IT Outsourcing at Dell

ISSN 0832-7203
Information Technology Outsourcing from a Business Strategy Perspective Par : Benoit A. Aubert Anne-Marie Croteau Cahier du GReSI no 05-01 Fvrier 2005
Copyright 2005. HEC Montral. Tous droits rservs pour tous pays. Toute traduction et toute reproduction sous quelque forme que ce soit est interdite. HEC Montral, 3000, chemin de la Cte-Sainte-Catherine, Montral, Qubec, H3T 2A7 Canada. Les textes publis dans la srie des Cahiers du GReSI n'engagent que la responsabilit de leurs auteurs.
Information Technology Outsourcing from a Business Strategy Perspective

Benoit A. Aubert HEC Montral 3000, chemin de la Cte-Ste-Catherine Montral, Qubec, Canada H3T 2A7 Benoit.aubert@hec.ca and Fellow, CIRANO Anne-Marie Croteau John Molson School of Business Concordia University 1455, boul. de Maisonneuve O. GM 209-13 Montral, Qubec, Canada H3G 1M8 croteau@alcor.concordia.ca Prire de faire parvenir toute correspondance : Benoit.aubert@hec.ca
Information Technology Outsourcing from a Business Strategy Perspective Benoit A. Aubert and Anne-Marie Croteau
Rsum Cet article explore les liens entre limpartition et la stratgie dentreprise. Les recherches en impartition ont traditionnellement port peu dattention au profil stratgique des organisations. Cette recherche sattarde ces liens. Une illustration, utilisant de cas de Dell, est prsente. Abstract This paper investigates the links between outsourcing and business strategy. Traditionally, outsourcing literature has rarely focused on the effect of a firms strategic profile in relation to outsourcing. This paper explores this link. An illustration, using the case of Dell, is provided. Mots-cls Outsourcing, Transaction Costs, Strategy, Strategic Profile
Copyright 2005. HEC Montral.
Introduction The objective of this paper is to underline the impact of business strategy on the level and type of information technology (IT) outsourcing used by an organization. Past research in IT outsourcing has mainly focused on the transaction itself, without investigating the strategic characteristics of the organization. When observing organizations, one cannot avoid noticing that those of similar size, dealing in the same markets, can make very different decisions with respect to IT outsourcing. Since major organizational decisions should reflect a companys business strategy, there is a need for scrutinizing the decisions to outsource IT activities and evaluating how aligned these decisions are with the business strategy. Therefore this study investigates the characteristics of organizations with regards to their outsourced IT activities, the structure of IT outsourcing contracts, and their business strategy. This paper draws from the fields of economics, strategy, and management information systems. It lays out the theoretical background supporting the study and presents the hypotheses. From these hypotheses, an illustration is provided using the example of Dell Inc. Future research avenues are presented. Expected results should contribute to a better understanding of how performing organizations outsource their IT activities and how they adjust their outsourcing portfolio to their business strategy. Subsequent results coming from this stream of research should provide practitioners with guidelines to better select the IT activities that should be outsourced and to negotiate performing IT outsourcing contracts, taking into account their business strategy. Context The IT outsourcing phenomenon has been expanding during the past decade, and this growth is likely to continue (Tettelbach, 2000). The relationships implied in IT outsourcing arrangements are increasingly complex. For example, while as client and supplier Xerox and EDS were engaged in a legal battle on some aspects of their agreement, as business partners they collaborated on ventures such as the State of Connecticut's 1-billion-dollar outsourcing deal (Madden, 1999). Two key questions arise when studying the IT outsourcing phenomenon: Based on their characteristics, which IT activities should be outsourced? and How should IT outsourcing contracts be structured? The following paragraphs briefly review both streams of research. Outsourced IT activities An important strand of research has examined the make-or-buy decision using transaction costs theory. Its foundation was laid by Coase (1937) who positioned the market and the firm as alternative mechanisms that could be chosen to conduct a transaction. The theory has been refined and used extensively in the last twenty years. According to the transaction costs theory, the decision to use the market or the firm to regulate a transaction depends primarily on four variables (Milgrom and Roberts, 1992; Williamson, 1985): Specificity of the assets required to produce the good or service; Uncertainty and measurement problems surrounding the transaction; Origin of the most important investment; and Frequency of the transaction. These considerations constitute deviations from the ideal situation of a perfectly competitive spot
market transaction where all goods are available, all information is public knowledge, and all transactions are performed instantly (Williamson, 1985). Asset specificity has received a lot of attention from researchers (Williamson, 1985). When the value of the next best use of an asset is less than the value associated with its primary use, it creates a lock-in situation between the parties and creates a risk associated with this investment. The role of asset specificity has been supported by studies in many fields: auto parts (Monteverdee and Teece, 1982; Walker and Weber, 1984), aerospace (Masten, 1984), and aluminum (Hennart, 1988). However, results were ambiguous in the IT field (Nam et al., 1996; Aubert et al., 2004). A fundamental assumption of transaction costs theory is that the parties ought to be able to measure the quality and the quantity of the goods exchanged in order to complete a transaction. Uncertainty prevents the establishment of a contract, especially a long term one which is a traditional remedy for asset specificity. Empirical studies showed that uncertainty played a key part in the choice of a governance mode (Masten, 1984; Walker and Weber, 1984; Anderson, 1985), and interacted with asset specificity (Murray and Kotabe, 1999). Recently, empirical studies also supported the agency proposition that the measurability of the transactions strongly increases the probability of outsourcing decisions by reducing the cost of using market mechanisms (Poppo and Zenger, 1998; Aubert et al., 2004). Accepting that all possible contingencies are impossible to foresee, the parties can decide to allocate to one of the contracting parties the ability to decide ex post what the appropriate actions should be. This is exactly what happens when a company buys a supplier. Grossman and Hart (1986) demonstrated that the party making the most important investment for the success of the transaction should be awarded the decision rights. Supporting this argument, Aubert et al. (2004) showed that companies were more likely to outsource IT activities requiring less technical skills and keep in-house activities with higher organizational skills. These results were in line with Pisanos (1990) results, suggesting that companies with less experience in specific areas were better off relying on outsourcing for activities in these areas, because the supplier could bring the investment and expertise they lacked. Finally, organizing a transaction inside a firm implies creating a governance structure, which means incurring important and irreversible costs. If a transaction is known to be unique, the firm will prefer to bear the risk associated with specific assets or uncertainty rather than to invest in order to internalize a single transaction. Internal organization is only efficient for recurrent transactions (Williamson, 1985). This is why companies will outsource IT activities that they do not conduct on a regular basis (Aubert et al., 1996). This variable is not often studied extensively in IT since most IT operations are recurrent and therefore have a high frequency. However, frequency is relevant for software development activities, which can be conducted more or less often in organizations. Contracts of IT outsourcing The second question is how a company, once it has decided to outsource its IT activities, decides to structure the contract. They can put more or less efforts in contract design to cover all contingencies. Firms can increase their protection against contractual hazards by reducing their
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contract incompleteness until the marginal cost of risk exposure equals the marginal benefit associated with a reduction in risk exposure. For instance, in order to reduce the probabilities of negative consequences or sometimes reduce the impact of these events, the parties can include contingencies for different outcomes, arbitration mechanisms, termination conditions, sequential contracting mechanisms, or other contract clauses to reduce their risk exposure. All these clauses are costly to negotiate, implement, and manage (Williamson 1985). Therefore, parties will have to compromise between the level of risk they are supporting and the level of completeness of the contract they accept to aim for. Using the same theoretical background as transaction theory, incomplete contracting predicts that as asset specificity increases, as uncertainty and measurement problems rise, as the business skills become more important, and as the technical skills lose importance, the contract will become more difficult to write. This increase in difficulty means that the party will settle for a more incomplete contract because increasing completeness would be too costly. Transaction characteristics have been measured in a few studies and several aspects of contract completeness were predicted by Crocker and Masten (1991), Crocker and Reynolds (1993), Adler et al. (1998), and Saussier (2000). One study addressing the level of completeness of outsourcing contracts was specific to the IT industry (Aubert et al., 2003). Another type of research analyzing IT outsourcing contracts stemmed from the resource-based view. This view analyzes the resources available in an organization and their strategic value in order to explain strategic advantage. When applied to outsourcing contracts, it makes it possible to define if companies should enter into partnerships or use regular outsourcing forms (Roy and Aubert, 2002). Regular forms can be described as arms-length transactions while partnership contracts imply significant exchange of information and expertise. The key variables considered are the strategic value of the resource and its availability in the organization. Strategic types of organizations All these studies relying on transaction costs, while providing several insights on the organization behavior, have ignored intrinsic properties of the organizations. The transaction costs model only considers the characteristics of the transaction itself. It does not take into account, for instance, any preferences of the managers or intent from the organization. While ignoring these differences did not prevent transaction costs theory to explain outsourcing patterns, taking into account these unique organizational properties would increase our understanding of IT outsourcing. A similar concern arises with the resource-based view. Its analysis remains more focused at the resource level, not at the organization level, although it considers the historical path of the organization and the configuration it generated (Barney, 1999). Business strategy is one key organizational element that distinguishes one organization from another. It corresponds to the outcome of decisions made to guide an organization with respect to its environment, structure, and processes that influence its organizational performance. In other words, it represents the means taken by an organization to reach its goals. Approaches to identifying a business strategy can be textual, multivariate, or typological (Hambrick, 1980). The typological approach is recognized as creating a better understanding of the strategic reality of an organization, since all types of business strategy are viewed as having particular characteristics
but a common strategic orientation. While several typologies have been proposed by Ansoff and Stewart (1967), Freeman (1974), Miles and Snow (1978), or Porter (1980), the most frequently used in empirical research is Miles and Snows (1978) (Smith et al., 1989; Zahra and Pearce, 1990), which has been quoted more than 1000 times (ISI Web of Knowledge, 1989-2004). The principal strength of this typology is the simultaneous consideration of the structure and processes necessary for the realization of a given type of business strategy. Miles and Snows (1978) typology reflects a complex view of organizational and environmental processes, as well as the attributes of product, market, technology, organizational structure, and management characteristics (Smith et al., 1989). Miles and Snows typology is defined with four types of business strategy: prospector, analyzer, defender, and reactor. Firms choose one type rather than another according to their perception of their environment. The first three types are expected to enhance organizational performance and share a continuum where the prospector strategy is at one end, the defender at the other, and the analyzer strategy stands in the middle. The reactor strategy is excluded from the continuum since it represents an organization having no specific strategy identified, which is likely to impede organizational performance. Organizations supporting the prospector strategy try to reach the largest possible market. They repeatedly make efforts to innovate and bring changes in their industry. Organizations choosing the defender strategy have a restricted market. They emphasize the production efficiency, the excellence of their products, the quality of their services, and their lower prices. Organizations implementing the analyzer strategy share both prospector and defender characteristics, but in moderation. They try to be the first to introduce new products, yet remain in second place with certain products for which they offer a good quality/price ratio. Finally, organizations supporting the reactor strategy do not have the capacity to take over new opportunities or maintain markets already acquired. Several empirical studies have used Miles and Snows typology (1978) (Snow and Hrebiniak, 1980; Hambrick, 1983; Conant et al., 1989; Namiki, 1989; Smith et al., 1989; Tavakolian, 1989; Shortell and Zajac, 1990; Thomas et al., 1991; Parry and Parry, 1992; Abernethy and Guthrie, 1994; Julien et al., 1996; Karimi et al., 1996; Croteau and Bergeron, 2001; Croteau et al., 2001; Sabherwal and Chan, 2001; Moore, 2003; Auger, 2004). Some variations among the four strategic types have been observed depending upon the industry, the sample size, or other organizational constructs. Organizational performance has been regularly used in evaluating the impact of business strategy based on this typology. Linking Strategy and Outsourcing Taking into account the strategic type of the organization can enable a finer analysis of outsourcing. While common wisdom has often suggested that strategic activities should be kept inside the firm, research has avoided the analysis of outsourcing taking into account specific strategic characteristics of the organization. Activities were deemed comparable from one organization to another. While this approach is not false, it may be improved. A given activity might be managed very differently depending on the strategic type of an organization.
For instance, the prospector is the risk taker in Miles and Snows typology. At the opposite, the defender is the risk adverse. Entering into an outsourcing contract entails changes and contractual risks (Earl, 1996, Aubert et al., 2002). Therefore, taking into account the strategic type of the organization leads to a first set of hypotheses. First, we can measure if different strategic types will have different IT outsourcing behaviors. This would lead to the evaluation of the following model: IT Outsourcing level = bi Xi + , where X1 is the level of uncertainty and measurement problems, X2 is the level of business skills, X3 is the level of technical skills, X4 is the asset specificity, and X5, X6, and X7 are dummies for defenders, analyzers, and prospectors respectively. Since our default is the reactor, we can hypothesize that 0 < b5 < b6 < b7. Defenders will be the most cautious users of IT outsourcing while prospectors, being the most prone to change and innovation, will be the highest users of IT outsourcing. Analyzers will be between the two groups. If the hypotheses are true, defenders should be doing more of their activities in-house, analyzers having a moderate use of IT outsourcing and prospectors presenting the highest usage of IT outsourcing. A similar analysis can be done to predict the contract type. The initial incompleteness model would take the following form: Incompleteness Level = ci Xi + , where X1 is the level of uncertainty and measurement problems, X2 is the level of business skills, X3 is the level of technical skills, X4 is the asset specificity, and X5, X6, and X7 are dummies for defenders, analyzers, and prospectors respectively. We can hypothesize that c5 = c6 < c7. Defenders and analyzers should tolerate very limited levels of incompleteness. While defenders will put less effort in analyzing and defining their contract than analyzers, they will be involved in simpler, smaller contracts. Analyzers will tackle more complex contracts but will invest more effort in completing them. This leads us to suppose that both groups will end up with contracts that show comparable levels of incompleteness. However, prospectors will tolerate higher levels of incompleteness than both defenders and analyzers. Finally, the contract type (arms-length transaction vs. partnership) should also depend on the strategic type. Defender, trying to maximize efficiency, will aim at arms-length transactions, trying to benefit from economies of scale and lower prices. These contracts should be traditional outsourcing contracts. On the other end of the scale, the prospectors should be more inclined to sign partnership contracts. Because they repeatedly make efforts to innovate and bring changes in their industry, they will need changing capabilities, flexibility and a large
variety of different resources. This should generate more alliances and more strategic outsourcing. Analyzers should be in the middle. Illustration In order to explain the links between the strategic type and the outsourcing decisions, the case of Dell Inc. was selected. No original data was collected. Secondary sources were used. The objective was not to conduct a formal case in order to validate or invalidate the hypotheses, but to illustrate them. Further research will have to be conducted to test the hypotheses. Since contracts were not available, the completeness levels could not be assessed. However, the case data gave an indication of the type of contract that Dell signed. Dell Inc. was chosen because the company is very well known and its history is common knowledge. Key points of Dells history (Dell and Fredman, 2000; Lashinsky, 2004) are presented in Table 1.
Table 1 Excerpts from Dells history1 1984 1987 1988 1989 1992 1993 1994 1996 1997 1999 2000 2001 2002 2003 2005 Michael Dell founds Dell Computer Corporation Dell is the first computer systems company to offer next-day, on-site product service Dell conducts initial public offering of company stock, 3.5 million shares at $8.50 each Dell introduces its first notebook computer Dell is included for the first time among Fortune 500 roster of world's largest companies Dell joins ranks of the top-five computer system makers worldwide Dell launches www.dell.com Customers begin buying Dell computers via Internet at www.dell.com Dell becomes the first company to record $1 million in daily online sales Dell ships its 10-millionth computer system Dell introduces E-Support Direct from Dell online technical support Company sales via Internet reach $50 million per day For the first time, Dell ranks No. 1 in global market share Dell enters the projector market The name change to Dell Inc. is official Dell introduces printers for businesses and consumers Dells web site receives close to 2 billion page requests per quarter at 81 country sites in 28 languages and dialects, and 26 currencies
1984-1999
Dell the Prospector
Right from the start, Dell innovated by developing a new sales model in the computer manufacturing industry that eliminated the intermediary layer by selling computer systems directly to customers. This approach allowed Dell not only to save on time and costs by cutting out the retailers but most importantly to better understand the needs and expectations of its clients. This make-to-order model enhanced the possibility for Dell to offer powerful, customized and richly configured systems at competitive prices.
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Source: Dell web site: http://www1.us.dell.com/content/topics/global.aspx/corp/background/en/facts
Dell was recognized for being the first company in this industry to bring the notion of customer service out of the closet (Saccomano, 1999). As Michael Dell noted, At Dell, we continue to focus on differentiating ourselves through a positive customer experience by taking ownership of the customer relationship. Our goal is to provide an unparalleled level of service in our industry.2 To translate this mission statement into a daily reality for all its 26,000 employees dedicated to service, Dell created a Customer Experience Council whose main role was to identify and implement three key operational measures of the customer experience. The ship-totarget statement was established to address the order fulfillment experience, which underlines the need to deliver a complete order to the customer on time. The second measurement, the initial field-incident rate was established to evaluate the performance rate by determining how often something went wrong when a system was delivered. The last key indicator focused on service and support and was stated as on-time, first-time fix. Over the years, these key operational measures continued to evolve, always focusing on customer satisfaction. Dell used a third-party, which surveyed a sample of customers via telephone to ask them to rate their experience with Dell support. This was a crucial tool to assess and constantly improve Dells service effectiveness (Frei et al., 2003). Dell was also a prospector, as it was the first in the industry to exploit the Internet (Ng and Farhoomand, 2000). This emerging technology was a new medium through which it could get even closer to its customers and enhance its direct-sales approach (p. 5). The web enhanced its make-to-order model by making it even more direct. The first stage was to launch www.dell.com in 1994. It created a link with its customers by listing Dells products and prices on-line. Two years later, it was possible for customers to configure and order their computer systems directly online. Again, this new approach made Dell the first company to offer a complete on-line purchasing tool. The third phase of this on-line endeavor was to offer on-line technical support, order status information, and software downloading. By mid-1998, Dell customers had access to all these features, including a 24/7 online service and support. These achievements created enormous benefits for Dell that had never been reached by anyone else before, such as removing all inter-company boundaries and improving the speed-to-market rate. Dell saw the potential that the Internet had in changing the way of conducting business in this industry. It became the leader by using the web as an extension of its direct model.
1999 Dell the Analyzer/Defender
By 1999, Dell reached a leadership position. However, observations suggest that the company has started to change its strategic position and is no longer behaving like a prospector as such. For instance, Dell decided not to enter the Tablet PC market, suggesting that it was better to wait and see (Lashinsky, 2004), which is more of an analyzer position. Another sign that Dell has moved away from the prospector behavior is its reliance on low cost production as a strategic advantage.
Dell mission statement, www.dell.com
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When everybody is outsourcing, Dell continues to manufacture in the United States because over two decades of fine-tuning, they've figured out how to do it cheaper and smarter, said Charles Wolf, an analyst at Needham & Co. who has been following Dell since 1991.3 Because of the slow growth in the PC industry, Dell was forced to look elsewhere to keep its profitability up. It decided to branch out into a new market, such as selling printers. Since the mid-1990s, Dell has been reselling other companies printers, including HPs. When HP bought Compaq, it became a threat to Dell in the PC industry. Dell decided to cut the links with HP and moved from a partnership relationship to that of a rival. Since the printer market was still promising to be an important source of revenue and profits, Dell had to find a way to benefit from this industry. It succeeded in selling Dell-branded printers that were initially manufactured by Lexmark International, and more recently by Fuji, Xerox, Samsung, and Kodak. These collaborations provided Dell with direct access to more intellectual property without allocating an important budget on research and development. In counterpart, its partners gained access to better customer relationships which they did not have before. This is another example that illustrates how reluctant Dell was in trying to innovate in a new market. It just created sufficient relationships with others to be good enough to maintain its share of the market. This behavior has not changed over time. For example, its research and development budget is now at 2%, while the industry average reaches 5 or 6% (NY Times, 2004). Outsourcing at Dell When discussing the various types of network, Miles and Snow (1994) explain that businesses evolving within a dynamic network must have upstream and/or downstream partners [that] are constantly changing to meet the demands of new products or services, utilize available capacity, stimulate or create new patterns of cooperation, and so on. (p. 126). This is exactly what happened to Dell which was a leading firm in such a network, because it was capable to not only envision the next generation of products or services but also managed to surround itself with strong allies. This implies that outsourcing activities played a crucial role in the success of Dell. Indeed, during the first fifteen years of its history, Dell used outsourcing intensively. While we have no information about the detailed structure of the contracts, we can observe that Dell formed some partnerships. For instance, the entry in the UNIX market was done with UniDirect (Miles and Snow, 1994). Dell did not own manufacturing facilities but was leasing two small factories, one in Texas and one in Ireland, where computers were assembled from outsourced parts. By partnering with Sony for monitors, Intel for chips, Microsoft for software and UPS for logistics, Dell was able to provide an offer that was totally integrated while still concentrating on a limited number of elements (Farhoomand et al., 2002; Frei et al., 2003; Magretta, 1998; Rangan and Bell, 1999; Rivkin and Porter, 1999; Ryans and Vandenbosch, 2000; Thomke et al., 1999).
Rivlin, Gary, Dell bucks the outsourcing trend, The New York Times, Monday, December 20, 2004, accessed at: http://www.iht.com/bin/print_ipub.php?file=/articles/2004/12/19/business/dell.html
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In recent years, Dell has become more defensive with respect to outsourcing by focusing on the safer market. This corresponds to a behavior associated with defenders or analyzers. Dell built three giant assembly plants in the United States, two in Austin and a third one near Nashville, where all computers are now manufactured. This is happening when the other major competitors are heavily outsourcing their production. Michael Dell recently said, It's been a long time since one of our competitors actually made a computer (Rivlin, 2004). The rationale behind this approach was to keep computer equipment closer to the customer, which made it most cost effective. While most players were outsourcing their call centers, Dell was ending its technical support outsourcing arrangement in Bangalore, in November 2003. This service is now offered from Texas. These changes of behavior with respect to outsourcing correspond to a change from a prospectors behavior to an analyzer/defenders behavior. It is difficult to say if Dell is a pure defender or a pure analyzer because of lack of data, but it is clear that it is no longer acting as a prospector. Dell has not changed its core mission or values, which are to remain close to its customers by offering, packaging and marketing a product, rather than improving such product. Therefore, what made Dell so innovative from its beginning until the end of the 1990s characterized it as a prospector. But because this approach is now well known and duplicated by others, and mainly because Dell has not offered any ground-breaking approaches in customer service or in any other areas since then, it is now difficult to consider Dell as a prospector. In fact, Dell is looking more and more like an analyzer or defender. This change also translated into a different level of outsourcing and different types of outsourcing arrangements. Conclusion Dell Inc. was used to illustrate how outsourcing behaviors are linked to business strategy. It is true that the outsourcing arrangements presented here are not very detailed, however what matters is the demonstration that when a company behaves as a prospector, its tendency is to outsource more than when a company adapts a defender or analyzer strategy. Dell did not own any manufacturing plants at the beginning and was heavily reliant on its partners to assemble computers. Its main mission was to develop a sensitive and direct relationship with its customers. Now that its brand is recognized and trusted, Dell is trying to reduce its dependency on others by maintaining as few partners as possible, manufacturing computers in its own factories, keeping its call-centers in-house, and avoiding new innovation. Two main avenues could be pursued to validate the hypotheses. The first one would be to conduct a longitudinal case study. If a company changes its strategic type over time, like Dell seemed to do, it can be possible to track the changes occurring over the same period with its outsourcing profile. This approach would enable the identification of links between these two groups of variables and rich information from managers would provide key insights on apparent causality. The second approach would be to conduct a survey. Many measures already exist to assess the strategic profile of an organization. Measures also exist to identify contract types. A survey would provide static information but the number of observations would enable a formal test of the hypotheses. It is clear that one illustration does not constitute a validation of the hypotheses. It was never our intention to validate the model with one illustration. The objective was to increase our understanding of the relationship between outsourcing and strategic profiles.
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This program of research should lead to several results. First, the interaction between the strategic type of the organization and the IT outsourcing profile, which has never been investigated before, will be examined. This should enable the test of the hypotheses discussed earlier. It will provide an explanation of IT outsourcing behavior that relies on both transactional characteristics and intrinsic organizational properties. This will also provide new insights on contract types and incompleteness.
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Information Technology Outsourcing from a Business Strategy Perspective

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