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Abstract

In this paper, we present an economic learning model that helps to formalize the complex relationships among an offshoring firm’s knowledge levels, production costs, and coordination costs. Specifically, we model a domestic firm’s use of a selective offshore strategy (i.e., offshoring only a portion of its information technology activities) to exploit, through IT investments or contractual provisions, the foreign vendor’s large, scale-driven repository of production knowledge. We illustrate the conditions under which knowledge transfers during offshoring may reduce a domestic firm’s in-house production costs, leading to total cost savings in both the short term and the long term. Alternatively, when knowledge transfers are not sufficiently large, some short-lived offshoring projects may generate substantial cost savings to the domestic firm; however, long-lived offshoring projects may cause a disruption in the knowledge supply chain, resulting in substantial losses in the later stages of the project. A firm that fails to realize the costs associated with such a disruption soon enough in the project life may find itself locked into a disadvantageous offshoring agreement without any recourse. However, a domestic firm may be able to overcome a disruption in its knowledge supply chain by exploiting the learning-by-doing production knowledge generated by the foreign vendor’s economies of scale. The managerial implications derived from our learning model may help guide firms as they consider the impacts of offshore contracts and knowledge management investments on firm knowledge, production costs, and coordination costs.

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