COURSE 4A

INTERNALIZATION - EXTERNALIZATION
THE VIRTUAL CORPORATION
TRENDS ON THE TNC MARKETS:
- Redefinition of the firms core activities through stripping away
activities that no longer fit the firms strategy the emphasis is on
core competencies, core business), resulting in a separation of
peripheral
activities.
Thus,
companies
involve
in
external
arrangements in order to improve the operational efficiency and the
capacity to create value added.
- Repositioning of the firms focus along the production chain to
place a greater emphasis on downstream service functions;
- Geographical reconfiguration of the firms production chain
activities internationally and in some cases globally to redefine the
roles and functions of individual corporate units
- Reconfiguration of the firms production chain activities which involves
redefining
the
boundaries
between
internalized
and
externalized transactions.
CHOICE OF INTERNALIZATION OR EXTERNALIZATION STRATEGY
Contracting out of organizational activities is no new phenomenon. The
Romans contracted out tax collection, while in the 18 th and 19th century
England, services provided by the private sector under contact to the then
local authorities included the maintenance and operation of street lights,
prison management, road maintenance, the collection of public revenue.
Similarly, in the USA and Australia, the carriage of mail delivery was
entrusted to private operators during much of the 19 th century. In France, the
building and operation of the railways, water storage and distribution
facilities were auctioned to private operators by competitive tender. Thus,
prior to the industrial revolution, contractual relationships between
government and the private sector dominated the economic organization of
production and distribution.
With the onset of the 20 th century, the development of a production
technology that favored large, vertically integrated enterprises and the
growth of direct government involvement in the economic activities of the
state led to an internalization of transactions within organizations and a
decline of contracting out.
Historically, centralization of the company and its vertically integrated
organization was seen as necessary for three reasons:
- First, the physical location of machines, it can be argued, necessitates
centralization, which in turn, generates benefits from specialization in
labor, or vice versa.
On this particular view the firm is characterized by its production function,
which is to say that its internal organization is not shaped by market forces,
but by the nature of the production process and the technology employed in

it. Thus, the emergence of large centralized enterprises, with which we

associate mass manufacturing, is determined by technological developments.
- Second, a hierarchy emerges when the costs of using the market
mechanism exceed the costs of internal organization (Coase, 1937).
The costs to use the market mechanism include (1) ex ante marketing
costs, (2) bargaining costs and (3) ex post contract enforcing costs
(Williamson, 1985).
- The third explanation of the existence of centralized firms traces its
lineage to Knight (1921) - any decentralized method of implementation
will lead to bottlenecks due to human error or opportunistic behavior,
i.e., when agents break away from their previous agreements in pursuit
of higher gains. Also, a primary source of market uncertainty is
competition. As firms introduce new products and new methods of
production the market life of existing products is shortened, and more
so, of products that are manufactured with less cost-effective methods.
Thus, uncertainty weighs heavily on producers because competition
can cause production losses and assets obsolescence, and can force
firms out of the market.
However, the same factors that forced a retreat from contracting out have
also let to its resurgence during the last 25 years:
- the shift from the perception that managerial power and pay within
organizations are largely determined by the size of revenue created
and by the number of employees, to concepts concerning the
profitability of business units and the value added they
promote the perception of success has shifted from running large
empires to running lean organizations.
- the development of a market for the provision of outsourced services,
so that external service providers can deliver to a scale and scope that
many single organizations would find difficult to match in-house
Similarly, in the public sector, government pressure and legislative
requirements have encouraged organizations to contract out certain of their
internal processes, functions and even prime services, to competitive tender.
The theoretical seeds of this discussion can be found in Coase's (1937)
article. In it he foresees two factors that contribute to the growth of firms:
(1) inventions that reduce the cost of organizing spatially, such as telephone
and computer networks, and
(2) improvements in managerial techniques, which also tend to reduce
the cost of organization.
Two of the costs associated with using the price mechanism are transaction
and marketing costs.
The coordination of productive processes may be performed through
transactions on the market or inside the company, on the basis of hierarchical
procedures and principles (Coase, Williamson).
Coase argues that it costs to go through the market and he identifies those
costs as transaction costs: according to Coase, in order to be able to satisfy
the need on the market we need to identify the partner, to negotiate the
conditions of the contract, to establish some form of guarantees.

Coases work was continued and refined by Williamson, who identified two
criteria for determining the option and arbitrating between internalization and
externalization:
- frequency of use more frequent the need, more will the company
try to avoid replicating transaction costs and will tend towards
internalization
- degree of specificity of the assets more specific the need, larger
the transaction costs, thus the tendency towards internalization > for
standardized services externalization
- uncertainty
Further insight into these issues lead to the conclusion that what processes
are internalized and what are carried through the market is determined not
just by consideration of production and transaction costs but also by whether
the internalization contributes to:
o the protection of competitively valuable information,
o the proprietary use of which gives the firm competitive edge,
o and secures the realization of its profits.
There are various meanings attached to contracting out or
outsourcing, ranging from contracting out work, to processes involving
activities traditionally carried out internally which are contracted out to
external providers, or to the use of outside resources to complement
organizational own design and development effort.
Consequently, outsourcing is the strategic use of outside resources to
perform activities traditionally handled by internal staff and resources. Small
business owners can outsource non-core functions to specialized and efficient
service providers. It is required of businesses to hire special contractors for
particular types of work or to meet the demands put forth by sudden spurts
in the workload. Recently, the trend of partnering with firms whose
capabilities complement their own giving them an access to resources that
were beyond their individual reach has come up.
The difference between simply subcontracting and outsourcing is that
outsourcing involves the wholesale restructuring of the corporation around
core competencies and outside relationships.
Business process outsourcing is the contracting of a specific business task,
such as payroll, to a third party service provider. Usually, BPO is implemented
as a cost-saving measure for tasks that a company requires but does not
depend upon to maintain its position on the marketplace. BPO is often
divided into two categories: back-office outsourcing, which includes internal
business functions such as billing or purchasing and front-office outsourcing,
which includes customer-related services, such as marketing and tech
support.
Benefits and costs of outsourcing
The extent to which economic activity generates wealth depends on the
efficiency of both production and exchange (Ricardo, 1962). Inefficiency in
either factor can lead to a considerable increase in costs. Hence, the benefits

of outsourcing essentially stem from gaining benefit from either production or

exchange through contractual relationships. However, successful contractual
relationships are not simple spot transactions, or bilateral exchanges, but
rather ones that combine market discipline with long-term, cooperative
relationships.
Benefits from outsourcing:
Four broad categories of benefits from adopting outsourcing arrangements
are identified:
1. specialization having other companies specialist in the production
and provision of supporting goods and services allows the host
organization to concentrate on core competencies. Focusing on core
competencies and leveraging against other sourced relationships
allows for the achievement of economies of scale, thus producing
goods and services more efficiently, while improving quality through
the application of specialist knowledge and promoting competitive
advantage.
2. clarifying configurational arrangements if the product and services
offered by the organization are considered exclusive, then the
configurational balance shifts in favor of vertically integrated
structures. If market disciplines highlight that the products offered hold
commodity status, in order to maintain differentiation, economies of
scale need to be introduced, which may involve the creation of
interorganizational synergies. Exposing the organization to market
disciplines assists the management to focus on configuring the
organization in a manner that sustains their competitive position by
enhancing their capability to offer goods and services at prices
attractive to purchasers and, in turn, promote conditions for innovative
work practices.
3. flexibility enterprises that are to survive in competitive markets need
to display an ability to appropriately adjust their infrastructure scale
and scope at a low cost and a rapid rate (Hayek, 1945). Competitive
advantage through flexibility operates on the premise that networks of
small companies, aligned with their clients, underpinned by
performance-related contracts, are able to adjust more quickly and
cost effectively to changing demand conditions than large integrated
corporations (Hayek, 1945). Outsourcing permits the organization to
redirect its resources from non-essential activities towards those
essential activities that generate the greater reward.
4. cost savings market competition usually induces an environment of
competitive pricing, thus forcing the lowering of the resource cost of
goods and service delivery. In order to maintain a cost-driven
competitive advantage, an efficient mechanism for reducing resource
cost is outsourcing. Frequently quoted contracting experiences indicate
cost savings between 10% and 30% of previous in-house production.
Costs of outsourcing:
Using markets to assist economic transactions in order for the enterprise to
become more efficient equally entails experiencing certain costs. Four broad
categories of costs associated with outsourcing are identified:

1. hollowing out excessive outsourcing can lead to considerable

reduction of overhead so that the host organization becomes a fraction
of its former self, sometimes termed as hollow corporation or virtual
organization. BMW, General Motors, Virgin, Benetton, BP, Amoco,
Nike, Marks & Spencer have been substantially moving in this
direction, whereby the system integrators in almost all functions are
contracted out to a collaborating network of companies. This trend will
continue as companies will outsource those activities that hold a
commodity status and keep those that make them unique.
2. loss of skills and corporate memory by contracting out goods an
services traditionally produced in-house, the organization loses the
skills, competencies and collective knowledge as both a producer and
client of those services. Such costs are not only associated with loss of
skills per se, but also leave the organization vulnerable to acquiring
desired expertise in the future, on reasonable competitive terms.
3. weakened innovative capacity contracting out reduces the incentive
to and the capability of being innovative, as the competitive pressure
to innovate is transferred to suppliers.
4. transition and switching costs contracting out activities requires a
redefinition of organizational boundaries, which in turn induces
possible further restructuring and dislocation of resources, thereby
inducing a variety of costs. Such costs, especially when associated with
loss of employment, are financial as well as social.
The nature of outsourcing
Current literature purports that an enterprise outperforms its competitors
only if it can establish a sustainable desirable difference, weather by
delivering greater value to customers, or promoting comparable value but at
a lower cost, or a combination of both (Porter, 1996).
In order to be able to deliver greater value or comparable value but at a
lower cost, the realization of the enterprises advantage stems from the
nature of the outsourcing purpose and the manner in which
organizational activities are sourced. Hence, the outsourcing of
organizational activities holds significance both operationally and
strategically.
Outsourcing purpose:
The nature of outsourcing is determined by the decision regarding the
allocation of resources on behalf of the enterprise for the undertaking of
organizational activities.
Until the early 1980s, vertical integration and conglomerate diversification
stood out as distinct configurational trends, and were considered as yielding
efficiencies in terms of economies of scale and synergies in terms of
market/consumer impact.
Since then, the trend has been reversed, with a going back to a philosophy of
`core business' (Peters and Waterman, 1982), resulting in companies
divesting peripheral businesses which were considered as unrelated to their
core activities. As a result, companies have increasingly searched for new

sourcing arrangements that will give them the lead in terms of competitive
advantage
As such, sourcing has been undertaken either:
1. to improve operational efficiency or
2. to enhance value-adding business capability (Porter, 1996).
1.) Increasing operational efficiency implies undertaking similar activities
but with greater cost discipline application than competitors and includes any
number of practices that allow a company to more effectively utilize its
inputs, for example reducing defects in products, or developing better, faster,
cheaper products or services (Porter, 1996).
In order to improve on efficiency, the senior management of a company
would need to continuously reconsider their capital investment, recruitment
policy and ways of managing, or a mixture of all three, as the productivity
frontier is constantly shifting outwards as new technologies and innovative
management approaches are developed and new inputs become available
(Porter, 1996). Competitors quickly imitate newly introduced best practice,
new technologies, input enhancements, and ways of meeting customer
needs, thereby emphasizing continuous operations effectiveness as
necessary in order to achieve competitive advantage.
2.) In contrast, improving business capability requires consideration of
issues of strategic positioning, which may lead to adopting a unique market
position which differentiates the enterprise from competitors (Porter, 1996).
Improving business capability requires reconsideration of product
configuration, the application of different equipment, the development and
training of employees' in new skills and the application of different
management systems, all of which hold sourcing implications.
Therefore, in deciding on the purpose of outsourcing, the company needs to
consider the location of organization boundaries. In doing so, the
management needs to decide which activities it should source itself and
which should be sourced through the market (outsourced).
Organizational activities
Organizational activities are defined as the basic units of competitive
advantage for an organization (Porter, 1996). Thus a business is profitable if
the value it creates exceeds the cost of producing such activities (Porter,
1985). In order to gain competitive advantage, a company must either
position its activities to perform at a lower cost than competitors, or perform
in a way that leads to differentiation according to perceived utilized value and
thereby attract premium prices (Porter, 1980).
As in Porter and Millar (1985), who differentiate between the two generic
categories of activities, primary activities and support activities, for
outsourcing purposes two generic categories of organizational activities are
also identified: essential activities and non-essential activities. Essential
activities are those involved in the creation of products and services, and
may include research and development, marketing, delivery. While nonessential activities provide the inputs and infrastructure that allow for the
functioning of essential activities, such as support service activities.

THE VIRTUAL CORPORATION

The concept of virtual organization is part of the broader concept of the
firm and its economic function. It is a new concept brought into existence by
developments in computer networks, which are changing the workplace in no
less significant way than the factory did during the Industrial Revolution.
If the eighteenth century firm moved workers from their homes to the factory,
today, corporate computer networks are moving the workplace back to the
homes of employees
The firm as an institution appears to be in transition and, hence, the question
is how future firms will differ from todays firms. The issue is what will be the
internal organization of firms and how decentralized they will be, because
virtualization implies the vanishing of the formal and spatial boundaries of
firms.
Prior to the emergence of the virtual organization the firm was perceived as a
centralized organization in terms of both control and the physical location of
its assets. The centralized or hierarchical organization is an alternative to
market exchange, and the difference is that within the firm command
directs the use of resources, while in the market prices direct the use of
resources.
LIMITS OF DECENTRALIZATION
Let us try to imagine how an ideal virtual firm does business.
An ideal virtual firm is one in which all processes that require additional labor
inputs are subcontracted. Thus, all unitary agents are dissolved into
individual market agents, which leave no logical possibility for hierarchy.
Therefore the market and its high-power incentives have triumphed over the
command and hierarchical organization.
When the relationships among individual market agents are highly
impersonal, all coordination is indeed achieved simply through the price
mechanism in a Hayekian manner. It emerges spontaneously as prices
transmit information to market agents, and thus, cause immediate
adjustments to individual plans.
The ideal virtual organization just described requires that independent market
agents bid to supply all inputs necessary for its operations. But what are the
implications of such an organization?
More precisely, the question is whether one can request bidding for
development of competitively valuable information and for collection of
competitively valuable information, and whether it is wise to do so.
If a software developer posts on his website all the components which
he needs in order for other programmers to bid for the jobs he is in fact
making public the architecture of his product. This is equivalent to making
blueprints, R&D plans, etc. public knowledge. In turn, it increases competitive
uncertainty, for any other agent can use the information to develop a similar
product, and if they do it faster, the virtual firm will be at competitive
disadvantagethe competitor will have secured a first-mover advantage. It
can be concluded that the ideal virtual firm is completely unprotected against

the actions of competitors for competitive bidding cannot be organized

virtually without producers giving important information.
The alternative to bidding for the supply of products and services is
bidding for jobs. The benefit of this process is that the employer does not
need to disclose the details of the job, and hence competitively valuable
information is better preserved. Thus, employment contracts can be
virtualized with significantly less risk of dissemination of competitively
valuable information. In fact, we see a substantial amount of job postings on
the Web. Employment, however, is not cheap for the employer, and involves
different types but equally substantial risks and costs. For instance, the
employee may not be suitable for the job, and at the same time, the
relationship often cannot be terminated immediately, which means that
wages are sunk costs to the employer.
Hence, it can be said that if it were not for the impossibility of
firms to subcontract certain processes without increasing their
competitive uncertainty, firms will not hire any workers.
The conclusions that can be drawn is that processes which
contribute to the collection, development, and protection of
competitively valuable information will not be outsourced since
outsourcing increases the dissemination of information, and as it becomes
available to competitors, competitive uncertainty also increases. On the other
hand, processes that do not contribute in any way to the management of
competitively valuable information will be outsourced for their internalization
utilizes managerial resources, which is one of the most costly inputs in the
firm.
THE VIRTUALIZATION OF FIRMS: THE CASE OF THE FORD MOTOR
COMPANY
The Ford Motor Company's recently adopted new business model
provides a starting point to see whether the adaptive strategy of firms to the
virtual economy conform to the predictions of our conclusions.
The Ford Motor Company case is even more relevant given that the
company has transformed itself many times over the course of its existence.
Its transformations not only occurred parallel to the changes in the concept of
the firm, but may be viewed as a test of the validity of these theories.
According to the new business model the Ford Motor Company will
transform itself from a mass producer of cars into a consumerproducts and services company. That is, Ford does not see production to
be its core activity in the future. In fact, what classifies the change in Ford as
revolutionary is that Ford is the first car manufacturer to outsource final
assembly (The Economist, 7 August 1999). The outsourcing of final assembly
is a new trend that is exactly the opposite of what happened historically in
the automotive industry.
Vertical integration in the automobile industry proceeded in the direction in
which final assemblers, such as GM, bought out their part suppliers (Candler,
1982) Thus, Ford's decision to outsource final assembly appears as a reversal
of history, more so, given the fact that the Ford Motor Company today is
partly the result of the invention of the assembly line by Henry Ford.
Furthermore, Ford aims not only to subcontract final assembly but also to

make subcontractors responsible for maintenance, property management

and utility supplies in its factories. At first glance, it appears that that the
Ford Motor Company has jumped on the subcontracting bandwagon, and that
by opening wide its factory doors it is making its manufacturing blueprints
publicly available, and is, thus, exposing itself to competitive risks.
But is it? Unlike in the early days of the company, when improvements
in the assembly process were key to the firm's competitiveness, today
external vendors provide the assembly machines, and thus, there is little
competitively valuable information in this process. Hence, whether the Ford
Motor Company keeps or outsources its assembly does not affect in any way
its competitive position on the market, for there is no dissemination of
competitively valuable information when the doors of its factories are opened
for subcontractors, nor a threat that subcontractors may move into car
production.
Let us look now at the activities that will be retained in the
company, and that will sustain Ford's position as the world's leading car
company.
According to the new business model the Ford Motor Company will
concentrate in the future on the following core activities:
(1) product development and research, i.e. car design and engineering,
(2) branding, and
(3) marketing and service operations (Financial Times, 4 August 1999).
It is not difficult to see that these three activities contribute directly to the
collection, development, and protection of competitively valuable
information.
Taking into consideration that most of the information developed by
R&D is protected through patents and trade secrets, and that most of the
information collected by marketing and service departments is also protected
through trade secrets and confidentiality agreements, we can conclude that
information protection is implicit in these functions, and their retention within
the company only reinforces this protection. Branding, on the other hand, is
retained within the company because the massage that it conveys is closely
related to the strategic plans of firms, which no firm wants to expose to the
risk of being found out by its competitors.
As is evident, the virtualization of the Ford Motor Company is carefully guided
by considerations about which processes contribute to the collection,
development, and protection of competitively valuable information. This is a
controlled process of virtualization, which in contrast to the process
of uncontrolled virtualization adopted by IBM in 1981 for the
development of its PC. IBM gained a short-term advantage from outsourcing
key processes to Intel, Microsoft, and other vendors, for it was able to launch
the PC on the market within 15 months and with minimum investment. In the
long run, though, Intel and Microsoft intensified IBM's competition by
supplying its competitors, such as Compaq (Teece, 1996).
With the launch of its first personal computer in 1981, IBM chose to outsource
all the major components. The microprocessor was bought from Intel, while
the operating system was licensed from Microsoft. Moreover, the distribution
channels were outsourced to a large number of retailers such as
ComputerLand, Sears, BusinessLand, and MicroAge. The strong extrinsic

incentives produced by the market enabled IBM to get its first PC to market in
only 15 months and to launch an attack against Apple, the market pioneer.
However, with the passage of time, IBM had to learn a lesson. Because
outsourcing necessitates making knowledge explicit to allow production and
service level agreements, the competitors in the markets for PCs had an open
door to imitate. They could buy the same operating system from Microsoft,
the same software from Lotus, WordPerfect, and Microsoft and use the same
distribution channels. As a result, IBM lost much of its competitive advantage
as well as its ability to direct the evolution of the PC architecture.
However, the right balance between insourcing and outsourcing is crucial
because no company is able to develop internally all the technology
necessary for a successful future product.
Chesbrough and Teece (1996, pp. 7073) also discuss Motorola, a leader in
wireless communication technology, as a firm that has chosen the right
balance. To retain its competitive advantage over the long run, battery
technology is critical for Motorola. It therefore develops the critical parts of its
value chain (fuel cells and solid-state energy sources) internally and buys the
less critical battery technologies, such as nickel cadmium, on the market.
We have argued above that there is another set of costs associated with the
use of the market mechanism, i.e. the costs of reducing competitive
uncertainty. Such costs, called protection costs, are incurred to collect,
develop and protect competitively valuable information, which value
is determined from the ability of firms to use it. On this account, full
understanding of the internal organization of firms can be gained only if all
costs, i.e. those production, transaction and protection, are considered. The
proposed model for the virtualization of firms is based on the fact that
processes which contribute to the collection, development, and protection of
competitively valuable information will be internalized, in order to secure its
proprietary use. When the cost to retain processes within the firm is higher
than the cost to transact in the market, organizational costs are protection
costs. On the other hand, processes that do not contribute to the reduction of
competitive uncertainty will be outsourced to save on organizational costs.
Finally, it can be added that the spatial boundaries of quasi-virtual firms will
be set by the cost of the firewalls around corporate networks.

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