Uncovering the Hidden Costs of Offshoring

Assistant Prof. Marcus Møller Larsen on his forthcoming article in the Strategic Management Journal

Akey function in strategic decision-making is the ability to estimate the costs of implementing strategic decisions. “However,” SMG Assistant Professor Marcus M. Larsen explains, “many firms find that the implementation of strategic decisions can trigger substantial hidden costs that negatively affect firm performance.” For example, firms often find that the implementation of a diversification strategy requires substantially more coordination than initially expected. Firms may also discover that knowledge transfer in the context of internationalizing business activities is more costly than expected.

Marcus M. LarsenIn a forthcoming publication in Strategic Management Journal, SMG faculty members Assistant Professor Marcus M. Larsen and Professor Torben Pedersen, together with Assistant Professor Stephan Manning of University of Massachusetts, Boston, investigate why certain costs are hidden in decision making processes and thus not accounted for in initial cost estimations.

They use the growingly important phenomenon of offshoring of administrative and technical services to do this. To reap benefits such as lower labor costs and access to resources in foreign locations, large numbers of firms not only offshore standardized IT and business processes but also more complex, knowledge-intensive activities and product development. However, many firms have begun to realize that managing an increasingly globally dispersed organization is substantially more difficult and costly than initially expected. Decision makers often fail to accurately estimate the costs of offshoring and are therefore surprised by unexpected—or hidden—costs of implementing offshoring decisions abroad.

Using comprehensive data from the internationally acknowledged Offshoring Research Network, the authors find that complexity increases the discrepancy between the estimated and realized costs of implementing offshoring activities in foreign locations. They argue that complexity limits the ability of managers to rationally account for all important decision factors and thus increases the risk that certain performance-detrimental consequences remain hidden in the decision-making process. At the same time, they also argue that this relationship is moderated by the organizational design orientations of firms’ offshoring strategies and by firms’ offshoring experience. With design orientation and experience, firms are more likely to anticipate and align offshoring complexity with corresponding organizational structures and processes.

The article makes a number of important contributions. “In offshoring research,” Marcus M. Larsen says, “the idea of hidden costs is new and has predominantly been treated conceptually and anecdotally to underscore how offshoring might be more challenging than initially expected. With this article, we theoretically and empirically demonstrate why these hidden costs of offshoring emerge, how they may be operationalized, and with which measures firms may take to reduce them.”

More generally, this article makes an important contribution to research that emphasize the inhibiting role of complexity in decision-making processes. It does this by focusing on the role of the organizational context in decision makers’ estimation ability and, in particular, on how organizational complexity undermines decision makers’ ability to account for costs of implementation.

Larsen MM, Manning S, Pedersen T. Forthcoming. Uncovering the hidden costs of offshoring: The interplay of complexity, organizational design, and experience. Strategic Management Journal: DOI: 10.1002/smj.2023.