OUTSOURCING AND MARKET VALUE OF THE FIRM: TOWARD A COMPREHENSIVE MODEL

• Published date: 01 January 2014
• Author: Kalle Lyytinen,Andreas I. Nicolaou,Pankaj Nagpal
• DOI: http://doi.org/10.1002/isaf.1350
• Date: 01 January 2014

OUTSOURCING AND MARKET VALUE OF THE FIRM: TOWARD

A COMPREHENSIVE MODEL

PANKAJ NAGPAL

a

*, ANDREAS I. NICOLAOU

b

AND KALLE LYYTINEN

c

a

Department of Accounting, School of Business, Central Connecticut State University, New Britain, CT, USA

b

Department of Accounting & MIS, College of Business, Bowling Green State University, Bowling Green, OH, USA

c

Weatherhead Schoolof Management, Case Western Reserve University, Cleveland, OH, USA

SUMMARY

We analyze the effect of buyer, contract, and vendor characteristicson abnormal stock returns among firms that have

announcedlarge scale Information Technology(IT) and Business Process outsourcing(BPO) contracts. Wedraw upon

a comprehensive dataset on outsourcing announcements, augmented with data from public sources. Salient buyer

factors examined include use of a widerange of organizational controls. On the vendor side, we examine the impact

of vendorsize, contract sizeand reputation. Our studyshows that use of behaviorcontrols, outcomecontrols (negative),

vendor reputation, and industry of buyerfirm affect market value.When limited to buyer relatedfactors, use of behav-

ior and clan controls is positively related to abnormal returns around IT outsourcing announcements. An interesting

finding is that ITand BPO success requiredifferent sets of controls. Copyright © 2014 JohnWiley & Sons, Ltd.

Keywords: IToutsourcing; business process outsourcing; event study; organizational controls; median regression

1. INTRODUCTION

Information technology (IT) accounts for a quarter of non-residential fixed investment. Whilst the link

between overall IT investment and productivity is now well known (Stiroh, 2002), it is less known that

asignificant and increasing share of IT investments is outsourced and mediated through markets. IT

outsourcing has been defined as ‘the delegation, through a contractual arrangement, of all or any part of

the technical resources, human resources, and the management responsibilities associated with providing

IT services to an external vendor’by a buyer or client firm (Clark et al., 1995). Here, the buyer or client

firm

1

is defined as the contract granting firm, also sometimes called the focal firm. As a conservative

estimate, this share reached 20% of IT budgets among InformationWeek 500 firms (Vallis and Murphy,

2008). It has continuedto rise during this decade, reaching $314.7billion in 2011 with an estimated com-

pound annual growth of 4.4% through the nextfew years (Britz et al., 2011). Outsourcinghas also gained

wider adoption among firms of all sizes. Given that outsourcing is increasingly a direct proxy for a large

portion of ITexpenditure, success of the firm’s outsourcing initiatives should play a significant role in af-

fecting the firm’s productivity increases. Yet the impact of the outsourced ITelement in affecting produc-

tivity withinthe firm’s IT function,and more broadly within the buyeror client firm, is less understood. At

thesametime,asignificant share of firms are not satisfied with their outsourcing outcomes (Cohen and

Young, 2006). About half of large outsourcing contracts have been discontinued, or subjected to major

* Correspondence to: Pankaj Nagpal, Department of Accounting, School of Business, Central Connecticut State University,1615

Stanley Street, New Britain, CT 06050, USA. E-mail: nagpalp@ccsu.edu

1

Buyer, client, controller and focal firm are used synonymously in the literature.

Copyright © 2014 John Wiley & Sons, Ltd.

INTELLIGENT SYSTEMS IN ACCOUNTING, FINANCE AND MANAGEMENT

Intell. Sys. Acc. Fin. Mgmt. 21, 19–38 (2014)

Published online 26 January 2014 in Wiley Online Library (wileyonlinelibrary.com) DOI: 10.1002/isaf.1350

changes (CIO.com, 2003). In addition, outsourcing of highly specific and customized functions, such as

application development, is even riskier (Cohen and Young, 2006).

Recently, outsourcing aims have moved away from simple cost containment (Linder, 2004). For

example, Linder, (2004: 1) argues that ‘outsourcing can be more than a tool for cutting costs and

improving organizational focus. Increasingly, it is a means of acquiring new capabilities and bringing

about fundamental strategic and structural change’. Thus, more successful firms can be expected to

differ in how they identify, select and combine IT resources (namely, vendors), and how they control

their outsourcing performance through contracts and ‘non-contract’means of control. As the ‘IT

services market’has become increasingly a common global resource, with a large number of standard

(and even customized) contracts and service-level agreements (SLAs) available for buyers, it is the

distinct buyer-side capabilities related to outsourcing that appear to affect significantly a firm’s value

adding capability (Nagpal, 2009). At the same time, there is a paucity of research that has sought to

identify and systematically understand factors that affect success of such large-scale IT outsourcing.

The significant variance in outsourcing success rates and their nexus to firm-level impact suggest that

stock markets are cognizant of contextual information that affects IT outsourcing impacts. Thus,

abnormal returns related to outsourcing announcemen ts would signal rational investors’belief in the

success of outsourcing initiatives, and its positive impact on the firm’s market value. Hence, we can

use abnormal returns related to announcements as a proxy for success of outsourcing , and factors that

are included in those success calculations with the inherent assumption of rational and knowledgeable

investors. Earlier research also testifies to this: on average, outsourcing announcements have been

accompanied by positive abnormal returns (Hayes et al., 2000). Consequently, a small stream of

accounting information systems (AIS) literature has delved into factors that enter into investors’

calculations and what can be expected to affect abnormal returns. For example, Hayes et al. (2000)

found significant differences in the industry and size of the firm. Likewise, Oh et al. (2006) found

differences in contract and vendor size, and asset specificity related to contracts.

Surprisingly, buyer factors have received scant attention, compared with contract and vendor

characteristics. Yet, the capabilities of the client firm are instrumental in outsourcing success: in the end

it is the buyers’understanding of the goals and targets of outsourcing and its capabilities to orchestrate

outsourcing arrangements as controller that creates value. Therefore, it is instrumental to identify and

understand differences among buyers’capabilities in order to explain their level of success. A study of

senior executives, such as chief information officers (CIOs), of focal firms successful in outsourcing

demonstrated that successful outsourcers had several distinct capabilities (Nagpal, 2009). These distinct

capabilities and their impact on market value are the primary focus of the paper. We also seek to corrob-

orate the presence of vendor and contract impacts (Oh et al., 2006). To test for the presence of these

impacts we conduct an event study. The study draws upon a comprehensive dataset of recent outsourcing

announcements, to probe the influence of buyer-, vendor- and contract-related factors. In addition, we

integrate the findings with salient results from previous research (Oh et al., 2006); the latter are used as

controls to strengthen the validity of our results. In this context, we also distinguish between the impacts

of IT andbusiness process outsourcing (BPO).The former are often customized to the needsof the buyer

or focal firm, while the latterare more generic, involving standardized business process solutions that are

used to drive down cost. Finally, the paper adds to the literature in AIS thathas applied novel quantitative

methods to financial research (Biscontri, 2012; Miller, 2012).

The remainder ofthe paper is organized as follows.In Section 2 we review theliterature on outsourcing

and event studies. The research model, hypotheses, data collection and analysis methods are reported in

Sections 3 and 4. In Section 5 we will report the main findings. We conclude by discussing the findings

(Section 6), highlighting their implications (Section 7) and noting limitations (Section 8).

20 P. NAGPAL ET AL.

Copyright © 2014 John Wiley & Sons, Ltd. Intell. Sys. Acc. Fin. Mgmt., 21,19–38 (2014)

DOI: 10.1002/isaf