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ARTICLE IN PRESS

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

The impact of outsourcing on the transaction costs and boundaries of manufacturing Ian McCarthya,*, Angela Anagnostoub a

SFU Business, Management of Technology, Simon Fraser University, 515 West Hastings Street, Vancouver, BC V6B 5K3, Canada b Brasenose 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 valueadding processes that consist of transformation functions. Service, transportation and retail organizations perform processes that focus on information, geographical distance and availability, respectively. Manufacturing organizations focus, by definition, on processing raw material, but since the industrial revolution they have evolved into businesses that also deal with significant amounts *Corresponding author. SFU Business, Simon Fraser University, 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).

of information processing (design, marketing, R&D, customer service, etc.) geography processing (distribution and logistics) and availability (retail outlets). Pioneered in the 1930s by organizations such as the Ford Motor Company, which was fervent about control, rationalization and the elimination of uncertainty, many corporations since then have sought growth and power by conglomeration, and vertical and horizontal integration. The Ford Motor Company altered the boundary of its organization by acquiring and integrating businesses that were parts of its supply chain. These included mining companies, shipping companies, railway companies and rubber plantations. This strategy, not only provided ownership and

0925-5273/03/$ - see front matter r 2003 Elsevier B.V. All rights reserved. doi:10.1016/S0925-5273(03)00183-X

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I. McCarthy, A. Anagnostou / Int. J. Production Economics 88 (2004) 61–71

enhanced control of the supply chain and market, but as reported by Lonsdale and Cox (2000) it offered organizations the potential for economies of scale and the opportunity to exercise greater market power. Manufacturing organizations are complex systems that consciously evolve in response to market needs, competition and innovation. Directing this evolution is a key management responsibility that involves making decisions about the configuration and boundary of an organization, to ensure competitiveness relative to market demands and stability. This concept is central to the transaction cost perspective (see Section 2.2), which asserts that organizations seek to reduce costs (direct costs and associated support costs) by forming alliances or selecting structures and practices that lead to efficiency improvements. This cost minimization hypothesis has underpinned the purchasing function and is a key issue in both defining an organization’s boundary and understanding the benefits of outsourcing. For instance, in the early 1990s, many manufacturing organizations had evolved into businesses that were no longer just concerned with material processing and assembly. They had extended their boundaries and remit to focus on converting an idea or need into a marketable product, along with the provision of appropriate product support and service. The conglomeration and vertical integration activities of the previous 60 years had helped manufacturing organizations achieve this change in focus, but at the expense of burdening the organization with excess and inefficient processes and services, and uncompetitive transaction costs. With this development in organizational focus, the need and trend for outsourcing emerged. It was based on the assumption that a competitive advantage would be gained if external suppliers were contracted to carry out non-core processes more efficiently and effectively. To achieve more proficient and profitable functions in areas such as accounting, logistics, catering, design, production, IT support and customer service, manufacturing organizations began to utilize the core-competencies of other manufacturing, service and transportation organizations. Today, manufacturing is the industry sector most likely

to outsource, with durable goods manufacturers accounting for 39% of all activity and non-durable goods manufacturers accounting for 25% (Zhu et al., 2001). In addition, with a global outsourcing market estimated at d188 billion in 1998, and with annual growth rates of 15% (Coombs & Battaglia, 1998), the distinction between economic activities in different sectors has become blurred. With the practice of outsourcing experiencing exceptional growth, this paper examines a possible corresponding and related change, a decline in manufacturing as an economic activity, and considers how outsourcing alters the perceived contribution that an organization makes to a country’s GDP. The conclusion is that the boundaries of manufacturing activity have altered, changing the ownership of certain aspects of the economic activity. Thus, to properly understand and measure the economic value of manufacturing requires an approach that recognizes the highly integrated and codependent set of activities that constitute the modern economic system of manufacturing. To review and assess this notion, this paper will proceed as follows. Section 2 reviews the economic benefits and drivers that motivate manufacturing organizations to outsource. Section 3 provides an introductory account of the macroeconomic decline that has occurred in UK manufacturing and asserts that the decline has been influenced by the practice of outsourcing, which has shifted activities and employment from manufacturing to services. Section 4 examines this claim by using an input–output methodology and more specifically the decomposition approach (Dietrich, 1999) to investigate the impact that outsourcing has had on the boundaries and outputs of the manufacturing sector. This method can be used to analyze the flow of goods and services from every sector to every other sector in the UK economy at a specific point of time. Thus, flows of goods and services can be traced between sectors and their relative contributions to economic output, value added or productivity can be estimated. The methodology is demonstrated using a range of UK input–output data. Section 5 provides a conclusion.

ARTICLE IN PRESS I. McCarthy, A. Anagnostou / Int. J. Production Economics 88 (2004) 61–71

2. The case for and against outsourcing 2.1. What is outsourcing? Outsourcing has become an important business approach, whereby a competitive advantage may be gained when products or services are produced more effectively and efficiently by outside suppliers. It is an agreement in which one company contracts-out a part of their existing internal activity to another company. As a management practice it has probably been in existence for over 200 years, but during the last 15 years, with the support of academics, consultants and industry forums, it has developed into a popular strategic management initiative. During this 15-year period, the economic value, strategic importance and complexity of the outsourced function (when considering manufacturing organizations) has increased; evolving from routine and non-valueadding functions, such as security, cleaning and catering, to key support and value-adding functions, such as information technology, logistics and accounting, to core manufacturing-related functions, such as design and certain production processes. Outsourcing not only purchases products or services from sources that are external to the organization, but also transfers the responsibility of the physical business function and often the associated knowledge (tacit and codified) to the external organization. It is this adaptation, driven by transaction cost rewards, functional competitiveness, strategic development and the business pressures of globalization and technological change, that has altered the configuration (how the organization is designed managed and operated) and boundary of the modern manufacturing organization. These changes not only affect an organization’s performance, but also the perceived contribution of an organization and its industrial sector to an economy. 2.2. The case for and against outsourcing There have been several studies that have examined the motivations for and benefits of outsourcing. Abraham and Taylor (1993) identi-

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fied three reasons for outsourcing: (i) savings on wage and benefit payments, (ii) transfer of demand uncertainty to the outside contractor, and (iii) access to specialized skills and inputs that the organization cannot itself possess. Kakabadse and Kakabadse (2000) report that the main reasons for outsourcing are: (i) economic—greater specialization in the provision of services, as outsourcing allows economies of scale and the longevity of demand for the activity; (ii) quality—access to skills, the competency and focus of potential suppliers and geographical coverage is increased; and (iii) innovation—improvements in quality through innovation, and the development of new service products, can lead to new demands. Bendor-Samuel (1998) also asserts that outsourcing provides certain power that is not available within an organization’s internal departments. This power can have many dimensions: economies of scale, process expertise, access to capital, access to expensive technology, etc. The combination of these dimensions creates the cost savings inherent in outsourcing, because the outsourcing supplier (the organization specializing in a particular business function) has the economy of scale, the expertise and the capital investments in leading technology to perform the same tasks more efficiently and effectively than the internal departments of the outsourcing ‘buyer’. Another possible benefit is that outsourcing provides companies with greater capacity for flexibility, especially in the purchase of rapidly developing new technologies, fashion goods, or the myriad components of complex systems (Carlson, 1989; Harrison, 1994). Companies can buy technology from a supplier that would be too expensive to replicate internally. A network of suppliers could provide an organization with the ability to adjust the scale and scope of their production capability upward or downward, at a lower cost, in response to changing demand conditions and at a rapid rate. As such, outsourcing claims to provide greater flexibility than the vertically integrated organization (Carlson, 1989; Harrison, 1994; Domberger, 1998). Furthermore, outsourcing can decrease the product/ process design cycle time, if the client uses multiple best-in-class suppliers, who work simultaneously

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on individual components of the process (Quinn and Hilmer, 1994). The case against outsourcing is based on arguments such as loss of management control, reduction in flexibility and increased costs. For instance, competitive outsourcing requires a high standard of supplier management to avoid the pitfalls of transferring critical functionality, or becoming too dependent on a supplier for day-today performance of vital business functions. In addition, outsourcing can generate new risks, such as the loss of critical skills, developing the wrong skills, the loss of cross-functional skills, and the loss of control over suppliers (Domberger, 1998; Quinn and Hilmer, 1994). The possible loss of flexibility is connected to the typical long-term contractual relationship that is formed as part of an outsourcing agreement, and that during the contract term, the customer’s business, the available technology, and the competitive and regulatory environment may change dramatically. Thus, this inflexibility is mostly linked to an unyielding and inappropriate contract. Although outsourcing is undertaken by many organizations to control or reduce costs, there is some evidence that it does not decrease costs as expected, and in some cases, costs increase. For instance, when an item is outsourced, the assumption is that the supplier’s costs and required contribution is less and will continue to be less than the cost of internal provision. A survey based on 1000 managers worldwide by the PA Consulting Group (PACG) revealed that only 5% of organizations gained ‘‘high’’ levels of economic benefit from outsourcing (PA Consulting Group (PACG), 1996) and that 39% of organizations admitted ‘‘mediocre’’ economic benefit. Also, as outsourcing leads to a re-definition of organizational boundaries and, by implication, structural adjustments involving human resources, these changes incur social as well as financial costs. Although the social costs are transitory and can be mitigated by facilitating the adjustments through the re-training and redeployment of staff within the organization, their transfer to the supplier organization and ensuing redundancy payouts can still be considerable (Domberger, 1998; Hall and Domberger, 1995). Also, outsourcing can lead to industrial disputes

between employers and employees, which in turn can damage morale, trust and productivity. In summary, the rationale for practicing outsourcing is to exploit external suppliers’ investments, innovations, and specialized professional capabilities. This helps an organization to reduce its operating costs, whilst achieving an increased focus on its core competencies. This obvious and important benefit is consistent with transaction cost economics, which was largely developed by Coase (1937) and Williamson (1975, 1979). Transaction cost analysis integrates economic theory with management practice and organization science to study why organizations exist, what are their configurations and what determines their boundaries based on the assumption that transaction costs are minimized. Transaction costs are the full cost of providing products or services including negotiating, monitoring and enforcing the contractual agreement. Therefore, regardless of whether the motivation for outsourcing is strategic, operational, political, innovative or structural, transaction cost analysis asserts that the properties and economic benefits of business functions, whether internal or external, influence the configuration and boundary of the organization. How this effects the economic impact of outsourcing on structure and perceived size of industrial sectors is not clear. Yet, outsourcing is a management process that alters the boundary of an organization and therefore changes the economic contribution that an organization makes to its industrial sector and thus to the economy.

3. The changing context and boundaries of UK manufacturing Although manufacturing is essential to successful industrialization and has been regarded as one of the most important elements of the UK economy up until the late 1960s, it no longer occupies that status. The period from the early 1970s to the early 1990s was one of many changes with recessions and recoveries. In particular, the oil crises of the early 1970s and the recession of 1979–1981 had a severe impact on the structure of


the UK industry. The UK economy underwent a prolonged period of expansion in the 1980s. This represented recovery from a deep recession and entailed considerable structural change, particularly in manufacturing. Output fell at the turn of the decade and only returned to its 1979 level in 1987. Much effort in recent years has been devoted to comparisons of the UK’s industrial performance with that of other industrialized countries. For a sustained period, UK manufacturing lost share in world markets and within the domestic economy. Manufacturing gross value added (GVA) as a percentage of total national gross value added fell, from 26.5% in 1980 to 18.8% in 1999. This was accompanied by significant changes in employment in the manufacturing industry. In the 1969 manufacturing provided over 8.1 million jobs 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, and particularly in manufacturing employment, was accompanied by substantial changes in the relative size of other sectors. In essence, there are definable stages of economic development and the final stages are characterized by a growing and healthy tertiary sector (i.e. transport, construction, distribution and services) with growing preferences for service products. In addition, the contribution of value added from the services to national gross value added has been rising gradually from 59.9% in 1980 to 70.2% in 1999 (see Table 1), which suggests that the UK appears to be a servicedominated economy. When considering this competitive and structural change in UK manufacturing, it is important to recognize that organizations are open systems. They have permeable and changing boundaries that reflect the domain of an organization’s activities and functions. Outsourcing has encouraged manufacturing organizations to alter their boundaries and become extended enterprises (see Fig. 1) by setting up partnerships, and by collaborating and trading with other manufacturing, service and transportation organizations. This has increasingly resulted in a nebulous manufacturing sector, with indistinct manufacturing orga-

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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 Agriculture 2.1 Mining and 4.4 quarrying Manufacturing 26.5 Utilities 5.3 Construction 6.1 Services 59.9

1.9 2.7

1.2 2.3

23.0 2.3 6.9 67.1

18.8 2.3 5.3 70.2

1990

654 361

1999

592 208

525 107.8

7081 5398 3936 2343 1820 1886 1617 1559 1767 14,937 14,547 20,718

Source: UK National Accounts, 2000; National Statistics: Monthly Digest of Statistics, 2000. Traditional Single Organization Approach

Flow of market needs or idea

Products and services

Primary Value Adding Environment (PVAE)

Flow of resource

Waste

An Extended Enterprise based on a Value Adding Network of Organizations PVAE Flow of market needs or idea

Products and services

S S

OEM

Flow of resource

T

T OM

Waste

OEM =original equipment manufacturer S = service organization T = transportation organization OM = other manufacturer

Fig. 1. Traditional and extended enterprise.

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


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Table 2 Value added and gross output (d millions), 1989–1998

1989 Value added Gross outputc 1992 Value added Gross output 1997 Value added Gross output 1998 Value added Gross output

Manufacturinga share of total

Tertiary share of totalb

23.8 31.8

69.0 44.3

20.9 27.1

75.9 65.6

20.8 26.3

76.5 67.5

20.0 25.0

78.3 69.4

Source: UK National Accounts, 2000. a Manufacturing value added divided by total value added. b Tertiary value added divided by total value added. c Constant price estimates of gross output by industry.

manufacturing value are not appropriate. The manufacturing sector has been restructured and extended into non-manufacturing sectors, thus changing the contribution that this industrial sector makes to a sector’s gross domestic product (GDP). The significance of these differences is indicated in Table 2 where manufacturing value added and gross production are compared with that of a broadly defined private tertiary sector (transport, construction, distribution and services). As manufacturing has reduced in value added and gross production (23.8–20% and 31.8–25%, respectively), the tertiary sector has increased in terms of both value added and gross production over the period 1989–1998 (69–78.3% and 44.3–69.4, respectively). Using the input–output methodology and more specifically the decomposition approach explained below, the next section examines the impact that outsourcing has had on the boundaries and output of the manufacturing sector. The UK input– output tables between 1984 and 1998 show that there has been a significant increase in the gross purchases that UK manufacturing makes from non-manufacturing sectors (services and transport in particular).

4. A methodology for measuring economic restructuring Based on the assumption that supply equals demand, the input–output methodology permits study of the structural changes in an economy by separating economic activity into four categories: intermediate deliveries, final demands, primary inputs and final demands of primary inputs. Basically, supply or sectoral output must equal final demand plus intermediate demand; and on the production side, intermediate inputs and primary inputs are combined to produce the level of output. Thus, the standard input–output methodology for input–output data is based on the following identity: xi ¼ zi1 þ zi2 þ ? þ zij þ ? þ zin þ fi ;

ð1Þ

where the total output of any industry can be disaggregated into amount bought by industry from industry j and the output from industry i (zij ) supplying final demand fi : For all n industries, in matrix notation, x ¼ Z þ f:

ð2Þ

The intermediate deliveries Z denote transactions between economic (manufacturing) sectors. The manufacturing sectors use commodities of other sectors as inputs in production of their own commodity. An element zij of the n n matrix Z denotes the intermediate deliveries from sector i to sector j: A large part of the production is used directly for consumption as raw material for products or as a technology investment. The final demand f consists of the output of production sectors used for consumption, investment, government expenditures, changes in stocks and exports. An element fig of the matrix f denotes the deliveries from sector i to final demand category g: A manufacturing sector also requires inputs that are not produced solely by one of the sectors. Such inputs include payments for labor, capital, imports, indirect taxes minus subsidies, and profits. Hence, primary inputs consist of value added and imports, and factor inputs may be used directly for consumption, investment, etc. From the UK input–output tables, several relationships and coefficients have been derived.


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The matrix with intermediate deliveries can be expressed as a matrix of input coefficients with the elements of the vector of total inputs on its main diagonal:

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

# Z ¼ Ax;

Dx ¼ ðLtþ1 Lt Þf tþ1 þ Lt ðf tþ1 f t Þ ¼ DL f tþ1 þ Lt Df

ð3Þ

where which A is defined as A Zx# 1 ;

ð4Þ

x# denotes the digitalized matrix of the vector x. The matrix A consists of input coefficients aij as the amount of product x required per unit of product j: Therefore, the input coefficients are the elements of the intermediate deliveries part of the input–output table divided per column by the total inputs of that sector: zij aij ¼ ; ð5Þ xj which represents the direct requirements of the output of any sector i per unit of any other purchasing sector j ði; j ¼ 1; 2; y; nÞ: From Eqs. (3) and (2) yields x ¼ Ax þ f

ð6Þ

or x ¼ ðI AÞ1 f ¼ Lf;

ð7Þ

where I is the n n identity matrix and L is the Leontief inverse derived from the input coefficient matrix A. Leontief inverse matrix represents the direct and indirect requirements of sector i per unit of final demand for the output of sector j: A sufficient condition for the existence of the Leontief inverse is that no column sum is larger than 1 while at least one column sum is smaller than 1 (Nikaido, 1970; Takayama, 1985). Changes in the input–output data can be used to describe the extent to which restructuring, involving outsourcing and related activities such as contracting out, and subcontracting has occurred. Suppose that changes in total output x are decomposed into the contributions of two factors—the Leontief inverse and the final demand f—and if the value of total output is known at times t and t þ 1; the change in total output Dx is given by Dx ¼ xtþ1 xt ¼ Ltþ1 f tþ1 Lt f t :

ð8Þ

ð9Þ

or Dx ¼ ðLtþ1 Lt Þf t þ Ltþ1 ðf tþ1 f t Þ ¼ DL f t þ Ltþ1 Df:

ð10Þ

In both equations, changes are weighted with figures of a different period. This raises a time inconsistency in the weights of the changes. To solve this inconsistency the decomposition can be rewritten as Dx ¼ Ltþ1 f tþ1 ðLt f t þ Ltþ1 f t Þ Ltþ1 f t þ Lt f tþ1 ðLt f tþ1 þ Lt f t Þ Lt f t ¼ DL f t þ Lt Df þ DL Df

ð11Þ

or as Dx ¼ Ltþ1 f tþ1 ðLt f t þ Ltþ1 f t Þ Ltþ1 f t þ Lt f tþ1 ðLt f tþ1 þ Ltþ1 f tþ1 Þ Ltþ1 f tþ1 ¼ DL f tþ1 þ Ltþ1 Df þ DL Df: ð12Þ Taking the arithmetic average of Eqs. (11) and (12), changes in output can be expressed as Dx ¼ 12 DLðf t þ f tþ1 Þ þ 12ðLt þ Ltþ1 ÞDf;

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 gross output which is attributable to the change in the technical coefficients, keeping final demand at its second period level, while the first term captures the change in final demand, keeping the technical coefficients fixed at the first period level. The first term on the RHS is the change in technical coefficients evaluated using the first period’s level of final demand and the second term is the change in final demand evaluated using second period technical coefficients. Thus, Eq. (13) separates the total change in gross output into final demand and inter-industry effects, i.e. changing demand with given input– output relationships and changing input–output relationships with given demand.

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For purposes of empirical measurement, we can rewrite Eq. (13) as follows: Dxav ¼ 12ðD1 þ D2Þ þ 12ðS1 þ S2Þ;

ð14Þ

where D1 ¼ Lt1 f t Lt1 f t1 ¼ Lt1 Df t ; D2 ¼ Lt f t Lt f t1 ¼ Lt Df t ; S1 ¼ Lt f t Lt1 f t ¼ DLt f t ; S2 ¼ Lt f t1 Lt1 f t1 ¼ DLt f t1 :

ð15Þ

The first term on the RHS of Eq. (14) is the average demand-induced change in output. The second term defines the average supply-led change in output. Hence, it is possible to analyze the significance of this compositional effect by examining the relationship between demand changes and the extent to which industries use services activities. The latter can be measured by the average (input–output) coefficient for each manufacturing industry’s purchase of services. If this compositional effect is significant there should be a positive relationship between industry demands and service coefficients. It is clear from Eqs. (11) and (12) that if f t > f t1 ; then final demand as a proportion of gross value is increasing, whereas if Lt > Lt1 intermediate use of resources as a proportion of gross value is expanding, thus outsourcing is increasing. Based on the definition that outsourcing is an agreement in which one company contracts-out a part of their existing internal activity to another company, outsourcing can be quantified for measurement purposes as the proportion of bought-in goods and services in gross output, where gross output is calculated as bought-in goods and services plus value added. This indicator can be used for single companies, manufacturing sectors, or the whole economy, depending on the level of aggregation and boundary of analysis. In the following section, the input–output methodology and more specifically the decomposition approach explained above (Eq. (13)) are used to examine the impact that outsourcing has had on the boundaries and outputs of the UK manufacturing and service sectors.

4.1. Empirical investigation Input–output tables explicitly account for the interdependence of different economic activities by incorporating the size and composition of the various industries’ mutual input demands (measured by interdependent coefficients of the Leontief inverse), this permits analysis of both direct and indirect interactions. With the practice of outsourcing experiencing significant growth, it is possible to gauge how this management initiative may have altered the contribution that an industrial sector makes to GDP; thus, distorting the definition and boundaries of manufacturing sector. As the effect of outsourcing is not recognized by national economic accounts, input–output tables were used to assess if there is a significant increase in the gross purchases that the traditionally defined manufacturing sector makes from non-manufacturing sectors (services transport in particular). It should be noted that the data were converted to 1995 prices using sector-specific price deflators. Annual input–output tables for 1984 and 1989– 1998 were obtained from the UK Office of National Statistics (ONS). The 1998 tables at the time of writing were the latest available and provide the most up-to-date information about the inter-industry relations. Since the aim is to study the impact of outsourcing on the boundaries of manufacturing, a higher degree of aggregation is adopted to focus on the relationship between the manufacturing sector as a whole and other sectors. Thus, the following sectors were considered: agriculture, energy, manufacturing, construction, distribution, transportation, communication, and services. This aggregation creates a potential difficulty, as the supply-side effects may not be operating at industry level for specific industries. Instead, certain industries may make more intensive use of bought-in services and these industries may have become more important over time by growing more rapidly than the average. However, it is possible to analyze the significance of this compositional effect by examining the relationship between demand changes and the extent to which industries use services activities. The latter can be measured by the average (input–output) coefficient

ARTICLE IN PRESS I. McCarthy, A. Anagnostou / Int. J. Production Economics 88 (2004) 61–71 Table 3 Supply-side and demand-side effects in the manufacturing sector

1989–1990 1990–1991 1991–1992 1992–1993 1993–1994 1994–1995 1995–1996 1996–1997 1997–1998

Dxda

Dxs

Dx

— 54,212 51,526 85,081 78,302 70,741 50,149 40,973 54,212

— 37,747 10,990 34,668 23,715 25,670 20,900 25,712 9229

— 16,465 40,536 50,413 54,587 45,071 29,249 15,261 16,465

a

Dxd ¼ 0:5ðD1 þ D2Þ and Dxs ¼ 0:5ðS1 þ S2Þ as defined in Eq. (15).

for each manufacturing industry’s purchase of services. If this compositional effect is significant, there should be a positive relationship between industry demands and service coefficients. In this section, the use of input–output tables for the period 1989–1998 is presented to illustrate the decompositions proposed by Eq. (13). The results are shown in Table 3. In Table 3, the decomposition of gross output is used to identify what part of the changes in gross output of manufacturing can be attributed to shifts in the final demand. In addition, what can be attributed to supply-side changes (i.e. changes in the technical coefficients). For any period, the change in gross output of the manufacturing sector can be attributed to the change in technical coefficients. Also, for each period, there is a high increase in the demand-side and a significant supply-side effect captured by the change in technical coefficients. For example, during the period 1992–1993, manufacturing could have had recorded d34,668 million more output if the supply-side effect had been accounted for. Also, for the period 1997–1998, it appears that manufacturing’s gross output should have been some d9,229 million higher, suggesting that the total domestic output for 1998 from manufacturing, instead of being the d376,090 million as listed in Table 4, would have been the d388,080 million as listed in Table 5. The largest outsourcing out periods between 1984 and 1998 occurred during

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Table 4 UK’s domestic manufacturing and total output (d million), 1979–1998

1979 1984 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998

Manufacturinga (d millions)

Total outputa (d millions)

Share of manufacturing to total output

136,778 180,467 296,776 259,897 277,506 282,896 299,060 326,554 350,739 368,154 378,851 376,090

342,688 547,026 1,017,919 894,859 1,027,824 1,101,705 1,168,193 1,271,305 1,359,593 1,450,016 1,526,371 1,601,222

25.0 33.0 29.2 29.0 27.0 25.7 25.6 25.7 25.8 25.4 24.8 23.5

Source: UK National Accounts, 1980–2000. a Domestic 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

1979–1984 1984–1989 1989–1990 1990–1991 1991–1992 1992–1993 1993–1994 1994–1995 1995–1996 1996–1997 1997–1998

Outsourcing Contracting (d millions) out plus manufacturing domestic output (d millions)

Share of manufacturing and outsourcing to total domestic output

6930 6322 — 37,747 10,990 34,668 23,715 25,670 20,900 25,712 9229

34.3 29.8 29.2 33.3 28.1 28.8 27.6 27.7 27.3 27.2 25.4

187,397 303,098 259,897 297,644 288,496 317,564 322,775 352,224 371,639 393,866 388,080

Source: Input–Output Tables, 1979–1998; UK National Statistics, 1979–2000.

1990–1991 and 1992–1993. This suggests that the contribution of manufacturing output in 1993 to be 28.8% instead of 25.6%, thus 2.2 percentage points higher. In addition, in 1998 it would be 25.4% instead of 23.5%, i.e. 1.9 percentage points

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higher. These results support the notion that outsourcing has altered the configuration and boundary of manufacturing organizations in terms of value added and that true manufacturing output is underestimated.

5. Conclusions There are several compelling reasons to outsource, but the underlying rationale is consistent with the principle of transaction cost economics, i.e. to achieve economic improvement in the performance of business functions. This involves contracting out a function to a specialist supplier in an attempt to reduce costs and to benefit from competitive knowledge and practices. Thus, the economics of outsourcing alter the configuration and boundary of an organization and therefore change the economic contribution that an organization makes to its industrial sector and the economy. This suggests that even though a reduction in the economic contribution of the UK manufacturing sector has taken place, there have been important structural changes in the composition of UK manufacturing at the enterprise level which should provide a basis for stronger performance in the future. This is reflected by the input–output data presented for 1992–1998, that shows a significant increase in the gross purchases that manufacturing makes from non-manufacturing (services and transport in particular). In conclusion, it is argued that conventional economic views of UK manufacturing activity underestimate its importance and contribution to GDP. This is because existing macroeconomic data do not acknowledge that UK manufacturing organizations, in pursuing greater efficiency, have outsourced many functions such as logistics, IT, accounting telecommunications and legal services. This practice is the reverse of vertical integration and has led to a significant extension of the boundary of manufacturing organizations, which in turn has shifted transaction costs and associated economic value into other sectors, most notably the service sector. Thus, to recognize the real value that manufacturing makes to an

economy, it is necessary to understand and measure the significant purchases it makes from other sectors, using a method such as the input– output methodology that analyzes the flow of goods and services between sectors. The service sector by definition serves other sectors, and initiatives such as outsourcing have helped to develop and grow this sector. The input–output data shows that manufacturing is a key customer of the service sector, and through its purchases creates a significant and additional contribution to a nations GDP.

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