small firms and offshore software outsourcing: - novell open

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Journal of Global Information Management, 13(3), 33-54, July-September 2005 33

Small Firms and OffshoreSoftware Outsourcing:

High Transaction Costs and Their Mitigation

Erran Carmel, American University, USABrian Nicholson, Manchester Business School, UK

ABSTRACT

It seems surprising that small firms engage in offshore outsourcing given that they lack theresources that large firms possess to overcome the difficulties involved. We examine thesefactors using transaction cost theory’s three stages: contact costs, contract costs, and controlcosts. Then, using our field data from small client firms (in the United States and the UnitedKingdom), intermediaries, and offshore vendors, we analyze the mitigation approaches thatreduce transaction costs for small firms. We identify nine such approaches: three for client firmsand six for suppliers. For the small client firm, they are liaisons of knowledge flows, gainingexperience, and overcoming opportunism; and, for the service providers, they are onshorepresence, reducing contact costs, simplifying contracting, providing control channels, expertintermediaries, and standardization of services.

Keywords: please provide

INTRODUCTION

Over the last decade, many firms inthe U.S. and Western Europe haveoutsourced software development tasks tooffshore sites in countries such as India,Russia, and the Philippines. More than 50%of the American Fortune 500 firms and anincreasing proportion of Western Europeanand Japanese firms are users of offshoresoftware sourcing (Carmel & Agarwal,2002; Sahay, Nicholson, & Krishna, 2003).Research on onshore or domestic informa-tion-systems outsourcing has significantly

enhanced our understanding of why suchfirms outsource software development(Lacity & Hirschheim, 1993) and how re-lationships may be effectively managed withappropriate risk mitigation, coordination, andcontrol strategies (for example, Kern &Willcocks, 2000; Lacity & Willcocks, 2001;Levina & Ross, 2003; Sabherwal, 1999,2003). Other scholars and practitionershave drawn attention to the particular dif-ficulties presented by offshore softwareoutsourcing (Apte, 1990; Kumar &Willcocks, 1999; Nicholson & Sahay, 2001).Communication may be impacted by tech-

34 Journal of Global Information Management, 13(3), 33-54, July-September 2005


nical issues such as telecommunicationsinfrastructure, cultural differences, accents,and language ability (Walsham, 2001).Time-zone differences may lead to coordi-nation difficulties (Carmel, 1999). Often theoffshore team lacks domain knowledge inthe business application in question, andtransferring this knowledge is hampered bydistance (Sahay et al.).

This prior research in onshore andoffshore software sourcing has improvedour understanding of the management ofsoftware outsourcing and the additionalcomplexities presented in offshore relation-ships. However, most of this research hascentered on large organizations that havethe internal resources to address the prob-lems of managing across time and space.Therefore, in this article our approach is tofocus on the issues faced by small compa-nies when sourcing1 software offshore.

We have noticed in the course of ourrelated research, fieldwork, conferenceattendance, and consultancy that an in-creasing amount of offshore sourcing ofsoftware development work is taking placebetween small client firms and offshorevendors in India and other countries. Thistrend looks set to continue. Small and largefirms have chosen to outsource for a num-ber of reasons such as skills shortages, cost,capacity, flexibility, and a “bandwagon ef-fect” (Heeks, 1995; Lacity & Hirschheim,1993). We have encountered cases of smallU.S. and U.K. technology firms engagingin offshore software development since thelate 1990s. At that time, the growth of theIndian IT industry was closely linked to thedemand for skills from Europe and the U.S.for Y2K (year 2000) alleviation and subse-quently the demand for development skillsin dot-com companies. During the late1990s, small U.K. and American technol-ogy firms faced a recruitment crisis due tothe high cost of IT skills and the inability to

provide the perks and career paths thatlarge companies could offer. Access toscarce skills was shown to be a major driverin the cases of Sierra (Nicholson & Sahay,in press; Nicholson, Sahay, & Krishna,2000; Sahay et al., 2003) and HarlequinSolutions (Ballard, 2003), which are bothsmall technology firms that sourced soft-ware development in India during the late1990s. After the dot-com bust and U.S.economic downturn post-2001, the IndianIT industry has continued to grow despiterecession in the U.K. and the U.S.(“Nasscom Indian IT Industry: A SuccessStory,” 2004). This is largely because thehighly competitive American and British ITservices market compelled technology firmsinto sourcing software offshore in order tocut production costs.

Our sample of small firms is comprisedof American and British firms, so we notethese two nations’ propensity to source off-shore. First, small American and Britishfirms are more likely to source offshorethan small firms from other nations (Aepple,2004; Sonwalkar, 2004). The second pointis inferential; since, as is repeatedly statedin the media, a greater proportion of U.S.firms have been outsourcing than firms inEurope, it is likely that a greater proportionof small American firms have beenoutsourcing than in the U.K. Nevertheless,the forecasts for the U.K. suggest growth.According to Datamonitor, IT spending byU.K. smaller firms is estimated to rise from$76 billion in 2002 to $109 billion by 2006(Mortleman, 2003). Inevitably, asoutsourcing increases from small compa-nies and becomes common practice, off-shore firms will be striving to compete.

Defining “small firm”2 is controver-sial (D’Amboise & Muldowney, 1988;Nooteboom, 1993) as there is no singledefinition mainly because of the wide di-versity of sectors and business types, and



different treatments in different nations. Weuse as our guideline the definition fromSection 248 of the U.K. Companies Act(1985)3 that a small firm employs 50 or lessemployees. Even though the vast majorityof firms of all sizes are small firms, little isknown about the magnitude of offshoresoftware outsourcing by small firms4, al-though Ansberry (2003) found that 60% ofcompanies with fewer than 500 employ-ees were planning expenditures of morethan $1 million in the following 12 monthson all types of outsourcing including IT,manufacturing, and logistics — both domes-tic and offshore.

In this article, we posit that smallfirms face relatively high transaction (co-ordination) costs when undertaking off-shore software sourcing. This is becausesmall firms are disadvantaged relative tolarge firms in a wide range of resourcescrucial to coordination (DeLone, 1981;Pollard & Hayne, 1998). Resources fortravel, research, and control are tight. Smallfirms must deal with the relative shortageof management staff and with personnel-recruitment disadvantages. In small firms,the entrepreneur is often involved in op-erational and managerial tasks and there-fore his or her time is scarce. Usually smallfirms have no specialized staff for finance,legal affairs, or information technology, andthus are less likely to have the resourcesin-house for strategic software develop-ment projects. Communications improve-ments commonly used in large firms suchas videoconferencing or other collabora-tive technologies may be financially pro-hibitive for the small firm. Whenoutsourcing, small firms have higher searchcosts due to limited staff support, and theyincur relatively high set-up costs relative tothe transaction size. Furthermore, smallfirms tend to have fewer documentedsources of information, and this results in

them being more inscrutable to transactionpartners (Nooteboom, 1993).

As we noted above, the majority ofresearch on software outsourcing, whetheron- or offshore, does not make distinctionsbetween constructs as they apply to smallor large firms. However, the case of Si-erra (Nicholson & Sahay, in press;Nicholson et al., 2000; Sahay et al., 2003)describes the difficulties facing such ven-tures. This case involved a small softwarefirm that attempted to set up and sustainan offshore software development subsid-iary in India. The failure resulted from alack of resources typical to small firms:capital to sustain the growing offshore cen-ter, capital for the travel costs of expatri-ates with India-specific context knowledge,and resources (such as reputation and dedi-cated staff) to attract and retain the bestoffshore staff.

Therefore, sourcing software devel-opment offshore is an enormously difficultundertaking for a small firm. We set out toexamine whether small firms can mitigateoffshore transaction costs at least as wellas large firms. Transaction cost econom-ics (TCE; Williamson, 1975) andNooteboom’s (1993) differentiation of rela-tive transaction costs incurred by small andlarge firms respectively provide the theo-retical framework through which we ana-lyze the following questions.

• What are the transaction costs facingsmall firms engaging in offshore soft-ware outsourcing relative to large firms?

• What transaction cost mitigating strate-gies are small companies adopting tomanage the process of offshore softwaredevelopment?

The article is organized as follows.In the next section we present a summaryof the theoretical frame and present the



argument that small and large firms incurdifferent levels of transaction costs whensourcing offshore. Then, we present theresearch methodology and sample descrip-tion. Next, we present our empirical find-ings of small-firm mitigation strategies forrelatively high transaction costs. We alsodiscuss the special case of small technol-ogy firms. Finally, we present our conclu-sions, contribution, and implications.

THEORETICAL FRAMELiterature from strategic manage-

ment (Chen & Hambrick, 1995;D’Amboise & Muldowney, 1988; Dean,Brown, & Bamford, 1998) has demon-strated that small and large firms requiredifferent theories and models to explaintheir behavior, strategy, and performance.

One distinction is that small firms can-not rely on economies of scale to gain ad-vantage (Fiegenbaum & Karnani, 1991).They are restrained by limited resources interms of staffing with reliance on fewergeneralists and less structural formalism(Borch & Arthur, 1995). Smaller firms facerelative limitations in raising financial re-sources in contrast to the “deep pockets”of large firms that enable them to weatherfinancial losses or other difficulties and tobe less negatively impacted by sunk costs(Dean et al., 1998). This prior research hasadvanced our understanding of small firmsand has established the need for contin-ued, serious theoretical and empirical con-sideration of the particularities of firm size.

Offshore software outsourcing pre-sents communication and coordination dif-ficulties that are highly challenging for smallfirms. To analyse the importance of firmsize and offshore software outsourcing re-quires a framework that allows the analy-sis of such coordination costs and empha-sizes the particularities of small firms. Forthis we draw on the work of Nooteboom

(1993) and Nooteboom, Zwart, and Bijmolt(1992), who have utilized and extendedtransaction cost economics (Williamson,1975, 1985) to take account of small- andlarge-firm differences. In the sections tofollow, we summarize relevant TCE con-cepts and then proceed to discuss the rela-tive differences in transaction costs be-tween small and large firms whenoutsourcing offshore.

TCE explains where the firm bound-ary will be positioned based on the costs ofvarious production and coordination mecha-nisms. We draw on TCE for two reasons.First, the theory has been used often as abasis for examining outsourcing (Ang &Straub, 1998; Aubert, Rivard, & Patry, 1996;Lacity & Hirschheim, 1993; Lacity &Willcocks, 1996; Wang 2002). Second, TCEis a framework through which many dif-ferences between small and large firmsmay be understood. TCE proposes thatcosts are comprised of production andtransaction costs. Transaction costs, orcoordination costs, are the costs of man-aging (controlling and coordinating). Unitswithin the firm can be combined or split updepending on their production and transac-tion costs. Some units will split off or beoutsourced if the costs of the internal unitsare higher than the market costs. In con-trast, large governance units may be moreefficient if units can be combined to re-duce transaction costs. Firms acting ratio-nally will adopt market-based strategieswhen their production cost savings ofoutsourced offshore work outweigh theadditional transaction costs incurred. Thismay be depicted numerically:

production cost savings > Σ(transaction costs)

Much of the production cost savingsin offshore outsourcing stem from thewages of the software staff in low-wage



nations such as India. Indian wages, notincluding overhead, are 10% to 30% ofcomparably skilled staff in the U.S. or theU.K. However, transaction costs incurredare the coordination costs due to such is-sues as the cost of monitoring the offshorevendor across time and space. These trans-action costs, if calculated, may exceed theproduction cost savings due to lowerwages. In such a case, the firm would moreprofitably organize production inside theorganizational hierarchy, that is, in house.This “make or buy” decision is also relatedto the frequency of transactions, whetheroccasional or recurrent, and the degree ofasset specificity or customization necessaryfor the transaction. Also of relevance is thethreat of vendor opportunism, especiallywhere there are small numbers of vendors.Finally, conditions of uncertainty presentpotentially high transaction costs as com-mensurate coordination and information-gathering mechanisms are required to beput in place to manage the uncertainty sur-rounding the transaction.

In particular, Nooteboom’s (1993, p.284) contribution has enhanced our under-standing of how “smaller firms as both sup-pliers and buyers, incur higher transactioncosts directly, and cause higher transac-tion costs for transaction partners” thanlarge firms. In order to justify this,Nooteboom presents an extension to theTCE framework to include firm size, tak-ing into account economies of scale, scope,experience, and learning. He states that“small firms generally produce small vol-umes (scale) of few products (scope). Of-ten they have not been in business long andthereby have little benefit from economiesof experience. Often they have limited ca-pacity for the acquisition of knowledge[learning]” (p. 283). Nooteboom identifieshow a transaction can be examined in threegeneric stages: contact, contract, and con-

trol. All three stages have threshold coststhat are relatively higher for small firms.These threshold costs are the set-up costs:the costs of setting up a contract, judgingan offer, and setting up channels of com-munication and governance mechanisms.These costs arise regardless of the trans-action size and thus weigh heavily forsmaller transactions.

In the following three subsections, weexplain and expand on Nooteboom’s (1993)work and examine the relative transactioncosts incurred by small firms relative tolarge firms. These issues are presented inrelation to the three generic stages — con-tact, contract, and control — focusing onthe particularities of offshore outsourcing.

ContactAt the stage of contact, buyers incur

search costs and the seller incurs costs ofmarketing. Small firms may be attractedby economies of scale and scope offeredby offshore vendors. Economies of scalesuggest that the small firm would benefitmore than the large firm from outsourcingsince small firms tend to have difficultiesattracting and retaining the best personnel,generally cannot afford to maintain techni-cal specialists in house in narrow areas, andcannot “ramp up” for one-time largeprojects. The process of vendor search andassessment is an example of a critical taskwhere small firms are hindered by econo-mies of learning. Nooteboom (1993) pointsto an increase in the ability to perceive, in-terpret, and evaluate when firms are largerdue to, for example, the numbers of spe-cialist staff, spread of personal networks,and propensity of access to technologies.In contrast, a small firm has fewer indi-viduals in specialized information roles whotend to have relatively lower levels of edu-cation. For Nooteboom (p. 289), “thesmaller firm rationality is more bounded



along three dimensions: width (fewer func-tional areas in staff support), depth (lowerlevel of education with the exception offirms in science based sectors), and vari-ety (dominance of the personal perspec-tive of the entrepreneur).”

The implications of these deficienciesare marked when engaging in sourcing soft-ware offshore. Small firms are unlikely tohave competent internal expertise to con-duct the search, evaluation, and implemen-tation of offshore software sourcing. Con-tact costs for suppliers tend to be higherwhen marketing to small firms than to largefirms because suppliers have more troublein generating awareness. The small firmhas a relatively limited number of individualstaff members, many of whom act in gen-eralist roles. For offshore software sourc-ing, these individuals must learn many newtopics, such as the legal and cultural normsof the vendor’s country. Small firms maymitigate this by hiring a variety of special-ists such as outsourcing consultants andlawyers, for example. However, these spe-cialists themselves bring about high thresh-old costs for small firms relative to largefirms.

ContractNooteboom (1993, p. 285) identifies

costs at the stage of contract as:

incurred in the preparation of an agreementto transact in which one tries to anticipatepossible problems during execution. Costsinclude search of information on reliability ofthe transaction, possible contingencies in thefuture and degree to which investments willbe sunk. They further include costs ofnegotiation, legal advice, set up of arbitration,design of safeguards and guarantees againstmisuse.

Small firms suffer higher relative con-tracting costs because of the relatively small

transaction size. This includes the costs ofnegotiation, legal advice, set-up of any third-party procedures, and designing safe-guards. Contracting across internationallegal regimes presents high threshold costsfor small firms. Enforcing contractualclauses and penalties such as proceduresfor data transfer upon contract terminationis more difficult and costly across differentregulatory and judicial environments. Pur-suing an offshore software vendor in In-dian, Chinese, or Russian courts is not atask a small firm should undertake lightly.Contract law is different in each nation, sodifferent enforcement and dispute-resolu-tion approaches need to be considered andincluded in the contract. These are all daunt-ing tasks for the small firm often withoutindividuals experienced in global business.If the small firm chooses to open a subsid-iary abroad (i.e., within the hierarchy), thenthe contracting and legal arrangements aresignificantly more complex and time con-suming. This may be contrasted with the“red carpet” treatment that large firms of-ten receive when outsourcing or openingsubsidiaries offshore. Large firms are wel-comed by a menu of incentives and match-ing investments. For example, Microsoftexecutives were received by national po-litical and business elites when they visitedIndia in recent years, particularly in AndhraPradesh where promises of changes toeducational curricula in colleges were madeto facilitate the supply of skilled labor. Intelexecutives were solicited by the presidentof Costa Rica himself, who was closelyinvolved in negotiations.

ControlNooteboom (1993, p. 285) identifies

the stage of control as comprising of “costsof monitoring, settling disputes (‘haggling’),renegotiation, arbitration, litigation, loss ofinvestments due to the relationship break-



ing up.” When a firm sources softwaredevelopment offshore, it needs to have con-trol beyond the boundaries of the firm andbeyond the political, economic, social, andtechnological boundaries of the country. Inorder to control the software developmentprocess across this diverse environment,control measures need to be put in place.Appropriate measures include processmeasures (percent complete and numberof bugs) as well as outcome measures(meeting functionality and performance).Small client firms often do not have theknowledge of how to put in place measure-ment systems such as these for global op-erations. Measurement systems are anotherform of threshold cost that impact smallfirms relatively more than large firms. Smallcompanies are less likely to be accustomedto long-distance control. For instance, re-cent research on the use of informationsystems in small and large companies foundthat small firms tend to use computers moreas tools and less as a communications me-dium (Pollard & Hayne, 1998). Prior re-search has shown how using computers asa communications medium is important infacilitating communication and monitoringdistant suppliers of IT services (Sahay etal., 2003).

Offshore outsourcing is fraught withimplementation failures. Prior outsourcingresearch has shown that it is common tofind that firms fail on their first or secondepisode, and then give up on outsourcingor achieve success in subsequent attempts(Lacity & Wilcocks, 2001). Thus, successstems from experience, or in the languageof transaction costs, economies of experi-ence. However, Nooteboom (1993) pointsout that small firms are hindered by theirsize in achieving economies of experience.Economies of experience are the declineof average costs caused by the “increaseof cumulate production over time, accumu-

lation of knowledge and the ability to re-duce errors and redundancies that occurredthe first time that one performs a task.”This experience effect, in essence, is theresult of doing more of the same. Smallerfirms lack the financial resources to ab-sorb failures and learn from experience.According to Nooteboom (p. 290), knowl-edge in small firms tends to be “more craft-like and based more on experience (learn-ing by doing) as opposed to procedural, for-mal explicit rules and procedures associ-ated with the need to communicate morewidely and therefore more formally.” Inessence, small firms cannot absorb the fail-ures associated with learning from offshoreoutsourcing. Furthermore, they lack formal-isms, stores of processes, practice guide-lines, rules, or methodologies. This featurehas the effect of making the small firm lessable to adapt its processes over time aslearning takes place. It also makes the firmmore inscrutable to offshore vendors.Records or formalized documentation oncoding and quality standards, for instance,may be lacking. This may be justified in asmall firm because of the expense, or for-mal standards may be perceived as bureau-cratic and unnecessary due to the relianceon informal oral communication. However,lack of client-side formalism will meanhigher threshold costs at the start ofoutsourcing. Also, it may affect learningfrom experience and continuity, a problemthat may become acute in small firms ifkey persons should leave.

Opportunism is concerned with thecircumstances when one party to a trans-action takes advantage of the other. Thedistance between the client and outsourceraccentuates the possibility for undisclosed,“behind the scenes” improvizations andunseen third-party subcontracting. We il-lustrate a case of opportunism that welearned of in the course of our study. While



the end client was not a small firm, thisincident illuminates opportunism in offshoreoutsourcing.

N is a well-known U.S. firm that contracted toan Irish vendor. The Irish firm contracted forthe work to be done by a British firm. TheBritish firm then contracted the work to bedone by a Belarus firm. The Belarussian firmperformed all the coding! The Irish firm(unashamedly) did not disclose to the Americanfirm that it had passed on the software codingwork to these other firms.

Small firms, by contrast, are morelikely to purchase from a small number ofother small firms due to the lower pricestypically charged by smaller firms. How-ever, such small suppliers are more likelyto be opportunistic or “fly by night” anddisappear more easily than large firms.There is also evidence that the largest sup-pliers in India selectively choose not to dobusiness with small clients. Larger firmsare relatively less sensitive to a single actof opportunism because the risk tends tobe spread across many transaction part-ners. Doing business with large compa-nies enhances the reputation of suppliers,and they may act as reference sites forother potential customers. We have heardmany anecdotes of Indian outsourcingcompanies opportunistically moving theirbest staff unseen to new prestigious cli-ents with high-value contracts. The rela-tive size and prestige of large firms reducesthe risk of opportunism, especially if thereis a large contract and the possibility ofhigh-value contracts in the future. By con-trast, smaller firms tend not to have the“brand presence” of large firms or the con-tract size to guard against supplier oppor-tunism.

Controlling the high levels of uncer-tainty in this environment forces small firmsto incur high information costs. This can

be examined at three levels. At the macrolevel, small and large firms face uncer-tain political and economic instabilities.For instance, India has been close to warwith Pakistan on several occasions, mostrecently in 2002. Fiscal incentives to off-shore to the Philippines may be eliminatedbecause the national government has beenunder pressure to eliminate the generoustax incentives on offshore sourcing, whichcould push up prices. At the micro level,there is uncertainty over intellectual prop-erty in less developed countries; China, forexample, has weak enforcement. At theoperational level, there is uncertainty oversuch issues as vendor nonperformance,ineffective communication due to unreli-able telecommunications, corruption, andaccess to recruitment networks. Largeand small firms are, of course, affectedby these uncertainties. However, largefirms have the resources to overcomesome of them more effectively than smallfirms can. Sahay et al. (2003) discuss howGlobtel, a major North American tele-communications company, had the re-sources to standardize Indian operations bymoving large numbers of expatriates, meth-ods, standards, and training programs intotheir Indian offshore outsourcing partners.This had the effect of creating a piece ofthe U.S. in India in terms of the reductionof cross-cultural and communication prob-lems, provision of a reliable infrastructure,standardized project management pro-cesses, accounting conventions, and duediligence procedures. In the 1980s and1990s when offshore outsourcing began inIndia, large companies like Texas Instru-ments and Motorola had the technical andfinancial resources to install their own sat-ellite links to overcome local telecommuni-cations weaknesses, while smaller firmshad to rely on unreliable, low-bandwidthpublic telecommunications or on transport-



ing computer tapes on a daily or weeklybasis by air freight (Carmel, 1999).

In summary, our theoretical frameis derived from TCE and in particular thework of Nooteboom (1993). A consider-ation of the relative differential in trans-action costs between small and largefirms at the three stages of contact, con-tract, and control will enable a discus-sion of the transaction cost mitigatingstrategies adopted by the firms in thesample.

METHODOLOGYIn order to study this topic and ad-

dress our research questions, we soughtout to understand offshore outsourcingpractices by small firms. Therefore, wecollected data from the small (client)firms, from the vendors that serve them,and from the emerging layer of interme-diaries and specialized service providers.This approach is consistent with recentwork on IT sourcing by Hui and Beath(2002). During the period of 2000 to 2003,the authors collected data from 9 smallclient firms, 5 consultancies5, and 11 ven-dors. The principal thrust of our data col-lection was from the small client firmsthemselves, and we begin with a descrip-tion of our approach for this segment.

Table 1 summarizes our sample ofsmall firms. The client firms ranged fromhaving 3 to 180 employees. (The firm with180 employees was allowed into the samplebecause the client was a small unit of lessthan 25 employees that was largely inde-pendent from the larger company.) Mostof the clients sourced from India, but otherdestinations included Russia and Pakistan.Because of the authors’ location, the sampleclient firms are all in the U.S. and U.K.Our sample was opportunistic: firms wereidentified from the authors’ professionalcontacts and from articles in practitionerjournals. We had no restrictions on the lo-cation of the offshore unit.

We conducted in-depth semi-struc-tured interviews with key personnel. In all,there were 18 interviews. Interviews tookplace with the owner-entrepreneur in mostcases, and in some (C1, C3, C8) we askedand were allowed to interview other staffsuch as project managers and analyst-de-velopers. In one case (C8), interviews tookplace with the offshore unit in Iran as wellas with the client side in the U.K. Respon-dents were asked to reconstruct eventsfrom the inception of the offshoreoutsourcing project relationship as well asprovide us with their perspectives on therelations and tensions within the projects

Table 1. Small-firm-sample key characteristics

Client firm

Location of client

Client firm no. of employees

Offshore location Activity sourced offshore

C1 UK 25 India Coding in Lotus Domino C2 U.S. 25 India Collaboration product C3 UK 180 India Web site in JAVA C4 U.S. 20 India E-Commerce platform C5 UK 29 Oman (to Indian firm) Web site with online shop C6 U.S. 3 Russia Module for a streaming product C7 U.S. 12 Russia Insurance system C8 UK 25 Iran Utilities billing C9 U.S. 50 Pakistan Health care Median

25



over time. To ensure reliability, we used astandard format for data collection. Somefirms provided us with additional data suchas corporate information, reports, andspecifications. We also attempted to ob-tain data from the trade press and fromWeb sites in a process of the triangulationof data sources. Interviews were taped ifthe interviewees agreed and were thentranscribed verbatim. We offered anonym-ity to induce interviewees to share moresensitive aspects.

The cases we examined had varyingrelationship arrangements; some projectswere short-term while others involvedlonger-term arrangements. Some clientsworked directly with the offshore unit whileothers worked indirectly through onshorepersonnel or an onshore software housewith offshore arrangements. The nature ofthe work included both custom and soft-ware package development. The unit ofanalysis was at the level of the projectsourced to the offshore unit, but we alsogathered background data on other projects.

We triangulated our data collectionfurther by conducting interviews with ven-dors and intermediaries that are active inserving small client firms in the offshorecontext. Our approach here was to vali-date and complement our data from smallclient firms described above. We soughtout vendors and consultants for interviewsin which we focused on our two researchquestions regarding transaction costs forsmall client firms. For both communities,we probed for problems and solutions ofselling IT services in the offshore context.We interviewed vendors in a number ofregions including India, Central America,and Eastern Europe, as well as the vendorrepresentatives in the U.S. and U.K. Wealso sought out intermediaries (these re-side in the client nations, e.g., the U.S. andU.K.).

We analyzed all our data first by per-forming an interview summary and a pre-liminary theoretical analysis of the inter-views from each case. We then groupedtogether the themes and responses intocategories organized around the dimensionsof the theoretical framework by applying adata display method (Miles & Huberman,1994). The resulting tables allowed us tocompare and contrast the strategies andmultiple perspectives in the case compa-nies in subjective cross-case analysis. Italso enabled patterns to be identified in theprocess of moving back and forward be-tween the data and theory in a “hermeneu-tic circle” (Klein & Myers, 1999), enablingus to make sense of the large amount ofqualitative data. This process was accom-panied by reading and rereading the tran-scripts and summaries in relation to thetheory, and discussion between the authorsand with other colleagues and students inour respective institutions. With regard tothe generalization potential of the findings,the aim of the qualitative analysis of thecases is concerned with making an ana-lytical generalization (Walsham, 1995) of-fering deep insight into the transactioncosts mitigating strategies employed by thevendor and client to enable offshoreoutsourcing.

DATA AND DISCUSSIONIn the previous section, we introduced

and explored the relatively high transac-tion costs for small firms engaging in off-shore sourcing relative to large firms. Weturn now to a discussion of what small firmscan and are doing to mitigate these costs.We illustrate our analysis with our fielddata. We present our observations in threeparts. First, we examine what the small(client) firms can do to mitigate offshorecosts. Then, we examine how the offshore



marketplace (primarily the vendor firms)is evolving to mitigate offshore costs fortheir small client firms. Finally, we presentour findings about the special case ofsmall technology firms, which we find tohave different characteristics than smallnon-technology firms vis-à-vis offshoresourcing.

Client-Side Mitigation Approaches

Liaisons of Knowledge FlowsOur findings suggest that it is the pres-

ence of one or two key individuals, or liai-sons, that pivots the relationship betweenthe client firm and offshore vendor and iscritical to its success or failure. The role ofthese liaisons is critical since the IT teamsin the small firms we interviewed had lim-ited resources and thus placed greater re-sponsibility on one or two individuals. Thisis consistent with recent research on therole of individuals and relationships withininternationalizing service firms. Lindsay,Chadee, Mattsson, Johnston, and Millet(2003, p. 8) write that “services firms havenot only a higher dependence on knowl-edge flows, but also on individuals withinthe firm that are relationship builders andcreators and transmitters of knowledge.”The cases demonstrated several instancesof how these liaisons mitigated transactioncosts. First we illustrate the importance ofnetwork ties and then the importance ofindividual skills and qualities. Then we dem-onstrate the importance of stakeholders asliaisons of knowledge flows.

Transaction cost theory is often criti-cized for ignoring the importance of em-bedded network ties (Granovetter, 1995)that may significantly reduce transactioncosts. Firm C8 sourced software from Iran,which, due to many factors including a U.S.embargo, political instabilities, and corrup-tion, seems an impossible place to source

software. The high transaction costs ofsourcing from Iran were mitigated becausethe vendor software company was ownedby a close family with resultant high levelsof trust and a reduced need for extensivecontrol mechanisms. Other cases illustratethis importance of trust in the relationshipand network ties to mitigate high transac-tion costs. Firm C4 is an American firmdeveloping e-commerce software. C4’sU.S.-based chief technology officer (CTO)is an Indian expatriate. The CTO set up asmall development unit in his home city inIndia staffed with some of the CTO’sformer schoolmates. He had nightly tele-phone calls with them, and the personalrelationship reduced transaction costs con-siderably. The contact costs were reduced,and the contract costs were reduced be-cause of the trust between the Indian ex-patriate and the offshore supplier. Finally,the control costs were lowered due to thereliance on the trust between friends.

We found that in many of the smallfirms in the sample, the skills, personalqualities, and even appearance of the liai-son were seen to be crucial. In firm C3,the liaison between Britain and India wasresident in Manchester, U.K., and Cauca-sian in appearance. He had his upbringingin Burma (Myanmar) married an Indianwoman with family residing in India. Hehad many years of experience in man-agement consultancy in the U.K. and inoffshore outsourcing managementconsultancy, and subsequently started hisown business. He told us that he felt thathis appearance, manner, family, and busi-ness ties in India and Britain coupled withhis experience of living and working in bothcountries (and others) enabled him to sen-sitively “straddle” both the Indian and Brit-ish cultures in terms of his understandingof the norms and constraints of doing busi-ness and the social structural environments



in India and Britain. Thus, the resultingrelationship had relatively low informationand search costs, as well as a reducedrequirement for consulting with interme-diaries.

Another example of network ties miti-gating transaction costs was found in FirmC5, a U.K.-based multimedia companycontracted to a Dubai-based offshoreoutsourcing firm. The managing director ofC5 was introduced by a venture capitalistto a Dubai-based software firm for whichhe was a director. Due to his stake in bothsides of the business, the venture capitalisthad strong influence over the service C5received and became involved at severalpoints to overcome problems.

With strong liaisons of knowledgeflows, many of the disadvantages of smallfirms (relative to large ones) are mitigatedthrough friendship and kinship, straddlers,and stakeholders. The case studies indicatethat, in different ways, these liaisons canalso mitigate opportunism on the part of thevendor, reduce or eliminate contact costs,and lower contract costs because of trust,which reduces the need for control(Sabherwal, 1999).

Firm C1, however, was a contrarycase. The firm had no individual to play thekey role of liaison. Instead, the firm expe-rienced several failures and then institutedstrict control, incurring high transactioncosts. Over time, a liaison emerged, clientstaff identified with the key personality ofthe vendor’s managing director (in Chennai,India), and thus control levels were re-duced, leading mainly to larger batches ofcode sent offshore with less monitoring.However, the client-side developers saidthey were “stung when a large amount ofcode was sent by the vendor that was in-comprehensible and had to be returned.”This event led to a regression of trust inthe role of the managing director as liaison,

leading to a reinstatement of very smallbatches and high control.

Gaining ExperienceThe small firms in our sample were

gaining experience in the area of offshoreoutsourcing through trial and error, com-pensating for economies of experiencepresent in larger firms but initially absentat the small firm. Put differently, some smallfirms chose to persevere through severalexpensive failures in order to see theirprojects through with offshore vendors.Thus, they were paying a high cost to uti-lize the low-cost services of offshore ven-dors.

Firm C1 failed twice in offshoreoutsourcing endeavors, but the interventionof the entrepreneur maintained the deter-mination to succeed. The U.K.-based cli-ent outsourced to a small Indian vendor.Upon embarking on a third project, theproject manager on the client side statedthat “unless we found out otherwise, wewere pessimistic about the competence of[the vendor].” This company was cogni-zant of the reasons for prior failures andinstituted a control strategy that the projectmanagers said “was a pain to make work.”The client focused on the detailed controlof outputs preceded by clear specifications.The contract included a bug-fixing warrantyand payment on delivery. The client sentonly clearly specifiable coding work off-shore, and projects were broken into verysmall, manageable modules of around 300lines of code, which were then subsequentlybroken into regular-staged releases and it-erations. The small chunks facilitated out-put control and prevented intellectual prop-erty theft, which was also a concern. Therewere weekly checks on the telephone andregular increments for output progress. Theclient-side development staff in Britaindouble-checked Indian testing and quality



control. In this case, the small firm wascapable of overcoming scale and re-sources, and engaging in learning from ex-perience without formalization. However,the transaction costs were never measuredso it was not known how profitable off-shore outsourcing was when taking intoaccount the high cost of control considerednecessary.

Evidence from prior studies helps shedlight on this dynamic. The literature positsthat some small firms have a number ofbehavioral advantages over large firms thatmay contribute to overcoming their rela-tively limited experience (Levy & Powell,1998; Nooteboom, 1993; Pollard & Hayne,1998). These studies indicate that smallcompanies often have relatively greaterentrepreneurial drive, a propensity to risktaking, perseverance, contain highly moti-vated people, lack burdensome bureaucraticand political processes, and are fast andflexible. It is these advantages that we ob-served here.

Overcoming OpportunismOpportunism takes place when one

party of a transaction takes advantage ofthe other. The distance between the clientand vendor accentuates the possibility forundisclosed behind-the-scenes behaviors.Opportunism is particularly costly for thesmall firm. We describe here the case of asmall firm that responded reasonably to thediscovery of opportunism, but incurred highcontrol costs in the process.

Firm C2 is a small U.S.-based tech-nology firm that contracted with a large,established Indian vendor that is certifiedat CMM Level 5. Such certification wouldmean that the vendor’s processes areworld-class. Nevertheless, the project raninto difficulties early on when the vendorstaffed the project with staff who, in theclient’s view, were not able to execute the

specifications properly. The small companymanager told us:

“[i]t turned out, they do keep all thoseprocesses carefully, on a hard drive database,where somebody can look at them if they want,but they do not actually follow them. So thatwas a bit of a surprise to us.”

He was also disappointed with thelevel of the staff that were assigned to theproject. The developers assigned to theproject were essentially programmers whowould write code that met the specifica-tion. C2 management had expected staffwith project-management experience ca-pable of analysis and design. In addition,as the life cycle progressed, the same man-ager told us how it was discovered that theIndian team was not doing any unit testingor bug tracking:

“So, it’s pretty clear with 30 programmersworking on the project, some of them were verygood, and others were rookies who didn’t havea clue; the rookies didn’t have enoughsupervision. And they turned out some realjunk code. And they didn’t have any way totrack bugs, or discover bugs that were tracked,and no way to know whether they had beenresolved or not. They had no way of projectingcompletion dates because they had no datacollection going on. It was junk processes;there was nothing CMM Level 5.”

Serious quality issues arose as a re-sult of this, and in response, C2 manage-ment escalated control mechanisms signifi-cantly. This was in the form of improvisedoutput controls using spreadsheets for bugtracking. The U.S. manager moved toshorter development cycles of 4 weeks. Healso began to travel to India regularly, andwhen he was not in India, he introducedtwice-daily telephone calls at the start andend of the Indian working day despite the



time difference. He also complained bit-terly to the Indian company. As with thecase of Firm C1, these high levels of con-trol were time consuming and costly forthe client, although no formal evaluation ofthis cost was made to justify the “make vs.buy” decision. The project completionstretched to years. C2’s management jus-tified their continued involvement for tworeasons: the firm did not have internal re-sources (could not do it in the hierarchy)and, in spite of the difficulties, they felt itwas still inexpensive compared with Ameri-can outsourcing rates.

Marketplace Mitigation ApproachesFor the software vendor, selling ser-

vices to small firms is more expensive thanselling to large firms due to scale and setupcosts. Nevertheless, we present some evi-dence from our sample that point to sometransaction cost mitigation approaches. Themarketplace has adapted to the potentialmarket for offshore work by small firms.

Onshore PresencePerhaps the most important approach

that offshore vendors have adopted andrefined is onshore presence. Since under-taking software development tasks tendsto be more successful with proximatework of the client and vendor, vendors situ-ate some development and managementstaff close to the client or even at theclient’s site. Thus, the offshore vendormaintains an onshore site staffed withvarious relationship functions such assales, contracting, systems analysis, andsome client support. The local vendor con-ducts nearly all relationship functions viathe onshore staff.

Onshore presence has been commonfor vendors providing services to large cli-ent firms. But this relationship structure isnow prevalent for vendors providing ser-

vices to small firms. For example, there arenow 260 Indian IT service firms with atleast one office abroad, and many of thesevendors are small. Numerous offshorefirms from dozens of nations now maintainsome representation in the U.S.. The num-ber of Indian IT companies with U.K. of-fices has grown from 10 in 1994 to 150 in2003 (Ballard, 2003). For small vendors,the onshore presence is often one individualwho wears the “dual hats” of sales personand relationship manager.

Onshore vendor presence addressesmany of the offshore sourcing transactioncosts. Contact costs are reduced becausevendors are close by, contracting costs arereduced because vendors have domicile inthe country, and control costs are reducedbecause of proximity (e.g., legal presenceand low telephone costs). Resources arebetter utilized because the difficult phaseof requirements specification, for which theclient firm may be ill-equipped, can be donevia face-to-face contact.

We emphasize that the converse is tohave no onshore presence, which is thecase for some smaller offshore vendors.Thus, since they have no proximity betweenthe client and vendor, most communicationis conducted via IT. This keeps productioncosts low because there are no expensiveonshore staff. Thus, firms offering servicesusing this approach tend to be able to offerlower prices. To take advantage of this,Firm C5, which began offshore work withthe vendor’s onshore presence, has slowlyshifted a greater proportion of work to theIndian subsidiary center. Its plan was tomove toward removing the onshore pres-ence altogether and deal wholly with theoffshore operation.

Reducing Contact CostsIn practice, we found that contact

costs for small companies are lower than



might be expected. First, information searchcosts have been reduced by the Internet,particularly by online marketplaces.Online marketplaces expose firms to hun-dreds of vendors in many countries. Nu-merous online marketplaces haveemerged to provide match-making andthus provide the small client firm withrelatively low search costs6. Some ofthese marketplaces also provide basicproject advice. Information search costshave been reduced by attendance at spe-cialist offshore outsourcing symposia orconferences. Before 2000 there were fewof these events in North America or Eu-rope. At the time of this writing, theseconferences were numerous in majorU.S. and Western European cities. Forexample, a manager at a small client firmjust embarking on offshore sourcing, whentold about these conferences in an inter-view, said, “Oh, yes, we already went toone of these.”

In addition, creative approaches haveemerged to address the small firm’s needto conduct due diligence. For example,we learned in our interviews of quality-certification schemes that will produce adatabase of accredited small offshore ven-dors that can be provided to clients for afee.

Simplifying ContractingCrafting an offshore contract is be-

coming less expensive partly because agreater population of lawyers now special-izes in the offshore niche. These lawyersnow advertise their specialized expertiseof offshore outsourcing and meet their pro-spective clients at various specialized work-shops and conferences. As offshore ven-dors mature, they are also standardizingtheir contracts. This reduces the transac-tion costs of contracts for small firms. Anoffshore vendor we interviewed has cre-

ated a standardized, phase-based contractand a standardized contracting process.

Separately, the increased prevalenceof onshore presence, which we notedabove, implies that many of the vendor firmspresent a legal entity in their client’s homecountry, thus removing contractual uncer-tainties for dispute resolution and thecomplexity of foreign legal norms. Localcontracts reduce the risk of vendor oppor-tunism since poor performance may be pe-nalized and enforced in the client’s homecountry.

Providing Control ChannelsSmall client firms need a “control en-

vironment” for offshore sourcing similar tothose typically employed by large firms.This includes agreeing on a methodology,mandating frequent reporting, regular prod-uct increments (e.g., interim deliverablesand pilots), and payments at milestones.This process should be made visible andmeasurable to the small client. Most smallfirms find it too expensive to design andimplement such control mechanisms them-selves.

Vendors in our sample are providingthese control channels and reducing trans-action costs for their small clients. We in-terviewed one U.S.-based vendor with off-shore IT work in India that is phasing in aWeb-based project-management system or“dashboard” that will give its small clientsa more detailed and accurate view of theprocess. This firm is following the lead oflarger offshore vendors that began to pro-vide such online mechanisms to their largeclients several years ago.

The vendor-provided control channelreduces transaction costs in other ways: itallows the small firm to assess uncertainty,offers the potential to reduce opportunism,and reduces contract costs since fewersafeguards need to be in place.



Expertise IntermediariesIn recent years we have observed

growth in a variety of third parties that pro-vide expertise and services to firms seek-ing offshore work. Such intermediaries havebecome expert at educating and preparingthe small clients for outsourcing. We illus-trate with two examples of intermediaries:I1 and I2. I1 is an American consultancythat helps small companies outsource off-shore by selecting partners and guiding themthrough contracting. One of the methodsthe firm implements before the clientoutsources is referred to as “clean house.”This is a process by which the consultancybrings the client’s IT function to such astage that the firm can construct robustmeasures for contracting and control. I2 isan Indian consultancy that specializes insetting up small development subsidiariesfor small U.K. companies in India. Theservice includes renting buildings, dealingwith local “officialdom,” handling the copi-ous bureaucracy, interviewing, employingstaff, and, if required, facilitating the ongo-ing incubation of the firm. This companyhas already had several successful imple-mentations.

Standardization of ServicesStandardizing the software sourcing

service lowers transaction costs in all threeof the stages: contact, contract, and con-trol. These lower costs can raise profit-ability for the vendor to be passed on tothe client. The standardization of servicesreduces asset specificity, meaning that atransaction is less expensive if the assetis less specific to one of the transactionparties.

We observed that offshore vendorsare reducing asset specificity by standard-izing the software development methodol-ogy. This results in reduced transactioncosts for the vendor. We interviewed one

offshore vendor that developed its ownmethodology derived from the well-ac-cepted rational methodology augmentedwith distributed development techniques.The firm’s process to support the small firmbegins with a standard four-page templateto collect data from the client. This tem-plate is then immediately e-mailed to theoffshore staff for comments.

Many of the firms in our study re-ported that they had been (or are planningon) improving their life-cycle methodolo-gies. These were especially noticeable inthe small firms that maintained their ownsubsidiaries offshore. While the initial stagewas characterized by ad hoc development,typically within a year the firms were insti-tuting “CMM-like” process improvements.

There are some indications that ven-dors are attempting to reduce their pro-duction costs. As the crop of vendors thatserve the small-client market mature, theyhave implemented factory-like processesand moved away from the ad hoc pro-duction processes that characterizedtheir operations in their early years. Forexample, the previously mentioned offshorevendor, which has many projects that in-volve Web sites, is increasing code reusein FLASH.

The Special Case ofSmall Technology Firms

Our case studies and secondary sourcessuggest that small technology7 firms behavemuch differently than small nontechnologyfirms. Specifically, our data suggest that theyare far more likely to source offshore thannontechnology small firms. We illustrate withfour examples from our interviews with smallvendors that provide offshore softwareoutsourcing. From the first firm, we learnedthat 60% of the firm’s clients are technologyfirms. At the second firm, the CEO expressedhis frustration at the difference between selling



to small technology firms and other small firms:“We don’t have to educate IT firms aboutoffshore — they already know about it.”

A third firm is a small Swiss firm thatdoes almost all its telephony software workin Russia. The fourth firm is an Americanfirm, which upon start-up with only threestaff, contracted with an Indian vendor todevelop its software product.

In small business l i terature,Nooteboom (1993) and Nooteboom etal. (1992) note that small business staffare relatively less educated than in largebusinesses. However, they note that theexception in education is technology firms;in these cases, the level of education ishigher than in the general population ofsmaller companies. Thus, the capacity forlearning is high and may, indeed, be higherthan in some large firms. This learningmeans that the firm can detect and absorbnew information, making it more likely tobe aware of offshore sourcing.

In the internationalization literature,we see that small technology firms have aglobal perspective relative to nontechnologyfirms (Jones, 1999). Jones summarizes thereasons for this: the orientation and per-spective of the entrepreneurs, the shortproduct life cycles (time-to-market pres-sures), and the drive for innovation. Sincethe 1990s, some of the literature referredto this class of firms as “born global”(Rennie, 1993). However, much of the lit-erature is about small technology firms sell-ing to international markets rather thansourcing from international markets.

It seems, based on our data, that quitea number of small technology firms “knowabout” offshore sourcing because of a keymanager who is of Indian or other ethnicorigin. Repeatedly, we have seen this to bea critical factor in the process of aware-ness and information. Importantly, this in-

dividual becomes one of the “liaisons ofknowledge” that we noted earlier and thusmitigates the small firm’s relatively higheroffshore transaction costs.

In our fieldwork in India, we cameacross an Indian vendor that specializes inoutsourcing for small technology firms. Weasked the CEO (chief executive officer)why such small firms seek offshoreoutsourcing. He noted three reasons. First,small technology firms are very sensitiveto the competitive pressures of time-to-market, and therefore hiring offshore re-sources reduces the time-to-market. Sec-ond, because they deal with inherentlyriskier business, small technology firmstake bigger risks. Third, small technologyfirms are often encouraged, and some-times even mandated, by their venturecapital investors to develop offshore andare even given the name of the firm thatthey should work with. While we notedearlier that the large Indian firms turn downsmaller clients, the exception is for tech-nology clients. Working on leading-edgetechnologies with entrepreneurial clients,the large Indian firms can keep up with thelatest innovations.

CONCLUSIONIn this article we delineated the off-

shore transaction cost categories that arerelatively higher for small firms comparedto large firms. We divided these into cat-egories, as suggested in Nooteboom et al.(1992), into contact, contract, and control.We were then able to assemble the prac-tices and approaches used in the small com-pany cases to mitigate the transaction costs.We summarize all our findings and obser-vations in Table 2.

We make several observations basedon our summary analysis of Table 2. First,given that the landscape of offshoreoutsourcing is relatively new and that the



involvement of small (client) firms is evennewer, many of the transaction costs miti-gation approaches are emerging and notfully diffused. Our data do not suggest thatall small firms or their vendor-suppliers areusing all the mitigation approaches listed inTable 2.

Second, two of the mitigation ap-proaches that we found in small firms (onthe client side in Table 2) are actually costlyin the short term for the small firm. Gain-ing experience and overcoming opportun-ism are approaches that involve consider-able resources for the small firm. It is ques-tionable whether these small firms would

have invested so much money, effort, andcalendar time in these approaches if theycould correctly anticipate them ahead oftime.

Third, we restate a key predictivequestion about small firms sourcing off-shore: Can small firms mitigate offshorecosts at least as well as large firms? Basedon our study, we suggest that small firmsare not using their resources in unique waysrelative to large firms in order to mitigatethe offshore costs. The nine cost mitiga-tion actions that we point to are not mark-edly different from the practices in largefirms. It seems, at this stage, that the trans-

Table 2. Summary of transaction cost mitigation findings for small firms engaging in offshoreoutsourcing

Source of mitigation

Mitigation approach

Brief description of mitigation approach

Impact on transaction costs

Liaisons of knowledge flows

Key individuals pivot the relationship between the client firm and offshore vendor.

Lowers transaction costs, primarily via control-cost reduction

Gaining experience

Small firms use their strengths: motivated people, perseverance, and flexibility.

Expensive trial and error until economies of experience are gained

Client side

Overcoming opportunism

Small firms use their relative strengths: motivated people, perseverance, and flexibility.

Expensive trial and error until opportunism is overcome

Onshore presence

Vendor has presence of staff close to client rather than offshore.

Reduces contact costs, contracting costs, and control costs, leading to an overall reduction in transaction costs for the client, but raises production and vendor transaction costs for the vendor that are passed onto client

Reducing contact costs

Client has greater access to vendor firms primarily via Internet-enabled mechanisms.

Transaction costs are reduced.

Simplifying contracting

Legal intermediaries specializing in offshore services have emerged.

Transaction costs are reduced.

Providing control channels

Vendors are providing control channels for their clients’ benefit.

Transaction costs are reduced for the client. Transaction costs increase somewhat for the vendor, which are passed onto the client.

Expert intermediaries

Third-party consultants specialize in assisting firms in the offshore context.

Transaction costs are reduced

Vendor side

Standardization of services

Standard development methodology. Introduction of reuse in software production

Lowers transaction costs for contract and control. Production costs are lowered.



action cost mitigation approaches for smallfirms are simply lagging behind those forlarger firms. We did find some weak evi-dence that some small firms find that theirbehavioral advantages can play a positiverole in these mitigation approaches, namely,their flexibility, perseverance, and motiva-tion. However, we did not find that theseadvantages played a key role in any of thesetransaction cost mitigation approaches.

Fourth, our most encouraging findingwas the potential for the marketplace toreduce transaction costs rather than anybehaviors or qualities of the small clientfirm. Small firms are benefiting from themarketplace, which is now offering loweroffshore transaction costs. Both the ven-dors and an assortment of intermediariesare filling gaps and thus lowering the rela-tive offshore costs for the small firms. Thus,our findings on mitigation approaches areconsistent with recent theory ofcomplementarity in IT vendors (Levina &Ross, 2003). Complementarity theory sug-gests that (vendor) firms improve produc-tivity by engaging in complementary activi-ties. These vendors’ value proposition isenhanced with the complementarity of theirthree core competencies: methodology de-velopment and dissemination, client rela-tionship management, and IT personnelcareer development. In our analysis, wenoted evidence of increased competenciesand the maturity of offshore vendors in thefirst two of these three activities, althoughwe did not collect data relevant to the third.

In summary, we cautiously suggestthat the most promising area may well bevendors’ standardization of services andproduction. It is this trajectory that is themost fertile area for research (and prac-tice) and will likely yield the most insightabout how the global marketplace is nar-rowing the gap for offshore sourcing bysmall firms.

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ENDNOTES1 The term “sourcing” encompasses

outsourcing and what is sometimes calledinsourcing. Some small firms do not per-form offshore outsourcing, but ratheroffshore (in)sourcing.

2 Small- and medium-sized enterprises areoften labeled SMEs in much of the Eu-ropean literature and small- and medium-sized businesses (SMBs) in currentAmerican literature.

3 More specifically, the act states that afirm is small if it satisfies at least two ofthe following criteria: a turnover of notmore than £2.8 million, a balance-sheettotal of not more than £1.4 million, andhaving no more than 50 employees.

4 We also note that Sobol and Apte (1995)found that firms with larger MIS bud-gets (a proxy for size) were more likelyto outsource both domestically and off-shore.

5 Third parties, intermediaries, orconsultancies provide expertise and ser-vices to firms seeking offshore work.

6 We note several of these online market-places facilitating offshore software



work: Elance (http://www.elance.com/),Freelancers (http://www.freelancers.com/),Guru, (http://www.guru.com/), andRentacoder, (http://www.rentacoder.com/RentACoder/).

7 By technology firms we mean firms thatdevelop either software products or areIT service firms (that may subcontractsome of their work offshore).

Erran Carmel’s area of expertise is global software development. His coauthored bookOffshoring Information Technology will come out in 2005 from Cambridge University Press. His 1999 book Global Software Teams was the first on that topic. He has written over 50articles, reports and manuscripts. His academic articles have appeared in MISQ Executive,IEEE Software, and Communications of the ACM, and many other journals. He is an associateprofessor at the Kogod School of Business at American University in Washington, D.C. wherehe cofounded and led the program in management of global information technology (MoGIT).

Brian Nicholson is a senior lecturer in information systems at Manchester Business School,UK. His interests lie in global software development, business process outsourcing anddeveloping countries. He is coauthor of Global IT Outsourcing , Cambridge University Press(with S. Sahay and S. Krishna) and has published journal articles in IEEE Software, Informationand Organisation and others. He has recently undertaken research and consultancy projects inCosta Rica, Iran and India.

small firms and offshore software outsourcing: - novell open

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