Outsourcing and firm performance in the Italian manufacturing industry

1. Outsourcing and firm performance in the Italian manufacturing industry Pinuccia Calia, Silvia Pacei Dipartimento di Scienze Statistiche Università di Bologna L’analisi dei dati di impresa per la conoscenza del sistema produttivo italiano: il ruolo della statistica ufficiale 21-22 novembre 2011Istat - Roma

2. Motivation (1) • Fragmentation of production has increased without precedent in the last two decades, boosted by: - diffusion on ICT that made it possible to perform activities in any location (Grossman and Helpman 2005); - continuous decline of transportation costs that has facilitated the worldwide flows of goods (Hummels 2007). • The fragmentation of production has more and more often gone beyond the boundaries of the firm, so as to involve other independent firms. • In this case we can speak about “outsourcing”. • If the outside supplier is an offshore company we speak about international outsourcing or off-shoring

3. Motivation (2) • The scope of outsourcing is : - to take advantage of specialization and scale economies in production tasks by specialized suppliers ; - to gain flexibility to respond to demand changes quickly. • As a consequence, firms may specialize in those activities where they have a competitive edge seeking to improve production efficiency, and consequently, their competitiveness (Dìaz-Mora, 2008). • The fundamental question is whether outsourcing is value enhancing and, in particular, whether firms undertaking outsourcing benefit higher productivity and profitability.

4. Theoreticalframework • Grossman and Helpman (2002) provide a comprehensive analysis of firms’ outsourcing decision, building on transaction cost theory (Williamson 1975, 1985) and property right theory (Grossman and Hart, 1986). • Outsourcing entails a variety of transaction costs that arise from the need of asset specific investment and the specification, monitoring and enforcement of contracts. • On the contrary, outsourcing increases the flexibility in the production process as well as it allows to benefit from provider cost advantages derived from specialization, experience, economies of scale and location. • Outsourcing is attractive only when transaction costs incurring from asset specificity, incomplete contracting and search efforts are lower than the production costs advantage.

5. Benefitsof outsourcing • Outsourcing allows access to better, cheaper and more varied (final and intermediate) inputs, because goods and services may be more efficiently produced by other firms and bought at a lower prices. • The benefits of outsourcing on productivity and profitability derives principally form savings resources in terms of both labor costs and capital • However it is an unresolved empirical issue whether outsourcing actually has a positive influence on a firm’s performance as is expected a priori.

6. Data • Firm-level panel that put together data collected in different surveys and administrative archives (SCI, PMI, balance sheets archives) • Years 1998-2007 • Target population: enterprises in industry and service sectors with twenty or more employees. • Catch-up prospective panel: starting from firms surveyed in 1998 and then locating firms in the present by subsequent observation. • New firms entering after 1998 are not included. • Only firms which, after 1998, are survey respondent or are present in the BS archives at least for 4 years are included. • We select manufacturing firms: 8,235 in 1998, 5,862 in 2007 with complete information.

7. Measuresof outsourcing • We measure outsourcing by “works contracted out to third parties on raw materials supplied to them” which refers to tasks which being a part of the own production process are carried out by other firms. • Neither external services nor purchases of raw materials and supplies (office materials or fuel,) are included. • Subcontracts are included within this concept. • This measure overcome the shortages implied by outsourcing measured as the value of material intermediate inputs: - it includes raw material purchases and arms-length purchases of standardized components in the market (Diaz-Mora, 2008). - it does not capture the outsourcing of the final production stage, the assembly or specific production tasks.

8. Indicatorsof outsourcing intensity • 1) The ratio of the value of outsourcing to the number of employees of the firm; • 2) The ratio of the value of outsourcing to the total wage bill of the firm. Outsourcing can be seen as a substitute for in-house production and hence may, in the short run, lead to a reduction in the total wage bill: the cost of outsourcing may be seen as the opportunity wage that would have occurred to in-house employees if these services had not been contracted out (Girma and Gorg, 2004). • The two are related by a factor equal to the wage rate.

9. Measuresof performance • Productivity indicator: labor productivity - ratio of operational value added to the number of employees. • Profitability indicator: “per capita gross earnings before taxation” - ratio of EBITDA (the difference between value added and labor costs) to the number of employees (Görzig and Stephan, 2002; Giannelle and Tattara, 2009).

10. Some summarystatistics (1) • The percentage of firms which outsource range between 70% and 74% across years. • Neither all the firms that start to outsource continue in the next years nor the outsourcing firms are the same every year • Considering the pure panel (60% of all the firms in 1998): - 23% of firms outsource every year - 19% outsource almost all the years but one. - 3% of firms never outsource, - 54% follows all the other patterns of behaviour

11. Table 1: Outsourcing firms, outsourcing costs, and outsourcing intensity: mean and CV by year

12. Some summarystatistics (2) • Outsourcing/employees increases slightly every year • Outsourcing/wage bill remains almost constant and decreases a bit after 2002. • The number of employees tends to remain almost stable across years while the wage bill increases steadily, due to the increase in wage rate • EBITDA /employee stays more or less constant • EBITDA /wage bill declines steadily till the last year considered. • Labor productivity, on the contrary, is constant through the period

13. Table 2: Performance and other characteristics: mean and CV by year

14. Table 3: Productivity and profitability indicators, by year and outsourcing status Note: difference in means significant at: *** 1%, ** 5%, * 10%

15. Some summarystatistics (3) • Non outsourcing firms exhibit higher average capital intensity but smaller size: outsourcing firms seem more labor-intensive. • Non outsourcing firms exhibit lower average total wage bill but higher wage rates (at least until 2004).

16. Table 4: Capital intensity, size, wage bill, and wage rate, by year and outsourcing status Note: difference in means significant at: *** 1%, ** 5%, * 10%

17. Table 5: Productivity and profitability indicators by classes of outsourcing intensity and year (thousands of euros)

18. Econometricanalysis – The model General equation of performance indicator augmented by a measure of “outsourcing intensity” at the firm level: [1] where is the performance measure for firm i at time t; is a vector of time variant controls variables; is the outsourcing intensity; are individual time-invariant effects; are time effects; are error terms. We use the longitudinal structure of the data to estimate alternative model based on different identifying assumptions.

19. Econometricanalysis – FD Assuming outsourcing depends on unobservable individual-specific effects and no restrictions are imposed on correlation between and covariates, we are in the fixed-effect framework and we may use a first difference transformation; [2] where time, sector and regional dummies are introduced. The above equation is estimeted by OLS (FD). A way to allow for a more general dependence between outsourcing and unobservable heterogeneity is to introduce in model [1] an additional source of heterogeneity as an individual specific time trend.

20. Econometricanalysis – RGM In the Random Growth Model (RGM), each individual (firm) is allowed to have its own time trend. [3] In this case we assume outsourcing depends on unobservable individual-specific (time invariant) growth rates in addition to the level effects Applying second difference eliminates and : [4] Parameters and maybeestimatedby OLS.

21. Econometricanalysis – IV • Consistency of both estimators relies heavily on the strict exogeneity assumption (Wooldridge, 2002, 2005). • Potential endogeneity problem of the outsourcing variable: there may be unobserved time-varying factors, correlated with both performance and outsourcing intensity. • A general approach to estimate models [1] that do not satisfy the strict exogeneity assumption is to carry out a transformation to remove , and next, use instrumental variables (IV) • The issue on the validity of instruments is particularly relevant in IV estimation method. Tests to determine whether a outsourcing must be treated as endogenous and whether instruments are valid have to be used.

22. Econometricanalysis – IV • We choose instruments for outsourcing intensity among the following variables (in logarithm) - skilled and unskilled wages rates - white collar ratio, either calculated as second differences and lagged differences • We consider the three above estimation strategies: FD, RGM and IV. • All models are estimated using a robust methods for standard errors to allow for heteroskedasticity as well as an unspecified correlation within but not across firm’s error terms.

23. Results - Productivity Dependent variable: log of labor productivity. Covariates: log of capital intensity; log of size; log of outsourcing per employees; time, sector and territorial repartition dummies. Instruments for outsourcing: second difference of the log of wage rate for skilled and unskilled workers. IV Estimates results: all coefficients are significant. The elasticity of labor productivity with respect to outsourcing is 0.88%. FD and RGM results: same sign observed for IV but much smaller values. Similar results between FD and RGM.

24. Table 6: Labor Productivity and Outsourcing: IV, RGM , and FD (Pooled OLS) Estimates

25. Results - Profitability Dependent variable: log of EBITDA per employees. Covariates: log of capital intensity; log of size; log of outsourcing per employees; time, sector and territorial repartition dummies. Instruments for outsourcing: second difference of log of wage rate for skilled workers log of white collar ratio. IV Estimates results: The outsourcing intensity has a negative but not significant effect on profitability. Between the two components of the value added (EBITDA and labor costs) outsourcing affects mainly the labor costs per employee. FD and RGM results: effect of outsourcing is positive (even if very small) and significant. Similar results between FD and RGM.

26. Table 6: Labor Profitability and Outsourcing: IV, RGM , and FD (Pooled OLS) Estimates

27. Conclusions • Importanceoflongitudinal data at firmlevel: - to take account offirm’s heterogeneity - totreatendogeneity in estimating the effectof outsourcing • Thispreliminaryanalysisproducesresultsthatneedtobefurtherinvestigated (bettermodelspecification, separate analysisbyindustry). • In particular, at the moment weneglect the analysisofdynamicsof outsourcing and itseffect on firms’ performance, i.e. whether outsourcing firmsgets a better performance after the decisiontooutsource.

28. Some references • Díaz-Mora, C. (2008) “What factors determine the outsourcing intensity? A dynamic panel data approach for manufacturing industries”. Applied Economics, vol. 40, 2509–2521. • Gianelle, C., & Tattara, G. (2009). Manufacturing abroad while making profits at home: the Veneto footwear and clothing industry. In M. Morroni (ed.), Corporate Governance, Organization and the Firm. Co-operation and Outsourcing in the Global Economy, Cheltenham, UK: Edward Elgar. • Girma, S. and Gorg, H. (2004) Outsourcing, foreign ownership and productivity: evidence from UK establishment level data, Review of International Economics, 12, 817–32. • Görzig, B., & Stephan, A. (2002). Outsourcing and Firm-Level Performance. German Institute for Economic Research, Discussion Paper 309. • Grossman, G.M., & Helpman, E. (2005). Ousourcing in a Global Economy. Review of Economic Studies, 72(250), 135-159. • Hummels, D. (2007). Transportation Costs and International Trade in the Second Era of Globalization. Journal of Economic Perspectives, 21(3), 131–154. • Williamson, O. (1975) Markets and Hierarchies: Analysis and Antitrust Implications, Macmillan, New York. • Wooldridge J.M. (2002), Econometric Analysis of Cross Section and Panel Data, The MIT Press: London.