Production Outsourcing and Demand Variability

Abstract

We examine the relation between demand uncertainty and firms’ production outsourcing decisions. Contrary to the traditional view on make-or-buy decisions discussed in management accounting textbooks, we predict that demand uncertainty has a negative impact on outsourcing by a manufacturer from a supplier. Research in operations management suggests that outsourcing can increase the production lead time and can result in excessive production variability due to lack of incentive alignment between the manufacturer and the supplier. These adverse effects increase the production costs to a greater extent when the demand is more variable, leading to a negative relation between demand uncertainty and outsourcing. We test this prediction using a large sample of manufacturing firms in Turkey. As predicted, we find that when firms face more variable demand, they outsource a smaller proportion of their manufacturing costs on average, and are less likely to engage in outsourcing. The results are significant both statistically and economically and are robust to alternative specifications.