Why do some firms contract out production? Evidence from firm-level panel data

Abstract

This article examines which factors determine outsourcing decision using firm level data. According to the theoretical and empirical literature, firm, industry and market characteristics influence the likelihood of contracting out. We try to identify which firm characteristics are prerequisites for becoming an outsourcer. Using a dynamic panel data probit model, our results show that firms with previous subcontracting experience, higher wages, frequent market changes, R&D activities, product differentiation, large size and exporter status are more likely to engage in outsourcing.

Keywords:

• firm behaviour
• organization of production
• outsourcing
• subcontracting decision

Acknowledgements

The authors are indebted to Rosario Gandoy for helpful suggestions. Financial support by the Consejería de Educación y Ciencia of the Junta de Comunidades de Castilla-La Mancha under the project PBI-05-021, co-financed by FEDER funds, is gratefully acknowledged.

Notes

¹ Whereas the first reference is a cross-section analysis, the second is a panel approach although it focuses on the role of agglomeration economies on outsourcing decision. Tomiura (2005), Görg and Hanley (2004) and Girma and Görg (2004) study the firm-level determinants of outsourcing intensity instead of outsourcing decision. Another work on outsourcing intensity but using industry-level data is Díaz-Mora (2007).

² See www.funep.es for further details about ESEE. We have decided to omit the first year of the ESEE, 1990, due to the lack of some data related to our issue (e.g. the value of production which has been contracted out).

³ The survey distinguishes two types of outsourcing depending on whether the main contractor provides the materials to the supplier or not. The second type implies a greater independence of the subcontracting firm which has a higher degree of control over the materials.

⁴ By type of outsourcing, around 20% of surveyed firms get involved in subcontracting providing materials, around 20% in subcontracting without materials and 10% use both types of subcontracting at the same time.

⁵ The evolution of the percentage of firms that subcontract production by sectors can show an erratic behaviour, partially due to changes in the number of firms that answer the survey every year, mainly in those sectors which the number of outsourcers is especially low. The dispersion, measured by the variation coefficient, is more pronounced in branches such as meat products, drinks and wood industry. Nevertheless, industries with larger proportion of firms engaged in subcontracting are the same along the period. Likewise, the Pearson correlation as well as Spearman correlation (which is based on ranking instead of values) between different years is high along the period, therefore, we employ the time average in the sectoral analysis of subcontracting.

⁶ By type of subcontracting, worth mentioning differences are found in textiles and clothing, leather and shoes, chemistry and other manufacturing where subcontracting decision is highly frequent, but it is very biased to subcontracting providing materials. These branches, except Chemistry, are labour intensive with low skill requirements. Here, the competition in prices is very important and competitive advantages are associated to the quality of materials, the design of products, etc. Therefore, it is very important to control the materials used and the main contractor prefers to provide them to the subcontracting firm. On the contrary, metallic products, machinery and mechanical goods, office equipment, motor vehicles and other transport material clearly show up in subcontracting without materials but do not in subcontracting with materials. These are industries with higher technological content where the most standardized production stages, which are not the core competences of the firm, are contracted out and the need to control the materials diminishes.

⁷ To consider the international dimension as well as the ownership dimension, Antras and Helpman (2004) develop a theoretical framework in which, based on productivity and sectoral characteristics, firms decide whether to integrate into the production of intermediate inputs or outsource them and firms also choose the location of inputs production (at home or abroad).

⁸ Other empirical research about outsourcing intensity also consider the influence of previous outsourcing (Girma and Görg, 2004; Díaz-Mora, 2007).

⁹ In fact, Grossman and Helpman (2002) point out that the degree of product differentiation can influence outsourcing in other ways. But, in this case, the effect on outsourcing can be positive or negative depending on other parameters. The net effect of product differentiation on outsourcing is therefore not clear.

¹⁰ In fact, these authors remind us that outsourcing is more likely to be viable, the larger is the industry and the larger the economy. If there are increasing returns in search, there can be two stable equilibria for an industry, one with vertical integration and the other with outsourcing.

¹¹ The role of firm internationalization on outsourcing decision will be relevant mainly when foreign outsourcing prevails. Although our data source does not let us distinguish between domestic and foreign outsourcing, other empirical research for Spanish economy using input–output tables show how the second one registers the greatest increase in recent years (Gandoy and Díaz-Mora, 2008), particularly in export-orientated industries.

¹² Demsetz (1995) reminds the role of technological change and, therefore, of the uncertainty on outsourcing decisions. Outsourcing will be more significant in high-tech products (due to technological change) as well as in sectors such as wearing apparel (due to changing fashion).

¹³ The author includes another type of firms where subcontracting is growing: firms producing goods not very sophisticated or difficult to make, where the labour-intensive stages of production are contracted out. These firms suffer a strong competence by low wage areas and they use subcontracting for cost-cutting motives. For them, wage is a determinant of subcontracting.

¹⁴ As we explained above, we use one period lagged wages. Nevertheless, since the subcontracting decision is already included lagged one period in the model, we have considered the value of wages in t − 2 obtaining very similar estimation results. Results are available from the authors upon request.

¹⁵ This argument is used by Görg et al. (2004) who study the impact of international outsourcing on productivity employing plant-level data for Irish manufacturing. Their results show that exporting firms obtain more productivity gains from international outsourcing of materials inputs than nonexporter firms. The authors argue that exporting firms face lower costs of searching for potential suppliers abroad.

¹⁶ We have also included the quadratic value of age and size in the regression to allow for a more flexible form, but the coefficients remain statistically insignificant.

¹⁷ The presence of yearly and quadrennial variables is due to the different nature of the information collected in the ESEE. Product differentiation is only asked every 4 years to firms and we use only the available information. For more information, see http://www.funep.es/esee/ing/i_esee.asp

¹⁸ The regressions were also run separately for each subsample of firms: firms subcontracting providing materials and firm subcontracting without materials. But the sign and significance of the coefficients of variables are similar to those obtained for aggregate subcontracting. Two particularities need to be mentioned. First, the estimates for subcontracting providing materials show that size has a significant and positive effect on subcontracting decision. For this type of subcontracting, the likelihood of subcontracting increases with the size of the firm. Second, the econometric findings for subcontracting without materials suggest that age is an important factor in the propensity to engage in contracting out. More mature firms are more prone to subcontract production without providing materials.