Impact of sourcing flexibility on the outsourcing of services under demand uncertainty

This paper investigates the relationship between market conditions and the value and use of sourcing flexibility for service processes. We develop and analyze a series of models, and we derive expressions for the optimal switching decision, the value of the option to outsource, the value of the option to backsource, and the probability and timing of switches between the alternative sources.One contribution is the models and associated derivations, which are largely new to the literature and may serve as a tool to support service sourcing plans and decisions. The second contribution is a series of results with managerial implications: (1) The probability of outsourcing is generally increasing in volatility for high-skill process and decreasing in volatility for low-skill processes. Earlier work has found that the hysteresis band is increasing in volatility, which is interpreted as an indicator of increasing organizational inertia. We also find that the hysteresis band is increasing in volatility, but interestingly for the case of high-skill processes, organizational inertia tends to be decreasing in volatility. (2) The option to backsource is generally more valuable for high-skill processes than for low-skill processes. This result suggests that investments to make it easier to backsource should have a higher priority for high-skill processes. (3) The value of the option to backsource a high-skill service process can be decreasing in volatility. The result suggests that a rather nuanced consideration of volatility is in order when considering investments in the flexibility to backsource a high-skill process.

► We model an in-house service process that is under consideration for outsourcing.
► We consider two cost structures with different fixed and variable costs.
► Transaction volume is modeled as geometric Brownian motion.
► We identify settings in which backsourcing investments are, and are not valuable.