firms and minimize the effects of threats. Manyscholars agree that through offshoring and externalizationof their non-core activities to the foreign service-providersfirms may also seek to achieve business transformation(Linder, 2004). The service-providers may possess inno-vative talents and world class service delivery model.Furthermore, as we have discussed, these providers oftenare specialists in certain activities that are externalized tothem. They are competent to cater to a wide range ofservices in the areas of audiovisual and culture, business,computers and allied areas, higher education and training,finance, health, internet related, and various professionalservices (UNCTAD, 2004). The offshoring firms benefitfrom their providers’ high-end skill sets, collective domainexpertise, and industry-specific knowledge that result inintegrated and innovative solutions. The world classdelivery model of offshore service-providers benefits theirclients who receive rapid but specialized solutions. Suchresources help clients to initiate rapid improvisationalchanges or boost business performance. For example, TCScame up with the overall strategy for Skandia Bank’s(Switzerland) financial services and e-commerce activities.TCS helped the bank to identify product direction,conceptualized a solution, worked with local regulatorsfor getting a banking license and defined bankingprocesses.

Offshoring partnerships can also create learning envir-onments for both partners (Kedia & Lahiri, 2007). Theseauthors observed that cumulative experience and learningscope is valued in offshoring relationships and can bepotential sources of competitive advantage. The impor-tance of organizational learning in the context of strategicalliances, joint ventures and other types of interorganiza-tional relationship has been adequately highlighted(O’Dwyer & O’Flynn, 2005).

In sum, externalization generates co-specialization andco-learning benefits for client firms. Thus, this set of inter-related advantages as perceived by client firms determines

offshoring activities. The matrix in the next section buildson this logical foundation and briefly discusses howdifferent types of outsourcing/offshoring decisions canbe explained utilizing the DLE perspective.

4. A DLE perspective of different sourcing types

Fig. 2 summarizes four different types of businessmodel that emerge from combining the perceived disin-tegration advantages and location-specific resourcingadvantages dimensions. We briefly describe exemplaryfeatures of each type and discuss how they evolve ingeneral. Each type represents a general pattern and therecan be subtle variations within each form.

In quadrant I, firms facing external pressure in the formof increasing customer demand for better products,increased inter-firm rivalry or institutional pressure maydisintegrate their value chain activities in order to focus ontheir core competencies and reap externalization advan-tages from external suppliers with superior capabilities.The presence of abundant specialized suppliers in thedomestic market makes it easier for these firms toexternalize their disintegrated activities to the outsideindependent domestic suppliers. In addition, sometimes,the inherent characteristics of disintegrated functions maycompel firms to externalize these functions to thesuppliers who are located in geographical proximity. Inshort, perceived disintegration and externalization bene-fits are high in such cases. However, the location-specificbenefits are found onshore. As the focal firms and thesupplier firms interact within the same institutionalenvironment, this arrangement is perceived as less riskyin nature and referred to as domestic outsourcing. Forexample, DuPont had an unwieldy system for administer-ing records, payroll, and benefits for its 60,000 employeesin 70 nations, with the data scattered among differentsoftware platforms and global business units. DuPontawarded a long-term contract to Cincinnati-based Con-vergys Corp., the world’s biggest call-center operator, toredesign and administer its human resources programs.The goal is to cut costs 20% in the first year and 30% a yearafterward (Business Week, 2006).

In quadrant II, firms face the same amount of pressureand perceive high disintegration advantages to staycompetitive and meet increasing customer demands.

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These firms take advantages of superior resources avail-able overseas and externalize their peripheral supportfunctions to independent suppliers who are locatedoverseas. Typically, in this type of scenario, the perceivedcost, quality and organizational learning advantages(externalization advantages) offset transaction cost-related concerns and other location-specific risk factors.Initially, prevalence of lower labor costs in the developingeconomies lures Western firms to migrate their non-coreroutine work to offshore locations. For instance, brokeragefirms, such as Lehman brothers and Bear Stearns & Co., areusing Indian financial analysts for data entry work.However, with time, focal firms may want to tap intothe specialized capabilities of the providers for highervalue chain activities. For example, Ranbaxy, a leadingIndian pharmaceutical company, has agreed to discoverand develop new drugs for GlaxoSmithKline, in sometherapeutic areas. This business model is termed as directoffshoring or offshore outsourcing.

Firms in quadrant III are very similar to firms inquadrant II. However, disintegration advantages as per-ceived by these firms are relatively low. This is not becausefirms face any less pressure but transaction cost-relatedconcerns (mainly opportunism) and risks associated withknowledge dissipation to the outside suppliers promptthese firms to internalize the benefits related to superiorresources found abroad. In addition, these firms are oftenmultinationals possessing enough resources and relatedexperience to successfully establish their own captivecenters in foreign locations. Typically, these firms benefitfrom labor, knowledge and time arbitrage. For example,GE’s John F. Welch Technology Centre, in Bangalore, India,is a large multidisciplinary Research and DevelopmentCenter outside the US India’s huge but inexpensive humantalent pool has enabled GE to hire nearly 3000 scientistsand engineers, who deliver advanced technologies to GEbusinesses worldwide. Similarly, Texas Instruments, SonyEricsson, Cisco have also set up their R&D centers in India.Google, Motorola and Toshiba have chosen China as theirpreferred R&D location. In some cases, the perceived loss ofmanagerial control may also encourage firms to choose acaptive model. For example, Shell runs five captive centerslocated in Malaysia, UK, Poland, Philippines and Guatemalafearing loss of command and influence associated withoutsourcing.

Finally, as shown in quadrant IV, firms may integratethe activities and/or support functions in their own valuechain or may simply develop in-house capabilities toperform support functions. In some cases, superiorresources may be already available onshore and thesefirms may acquire them through mergers or acquisitionsbringing them under their own umbrella. This is a case ofclassic vertical integration or hierarchical governance inwhich benefits accrue from internalization.

The positioning of a firm in each quadrant may alter asthe perceived costs and benefits from internalizationversus externalization, domestic versus offshore andcaptive versus direct may change over time. For example,many companies who outsourced their low value chainactivities to Ireland moved those jobs back to India andPhilippines where labor costs are significantly lower.

Ireland has retained its share in higher value activities likeR&D with leading healthcare and technology firms such asWyeth, GlaxoSmithKline, Microsoft and Oracle investing inR&D facilities in Ireland (captive offshoring) (Frost &Sullivan, 2007). Respectively, many banking and financialservices companies use a captive model for their businessprocesses which cannot be outsourced due to regulatoryconstraints (Frost & Sullivan, 2007).

5. Implications and conclusion

The objective of this paper was to address the keyresearch question guiding this paper: why do firms offshore

their business functions? This is an important question forthree compelling reasons. First, the decision to offshorenon-core activities reflects a shift in the mindset of thestrategic leaders from the dominating mindset of inter-nalization and vertical integration prevailing in the 1970sand 1980s. Second, there is a general consensus among theleading scholars in the arena of offshoring/outsourcingliterature that ‘why do firms offshore their business functions’is an important question meriting rational examination(Bunyaratavej et al., 2008; Graf & Mudambi, 2005;Niederman et al., 2006). Third, indirectly the frameworkthrows light on two core decision-making issues involvingeach activity undertaken by an MNE: (1) the locationdecision, and (2) the control or the ownership issue(Buckley, Devinney & Louviere, 2007).

To address the guiding question, we have drawn frommultitude of strategic management and IB literature. Theeclectic paradigm (Dunning, 1988, 1993), internalizationtheory proposed by Buckley and Pearce (1979) guided us totake a similar approach for a different research question, aswe developed our DLE framework. In addition, the theoryof core competencies (Gilley, McGee, & Rasheed, 2004;Gilley & Rasheed, 2000; Quinn, 1999) and disintegration,the geographic location theory (Dunning, 1988), resourceand capability-based perspective (Argyres, 1996; Barney,1991), social exchange theory (Blau, 1964), and organiza-tional learning theory have formed the basis of thisframework. The DLE framework contends that firmscontemplate offshore outsourcing when perceived advan-tages related to disintegration of value chain activities andexternalization are high and/or superior and the cost ofresources in offshore locations are lower. A captive modelis preferred when perceived disintegration and externa-lization advantages are low but resource-advantage existsin overseas location.

Two significant theoretical contributions distinguishthis article. First, the DLE framework offered here is robustin the sense that it is based on solid theoretical foundationsand can generate testable propositions. Each strand of thisframework can be explored into greater detail for futureempirical work. Past efforts in the realm of global sourcingstrategy (e.g., Kotabe & Omura, 1989) or internationaloutsourcing (Mol et al., 2005) have focused on one set offactors. For example, Graf and Mudambi (2005) focusedsolely on the location dimension. We have intertwinedfirm-specific factors, location-specific factors and inter-firm-specific factors while exploring the same phenom-enon. We believe that such systematic weaving adds

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significantly to the IB literature. Second, offshoring hasbeen identified as one of the most important emergingissues in IB research. This article is partially a response toBuckley and Lessard’s (2005) call for frameworks thatintegrate theories from other disciplines while examiningIB issues. The DLE framework has brought together strandsof strategic management theories, geographic locationtheory and organizational learning theory in the context ofoffshoring that is of profound interest today in the domainof IB and strategic management literature.

Our framework also contributes to the understanding ofpractitioners and policy makers. First, firms contemplateoffshoring when they perceive advantages associated withdisintegration of activities from their value chains. Thedisintegration advantages stem from increased modularityin their structure and enhanced focus on their corecapabilities. Top managers may play important role atthis stage by determining what should be disintegrated orunbundled and what should not be. Identifying corefunctions/activities are crucial, as getting rid of theseactivities by mistake can cause ‘‘competence destruction’’or ‘‘hollowing out’’ whereby the firms loses its corecompetencies (Lei & Hitt, 1995). As each generic activity inthe value chain can be subdivided into distinct sub-activities, a firm competing in any industry needs to askitself the vital question as to which part of an activity canbe unbundled for relocation purpose. We suggest thatfirms need to examine each activity’s critical successfactors such as provider availability, timeliness, flexibility,quality, and cost reduction. Top managers also need tounderstand that the core-versus-non-core distinction isnot always static and can alter depending on thecontinuous self-assessment process by firms. Second,firms usually attempt to harness superior externalresources and go offshore only when the top executivesperceive location-specific advantages in the form ofsupportive infrastructure, low wage rate and better qualityintellectual capital. At this stage, the top managers have todecide on the suitable locations from where the disin-tegrated activities can be sourced either internally(captive) or externally (direct). Our analysis suggests thatthis should be a careful choice based on the type ofactivities to be offshored and relative importance of arange of location-specific country level and human capitallevel factors.

For policy makers, the widening of the global talentpool and offshoring firm’s relocation activities can haveimportant ramifications. The shrinking pool of science andengineering graduates in the US and Europe has been citedby many as an important driver of offshoring activities(Deloitte, 2004; Lewin & Couto, 2007). The policy makers ofthe nations involved may play critical role at this juncture.On one hand, more emphasis on the overall educationinfrastructure in general may refill the talent-gap. Simul-taneously, a more relaxed immigration procedure meantmainly for the highly skilled foreign workers can help inretaining some jobs from going overseas. On the otherhand, developing nations should be encouraged to liberal-ize their economies thereby further widening the globaltalent pool. Additionally, the policy makers in thedeveloping nations should contemplate promoting an

infrastructural environment that would entice offshoringcompanies to use their human capital base. Liberalizedenvironment in these economies will also imply that therewill be more companies from these economies that canpartner with offshoring firms.

Finally, top managers may play the most important roleat the externalization stage by maintaining trust-basedrelationship, by coordinating with their offshoring part-ners, and by implementing externalization-related advan-tages (specialized capabilities and knowledge) to improvefirm performance. Such organizational relationships basedon relational contracting can mitigate opportunism con-cerns and reduce transaction costs associated withextensive monitoring. Consequently, it is also importantfor the offshoring companies to select right vendor(s) thatpossesses superior capabilities and can be trusted. Inaddition, these companies also need to create an environ-ment and culture that would promote the development ofsuch trust-based interorganizational relationships.

In terms of future research, it will be necessary to refineand deepen the broad ideas we have presented in the DLEmodel. The underlying variables representing each strandof the framework should be further explored. Additionalresearch should be conducted to clearly identify whatactivities of the firm can be unbundled and what activitiesshould remain under the hierarchical control. The verynature of the activities or business functions and thestrategic objective of the focal firm can influence thedecision-making process of the managers at the disin-tegration stage. Other industry and institution level factorsthat can impact the decision-making process as well assituational contingencies that are applicable to the frame-work should be examined. In sum, we maintain thatexternalization takes place when the perceived economicvalue of relationship capital, co-specialization and orga-nizational learning exceeds transaction cost driven con-cerns. By putting added emphasis on the theories thatdepict a more positive view of the human mind (e.g., socialexchange theory), we assert offshoring should be viewed inthe light of the new economic landscape of this world. DLEframework hopes to stimulate future research based alongthese lines of enquiries.

Acknowledgements

We are indebted to Professor Yadong Luo and twoanonymous reviewers for their helpful comments andguidance. We also thank Somnath Lahiri and Scott Mootyfor their comments on the earlier version of this manu-script. The senior author gratefully acknowledges thesupport provided by the Fulbright Commission in Irelandand the Wang CIBER at the University of Memphis.

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