Project Sourcing Decisions in the Presence of Learning and Integration Costs

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Firms in advanced economies are increasingly outsourcing software and technology development as well as other knowledge work to a worldwide supply base. Standard economic and learning models predict that focal firms should outsource either all or none of a particular activity unless extra resources are required during cyclical demand peaks or access is needed to some tightly appropriable intellectual property. However, recent evidence shows that, even when these exceptions do not apply, many firms pursue a partial-outsourcing strategy. We develop a general model to provide a rational explanation for this evidence. In our model, learning from prior projects occurs at both the subsystem level and the overall systems level (e.g. systems integration and architecture). In our model, learning at the two levels interacts such that integration capabilities can build and decay dynamically. The model generates conditions where partial outsourcing is rational and dominates the extreme conditions of complete insourcing or complete outsourcing. Our model also specifies the conditions for regime change (between in- and outsourcing), oscillation between in- and outsourcing, and over- or undershooting the outsourcing target. Finally, guidance is provided for why firms can overestimate the gains from outsourcing because of the dynamic nature of integration capabilities.