European Journal of Purchasing & Supply Management 6 (2000) 23}29

New dimensions of outsourcing: a combination of transaction cost

economics and the core competencies concept
Ulli Arnold*
University of Stuttgart, Chair for Business-to-Business Marketing and Supply Management, Keplerstr. 17, D-70174 Stuttgart, Germany

Abstract

The outsourcing discussion covers a well known area. The relevant literature refers to a situation which is traditionally well known
in theory and practice as `make or buya decision. But it is necessary to concentrate on the economic factors of outsourcing decision.
This paper contains a real and detailed analysis of the outsourcing problem. Besides its generic base, we develop an outsourcing model
with design alternatives based on institutional economic theory and work out an explanatory approach and concrete recommenda-
tions for outsourcing arrangements. Therefore, we combine transaction cost economics and core competencies approach. As a result,
the managerial applications of both approaches are compatible. ( 2000 Elsevier Science Ltd. All rights reserved.

Keywords: Outsourcing; Transaction cost economics; Core competencies

1. The generic base of outsourcing survive in competition. It is supply management's job

1.1. Outsourcing and supply chain management
In this paper, we will use the term outsourcing in its
original understanding. Traditionally, outsourcing is an
abbreviation for `outside resource usinga (BuK hner and
Tuschke, 1997; Koppelmann, 1996; Quinn and Hilmer,
1994; Zahn et al., 1998). To see the details, we have to
analyze all three parts of this construct:
f Outside means creating value not within the own com-
pany. With this outside perspective, a company's bor-
der becomes more and more interesting. The idea of
a borderless organization is the integration of external
partners for creating and adding value to end cus-
tomers (Picot et al., 1996). Strategic networks arise.
Early supplier involvement becomes a central element
of the company's research and development strategy.
f This outside focus does not end in itself. It means
a strategic perspective on external resources. Follow-
ing the resource-based view, the company can be
understood as a unique complex of resources and
knowledge (Penrose, 1959). Without getting these re-
sources from the environment, it would not be able to
* Tel.: #49/711/121-3161; fax: #49/711/121-3131.
E-mail address: ulli.arnold@po.uni-stuttgart.de (U. Arnold)
to analyze sourcing markets for obtaining competitive
advantages. Therefore, purchasing must develop suit-
able instruments to perform a supplier oriented strat-
egy (Arnold, 1997).
f It is not enough to know about these external re-
sources. They must be used by and for a company in
order to reinforce its position in competition. Supply
chain management is the approach to enable com-
panies to exploit such resources for their individual
purposes.
We develop a new design of an outsourcing model
focusing on a generic concept. Supply management will
be regarded as a central player. Historically, there are
three stages of evolution for purchasing:
f In the phase of manufacturing orientation, end product
demand was stronger than supply activities. In this
phase, companies normally used to concentrate on
mass production and the technical problems of manu-
facturing (Biergans, 1989).
f When so called customer markets evolved, the phase
of selling orientation arose. Most consumer demands
have already been satis"ed and competition became
stronger. Most businesses dealt with the sales market.
Marketing was just another word for a big sales force
and for the instrumental version of the `4P'sa (product,
place, price, promotion) (McCarthy, 1960). In both
situations, manufacturing orientation and selling

0969-7012/00/$ - see front matter ( 2000 Elsevier Science Ltd. All rights reserved.
PII: S 0 9 6 9 - 7 0 1 2 ( 9 9 ) 0 0 0 2 8 - 3
24 U. Arnold / European Journal of Purchasing & Supply Management 6 (2000) 23}29
Fig. 1. Outsourcing model.
orientation, purchasing played an inferior role. Its job
was to help manufacturing and sales based on their
detailed demands.
f Beginning with the 1980s, purchasing became more
strategic in the phase of a general market orientation
(Arnold, 1982; Lindner, 1983). Very strong competi-
tion forced companies to look for new sources of
competitive advantages. Marketing was no longer
dominating all other functions. Instead, purchasing
acquired more and more importance for realizing
quality improvements and cost reduction together
with suppliers. Purchasing, procurement, inventory
and materials handling, and logistics are optimized
simultaneously in the supply chain management ap-
proach.
1.2. A general outsourcing model
The outsourcing model consists of four major elements
(see Fig. 1): Outsourcing subject, outsourcing object, out-
sourcing partner, and outsourcing design.
Outsourcing subject is the economic institution which
plans to outsource (or not). The subject has to make the
strategic outsourcing decision. Outsourcing objects are
processes or process results which might be outsourced
(Reichmann and Palloks, 1995). With regard to the activ-
ities of a company we distinguish between (1) the com-
pany core (all activities which are necessarily connected
with a company's existence), (2) core-close activities (dir-
ectly linked with core activities), (3) core-distinct activ-
ities (supporting activities), and (4) disposable activities
(activities with general availability). From an industrial
perspective, the outsourcing object is closely linked with
the degree of manufacturing penetration. Outsourcing
partners are all possible suppliers for the activities con-
sidered for outsourcing. In this case, supplier is a term in
a wider sense. This supplier could also be an inhouse
supplier, e.g. an independent business unit within a group
of "rms. Outsourcing design is discussed below.
2. Economic institutions as design alternatives
Basic design alternatives for the outsourcing decision
can be based theoretically on Williamson's institutional
economics. Developed on the ideas of Coase (1937) and
Commons (1931), he sees three major `governance struc-
turesa for economic activities (Williamson, 1985; Arnold,
1998):
f Markets steer transactions by the price mechanism.
There are direct incentives for all transaction partners.
If a supplier cannot meet customers' requirements, he
will not be able to participate in economic exchanges
any longer.
f Hierarchies are based on the centralization of property
rights by management. Administrative control mecha-
nisms within a company facilitate the orientation on
one target (e.g. the production of automobiles).
f There are many governance structures which are nei-
ther clear markets nor clear hierarchies. Examples are
long-term contracts or strategic alliances between in-
dependent companies. All these in-between gover-
nance structures combine hierarchical and market
elements (TroK ndle, 1987). Therefore they are called
hybrids (Williamson, 1991).
Hierarchy is directly linked with insourcing. All gover-
nance structures with market elements are relevant for
the outsourcing design (see Fig. 2). We distinguish be-
tween internal and external outsourcing. External out-
sourcing means spot transactions or long-term
 U. Arnold / European Journal of Purchasing & Supply Management 6 (2000) 23}29
Fig. 2. Structural alternatives of outsourcing.
relationships with suppliers. Internal outsourcing refers
to a higher degree of hierarchical steering (Zahn et al.,
1998): by forming independent pro"t centers instead
of hierarchical departments, the market element becomes
relevant within a company (KruK ger and Homp, 1997).
If for example procurement operates as a pro"t center,
all sourcing activities can be outsourced internally
to an independent business unit. Internal outsourcing
can also be organized as a horizontal cooperation
of independent companies, sometimes by a general
service company (joint venture) even with capital
investment.
3. Strategic decisions on outsourcing and the degree of
manufacturing penetration
3.1. Outsourcing objects from a transaction
cost perspective
Coase (1937) was the "rst to discuss transaction costs.
These `costs of making each contracta appear because of
information asymmetry, bounded rationality and oppor-
tunism. Such costs arise from activities which include:
evaluating suppliers, negotiation, control function, etc.
(Picot, 1991). They appear not only in markets but also in
hierarchy. If a company has to invent and to run a system
to control the productivity of its workers, hierarchy costs
are inevitable. The basic idea is now to "nd a governance
structure with the lowest costs for each transaction.
Therefore, we need deeper insights into the character-
istics of transactions. According to Williamson (1989,
1991), specixcity is the most important aspect of a trans-
action. Speci"city refers to asset speci"city as well as
human capital speci"city. Goods and services with high
speci"city cannot be used in other transactions without
huge additional costs. For example, paintshop equip-
ment designed for the Volkswagen Golf can be used for
25
a Mercedes only if it is redesigned and relocated. In such
cases quite often a total loss must be accepted if the
original use is "nished.
Objects with low specixcity can be governed with an
external outsourcing design. Low speci"city means that
little information has to be exchanged with the transac-
tion partner. External outsourcing partners are able to
bundle demand and to exploit economies of scale. Much
information has to be exchanged before, during and after
the exchange of goods and services with high specixcity.
The results are extremely high market transaction costs.
It is not possible to realize large scale e!ects because only
a few customers exist (or perhaps only one). It makes
sense to establish an internal outsourcing design for these
transactions. Goods and services with highest speci"city
are based on the company's core competencies. They
should be kept under the full responsibility and control of
a company (insourcing).
3.2. Outsourcing objects from a core competence
perspective
Speci"city is closely related to the strategic importance
of a transaction. Which transactions are really of `stra-
tegic importancea for a company? Is the engine produc-
tion strategically important for a car manufacturer?
Micro Compact Car (MCC) does not build the engine for
their Smart car by themselves but has outsourced engin-
eering and manufacturing totally to DaimlerChrysler.
The core competencies approach tries to answer these
questions (Prahalad and Hamel, 1990). Its main idea is
that only goods and services which are considered to be
core competencies should be produced internally (in-
sourcing). In fact core competencies combine three ele-
ments (KruK ger and Homp, 1997):
f In the eyes of the customers their characteristics must
be relevant. They di!erentiate between the company
and its competitors.
26 U. Arnold / European Journal of Purchasing & Supply Management 6 (2000) 23}29

Fig. 3. Model for the outsourcing design.

f To gain competitive advantage, resources and know-
how for the product must be unique over time. It must
be possible to protect it against imitation by competi-
tors over time. So a competitive advantage must be
sustainable.
f Only if these resources are usable for multiple
purpose, they are core competencies and should
remain within a company and should not be out-
sourced.
For example, Mercedes-Benz is able to produce
high quality with high safety standards. This charac-
teristic must be recognized by customers. They expect
to be better protected in case of a crash. But engineer-
ing and manufacturing of `safetya is a core
competence only because Mercedes-Benz is able to
transform this know-how into new products like the
A-class.
3.3. The integrated model
Together, transaction cost economics and the core
competence approach help to develop a general model
for outsourcing decisions (see Fig. 3). They help to decide
which of the institutional economics' based design alter-
natives is optimal.
Therefore, management has to answer three questions
on the outsourcing object:
f Is the activity highly speci"c? If so, normally very high
market transaction costs for communication and
agreement exist. Economically, it makes no sense to
outsource such an activity.
f Is the activity strategically important? Sometimes it is
not helpful to outsource activities with low speci"city
because they are extremely important for a company's
ability to survive. To get a concrete idea of this
 U. Arnold / European Journal of Purchasing & Supply Management 6 (2000) 23}29
`strategic importancea, we have to answer the follow-
ing question.
f Is the activity a core competence, a central part of
competitive advantage? Does it help to be competitive
in a general way, or does it not contribute to com-
petitiveness in any way? Activities with no competitive
contribution at all are typical outsourcing candidates.
With a higher degree of contribution they move step
by step from external outsourcing to internal out-
sourcing to insourcing.
Together, the answers on these three questions help to
get an optimal outsourcing design. The recommenda-
tions of transaction cost economics and the core compet-
encies approach resemble one another. In fact, the
approaches complement each other perfectly. On the one
hand, transaction cost economics is a very short-term,
only cost-based approach. With implementing `strategic
importancea as a quality of transactions, we can add
a long-term perspective. This strategic importance can be
de"ned very clearly by the degree of competitive contri-
bution which has been formulated in the core competen-
cies approach. Fig. 3 gives a general overview. In fact, the
highest speci"city and core competencies are not neces-
sarily related to each other directly. Williamson himself
added `brand name capitala as one element of speci"city.
According to this, marketing and branding have to be
a core competence. Of course, this linkage between speci-
"city and core competence is rather simpli"ed, but the
recommendations for the outsourcing decision are clear
and compatible (in this case, outsourcing of all activities
except for marketing and supply management).
The University of Stuttgart was able to evaluate the
model empirically. In order to get detailed information,
the regional Chamber of Commerce (IHK) founded
a study on outsourcing in the Stuttgart area. A written
questionnaire was sent out to more than 3000 companies.
399 companies (10.9%) answered. 338 of these are indus-
trial companies, 61 service companies. The results were
published in 1996 (Zahn and Soehnle, 1996). Here we con-
centrate on some highlights of the data. Most companies
outsourced core-distinct and disposable activities like se-
curity services or supporting supply services (see Table 1).
Most companies achieved good results with outsourc-
ing activities. In particular, quality (52.9% of outsourcing
subjects ranked `very gooda or `mainly gooda results),
costs (50.6%), time (55.4%) and #exibility (50.1%) are on
a much better level than before. Most outsourcing part-
ners/suppliers (55.7%) expect a growth rate of approxim-
ately 20% for their outsourcing services.
4. The de-materialized company as the 99optimum of
outsourcing::
The evolution of outsourcing is closely connected with
the evolution of supply management. A lower degree of
27
Table 1
Outsourcing activities
Percentage of companies
with outsourcing experience
Activity in this area (%)
Support supply services 63.4
Environmental protection services 40.6
Maintenance of installed
equipment/manufacturing facilities 37.3
Information and communication
technology and services 36.3
Security services 34.6
Stocks, #eet services, logistics 30.1
manufacturing penetration means higher importance of
purchasing and supply. More and more, the company's
competitive advantage relies on suppliers' abilities. In
this section, we will look at outsourcing and supply
management as linked together in the so-called factory
within a factory approach (Arnold and Scheuing, 1997).
Traditionally, a high number of suppliers are respon-
sible for a high number of parts. Therefore the manufac-
turer of the end product has a high manufacturing
penetration. The "rst step to pro"t from economies of
scale is to standardize the parts bought from the supply
market, e.g. use the same door handle for all car models.
There is no change in the manufacturing penetration.
The second step is to outsource more manufacturing
processes to the supplier. Instead of producing the door
handle he has to deliver the whole door. Market mecha-
nism replaces hierarchical coordination. This modular
sourcing concept is linked with the responsibility of the
"rst tier supplier to coordinate the rest of the supply
chain and all sub-suppliers. Modules are highly speci"c,
but the supplier is able to realize economies of scope.
Typically, modules are delivered just-in-time. With del-
egation of R&D responsibility for a speci"c module to
a supplier the next step towards closer supplier}buyer
relationships called system sourcing is ful"lled. Reaching
this degree of outsourcing, the question of the necessity of
leaving any manufacturing and engineering operations in
the end product selling company comes up. We discussed
this question when looking at the company core. When
de"ning the core competencies of the company, the area
for using the factory within a factory-concept is de"ned
as well. Without factory within a factory, the supplier
produces his goods in areas outside the buyer's plant.
These goods can be simple parts or sophisticated com-
plex systems. After "nishing production, these goods are
delivered to the buyer just-in-time or from stock. In his
plant, the buyer adds value by using these goods for
manufacturing a marketable product.
The e!ect of re-designing processes with a value ad-
ded-focus is mostly the reduction of own manufacturing
28 U. Arnold / European Journal of Purchasing & Supply Management 6 (2000) 23}29
Fig. 4. Factory within a factory.
activities. For example, the customers of a car identify
a speci"c model more often by image factors based on
marketing e!orts meeting lifestyle clusters than by tech-
nical details like the type of door handle. Together with
the availability of general technology on the supply mar-
ket, the new approach for the lean company is a nearly
total reduction of manufacturing activities. Instead, these
activities are handled by suppliers. Manufacturing activ-
ities are no longer core competencies of the car company;
for them, manufacturing is an activity with low spe-
ci"city. There exist suppliers who are specialized in
manufacturing only. For example, Porsche decided to
outsource production of their US Boxer models com-
pletely to a company called Velmet in Finland. Porsche
themselves concentrate on engineering, marketing, and
supplier steering. Of course, the end-product (car) always
has to be produced physically. The idea of a free network
of suppliers without any physical consequences makes it
impossible to produce goods in reality. Therefore, factory
within a factory is the solution.
The basis for factory within a factory is the de"nition
of a small number of speci"c modules. Every module is
a de"ned part of the end product with de"ned interfaces.
For producing these modules, the supplier installs its
own manufacturing plants on the buyer's site or even in
the buyer's plant. He might also be responsible for the
installation of his module on the "nal assembly line. The
responsibility for the "nal assembly line is also the main
distinction between the two models of the factory within
a factory-concept (see Fig. 4). In-plants means realizing
the shop in the shop idea by bringing suppliers' produc-
tion lines into the buyer's plant (Arnold, 1997). The buyer
himself is responsible for the "nal assembly line. He owns
the physical assets of this line and he pays the assembling
employees. An example for the in-plant model is the
Micro Compact Car (MCC) company, now a full subsidi-
ary of DaimlerChrysler, which produces the so-called
Smart car. MCC built a new plant in Hambach, France,
where they own only the "nal assembly line. Press and
paintshop, engine production, seats, body parts, front
module, doors, and cockpit are de"ned modules produc-
ed on the same site in small `pre-plantsa owned by the
particular supplier. The supplier is responsible for engin-
eering and manufacturing the parts. Therefore he is
strongly connected with the production planning system
of MCC. He produces just-in-time and delivers directly
to the "nal assembly line where MCC workers assemble
these few modules.
The de-materialized company is not even responsible
for the "nal assembly line. All assembling activities are
done by the suppliers themselves. For example, Vol-
kswagen's truck plant in Resende, Brazil, is such a de-
materialized company (Woodru! et al., 1996). Vol-
kswagen's employees are not involved in any physical
production. All manufacturing work is done by the sup-
pliers. These seven suppliers, as shown in Table 2, own all
physical assets including the "nal assembly line. Only 200
out of 1500 employees in the plant work for VW. VW is
responsible for quality assurance, marketing, and sales
only.
The de-materialized company is a company working
as a supplier management and customer management
company. Its only job is to identify customer needs and
to "nd suppliers delivering parts for a product which
satis"es these needs. There are only two primary value
chain activities left: purchasing and marketing. The de-
materialized company delegates all manufacturing activ-
ities to suppliers. It links its supply markets with the
needs of its end customer markets. Purchasing becomes
the most important activity for the ability to produce
physical goods. It is the &linking pin' between marketing
and manufacturing because the suppliers are now manu-
facturing agents for a company which does not have any
physical assets at all.
 U. Arnold / European Journal of Purchasing & Supply Management 6 (2000) 23}29
Table 2
Volkswagen's de-materialized company in Brazil * suppliers build VW
trucks
Supplier: Installs:
Iochpe-Maxion (Brazil) Chassis
Rockwell (US) Axles, brakes, suspension
Iochpe-Maxion (Brazil), Bridgestone Wheels and tires
(Japan), Borlen (Brazil)
Motoren-Werke Mannheim Engine and transmission
(Germany), Cummins (US)
Tamet (Brazil) Cab
VDO Kienzle (Germany) Steering and instruments
Eisenmann (Germany) Painting
Supply Management has to be pro-active within the
factory within a factory-concept. Instead of being an
agent for manufacturing departments' needs, its new job
is the strategic identi"cation and support of e$cient and
powerful suppliers for the company (Scheuing 1989, p.
12). Outsourcing on its highest degree and supply man-
agement of its highest level of strategic importance are
linked closely together in the factory within a factory
approach. The de-materialized company is the logical
consequence of the recommendations of core competence
and transaction cost approach. The `corea remaining is
highly speci"c and includes marketing as well as supply
network management.
5. Conclusions
Transaction cost economics and the core competencies
approach complement one another as recommendations
for outsourcing design and outsourcing management.
Operative cost aspects and long-term strategic aspects
are brought together. On the long run, the `de-material-
ized companya seems to be the outsourcing optimum. On
the other hand, outsourcing itself is not a goal. De"ning
the borders inside and outside of the `factory within
a factorya systems seems to be the most important topic
for future research. Outsourcing is more than `yesa or
`noa * it is a decision with a multitude of `hybrida
alternatives.
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