Abstract
In a complex global business environment, more organizations are relying on offshoring to provide critical information technology services (ITS). While there can be substantial cost savings for the offshoring firm, the decision to offshore ITS involves a considerable degree of uncertainty and it is essential to understand the issues and hurdles that will be faced by the offshoring operation. Based on a sample of 189 firms from 34 industries (with most coming from the Asia-Pacific region) that have made at least one offshoring decision, we find that larger market capitalized firms are more likely to outsource offshore than smaller firms. Our results also indicate an initial decrease in downside risk with a diminution in the decline, as offshore intensity increases. We also find some evidence of offshoring’s contribution to growth premia. In considering contingencies to adopt in order to manage downside risk, a real-options framework is discussed. Our findings support the view of offshoring as a dynamic process firms use to create value by leveraging growth options and mitigating risk. By considering the real-options possibilities, the investor gets a better picture of the potential losses and gains which should lead to more prudent IT offshoring investment decisions.
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- 1
Offshoring Evolving at a Rapid Pace, States News Service, 5 August 2009.
- 2
Finance as a First-Mover, Literally, Janet Kersnar, CFO.com. November 1, 2010.
- 3
Offshoring and Global Sourcing, Mark Webber, Mondaq Business Briefing. March 28, 2008.
- 4
There is a large body of literature in finance that argues that international diversification results in reduced levels of systematic risk (as opposed to downside risk) for MNCs as compared to purely domestic companies. This assumes that international markets are less than perfectly correlated, and hence, firms that diversify internationally are associated with lower levels of systematic risk (Agmon and Lessard 1977; Fatemi 1984; Hughes, Logue, and Sweeney 1975; Michel and Shaked 1986).
- 5
Damodaran (2003) suggests that country political risk is not diversifiable, because the marginal investor is not globally diversified. In addition, as global capital markets have become increasingly integrated, the level of correlation between emerging capital markets and the US market has increased.
- 6
The FDIC identified political risk as a major component of offshoring.
- 7
Tong, Reuer, and Peng (2008) provide evidence that international joint ventures (IJVs) enhance firms’ growth option values, but only for minority IJVs and diversifying IJVs.
- 8
We do not test Stage 3, because our data do not span a sufficiently long-time period.
- 9
The Offshore Tracker database (at www.washtech.org) is now unavailable. The dataset did not provide us information about the governance structure, that is, whether the company set up a captive hybrid, offshore joint venture, or outsourced to an IT contractor. However, we posit that offshoring reduces downside risk and increases growth opportunities irrespective of the governance structure, although there may be some variation in the intensity of that benefit (e.g. an outsourced offshoring project may serve to better minimize downside risk when compared to a captive investment).
- 10
If no match was obtained on the first two digits, then the companies were matched on the first digit of the SIC code. If no match was obtained using the first digit of the primary SIC code, a match was obtained using the first two digits of the secondary SIC code.
- 11
There was considerable missing data for the number of jobs offshored and a comprehensive total could not be obtained. These percentages were computed using all available data.
- 12
The sample is reduced to 177 companies due to non-availability of Compustat data. All data description of the sample and logit analysis on the financial characteristics was conducted on this sample of 177 companies. Our sample includes 54 companies with multiple offshoring events. Of these firms, there are only 12 companies with two or more offshoring events within a 60-day window.
- 13
We did not include ROA and ROE in Table 1 to avoid multi-collinearity, since net profit margin times asset turnover equals ROA and ROA times total asset to equity ratio equals ROE.
- 14
Market value-added is calculated as the percentage change in the market capitalization over the one-year period prior to the offshoring decision.
- 15
This model is similar to the model used by Ang, Chen, and Xing (2006) to estimate downside risk. Their article provides an excellent survey of the theoretical and empirical work in finance on downside risk.
- 16
The use of the size premium allows us to control for firm size, a factor that we found significant in our previous logistic regression. Similarly, the inclusion of pre-event returns in the equation controls for changes in firm valuation prior to the offshoring event. In our logistic regression, we had observed that firms with reductions in market value were more prone to offshore.
- 17
We also ran Model 1 on both the sample and the control firms and observed a significant downside risk decline for sample firms and a significant decline in the INV_GRWTH_PREM, that is, the book-to-market premium (or, a significant increase in the growth premium). We decided to keep the Model 1 with just the sample firms, because it was a parsimonious model and also because we did not have offshoring intensity data for control firms for Model 2. However, we did retain the pre-event logistic regression for the entire sample, as it did provide insights into the nature of systematic risk and the change in market value of the offshoring firms compared to the control firms.
©2014 by Walter de Gruyter Berlin / Boston
