Efforts and efficiency in partial outsourcing and investment timing strategy under market uncertainty

Because outsourcing incurs hidden costs at the preparation stage and future profits are uncertain, outsourcing immediately is not always optimal. Thus, this paper studies when the optimal time to outsource is, by proposing a real option model. The timing strategy takes into account a firm's effort at the preparation stage and an outsourced proportion, because ex post future profits and consequently the optimal time are affected by how well prepared the outsourcing is and how large proportions a firm outsources. Based on the model, this research provides managerial implications about how outsourcing timing strategies should vary when outsourcing environments such as market uncertainty changes and a firm's effort. Our model shows that a firm can outsource earlier when an investment (effort) at the preparation stage is more efficiently made, when market becomes more stable, when it can expect higher marginal profits from the outsourcing, when it can outsource more proportion. Also, by comparing a widely used net present value model to our real option model, we show that the traditional method underestimates a firm's value for outsourcing and misleads a firm to outsource earlier. Finally, we provide a descriptive framework for a decision support system. (C) 2010 Elsevier Ltd. All rights reserved.