Service firms have begun outsourcing part of their activities in much the same way as manufacturing firms have sourced components and finished goods in the past 30 years.  Due to factors such as global competition and technological and telecommunication advances, service firms now enjoy the flexibility to outsource some of the service activities provided to their customers.  US financial services company Charles Schwab now outsources development and management of its e-business services to IBM’s Global Services unit, a leader in technology services, which accounts for about a third of the company’s sales. 

In analyzing the growth strategies of service firms, it is necessary to distinguish between 'core' and 'supplementary' services.  Core services are the necessary outputs of an organization that consumers are looking for, while supplementary services are either indispensable for the execution of the core service or are available only to improve the overall quality of the service bundle.  The core services represent the ‘front office’ offerings, while supplementary services are those that are mostly performed in the 'back office'.  In the car rental industry, for example, the core service is providing customers with safe and well-functioning vehicles for transportation.  The supplementary services may include special benefits for frequent renters, customer pick-up, ease of making reservations, speedy check-in and availability of maps. 

Competitive advantage.  The competitive advantage of a service firm lies in the performance and sustainability of the core and supplementary services.  Innovative core services may determine a service provider’s initial competitive advantage (in terms of strategic and thus financial performance), but core services will gradually resemble commodity characteristics as competition intensifies over time.  Subsequently, a service provider needs to increase its reliance on supplementary services to add value to its customers by offering differentiated service bundles.  In general, customers expect service providers to do a good job in performing the core service as a given, and evaluate different service providers on the ability of providing supplementary services that are of value to them. 

Generally, core service activities are performed by a service firm by itself (known as internal sourcing or in-house sourcing) as they are location-bound, but supplementary service activities may be made separable from core services and could be sourced from external suppliers (known as external sourcing or outsourcing). 

Outsourcing.  Our recent studies have found that due to various resource constraints, service firms that diversify into the business of building in-house supplementary service capabilities tend to dilute their core service competencies, thus losing, rather than gaining, their competitive advantage.  This suggests that through outsourcing of supplementary service activities, service firms should focus on their core competencies (i.e. using internal sourcing for the core service activities that they can do best) and be flexible enough to meet the ever-changing demand in the marketplace by designing the service package and outsourcing remaining supplementary service activities from the best-in-class providers.

An increasing number of service firms are further shifting some of their back office supplementary service activities (e.g. applications support) to foreign sites in countries such as Ireland, India and Argentina to capitalize on cost advantage.  Although service-buying firms enjoy greater leverage, there are potential problems related to outsourcing of service activities: 

·     Cost.  The use of foreign sourcing (where service 
      provider and receiver are located in different countries)
      tends to incur some transmission/processing costs. 

·     Quality.  Because of the geographic and cultural
     distance between the service provider and the receiver, 
     problems with quality control and feedback are also 
     encountered, thereby hurting a service firm’s market 
     performance. 

If customers complain about the outsourced service quality, the service-buying firm’s brand image is tarnished.  If the outsourced service activity is inseparable from the core services the firm provides to customers, and if it happens to be the only time when they are exposed to the human element, the service-buying firm would lose its only chance to have direct contact with those customers.  In such a way, the service-buying firm may not have the opportunity to build relationships with its customers. 

Pitfalls.  Our studies have indeed shown that foreign sourcing of supplementary services is negatively related to service firms’ strategic and financial performance.  This is mainly because of the inherent differences between manufactured goods and services.  Manufactured goods can be sourced anywhere in the world because they can be stored for future use, so the decisions on whether to source manufactured goods are contingent on the cost or strategic benefits involved.  However, the unique properties (perishability and inseparability) of service activities may introduce constraints such as location-boundedness and limited tradability.  (Perishability refers to the difficulty of storing service activities for later use; inseparability means that production and consumption of services take place simultaneously.)

Supplementary service activities are what makes service firms differentiate themselves from competition, and generally require highly specialized investments.  Although the number of suppliers available to provide the supplementary service activities may be limited, it does not automatically follow that these supplementary service activities should be performed in-house.  One alternative is to find strategic partners to become suppliers who have the competency to deliver innovative supplementary service activities and the ability to make the necessary investments.  Through the use of competent partner firms, the service-buying firm would have a tighter control on the service quality of the outsourced supplementary service activities, which in turn fulfils the two most important requirements of supplier selection:  supplier’s competency and service quality control.  Foreign sourcing of supplementary services simply for cost reasons may not offer the benefits that would accrue to manufactured goods.

IMPLICATIONS:
At the macro level, international trade in highly separable 'back-office' service activities (including software development, product designing, applications support, etc.) will increase.  However, to the extent human contacts are important in providing service bundles, those service activities will remain location-bound.  This location boundedness will be even more salient in 'high-context' cultures (i.e., Asia, Latin Europe and Latin America) where trust, group consensus, and long-term relationships are considered important than in 'low-context' cultures (i.e., the United States, Germany, and Nordic countries) where legal contract and individual responsibility are considered important.

Firms in 'low-context' countries tend to believe the divisibility (i.e., outsourceability) of service activities more than those in 'high-context' countries do.  Consequently, firms in 'low-context' countries will lead the so-called 'globalization' of services, making it appear that firms in 'high-context' countries are lagging behind in service globalization.  However, the world consists of more 'high-context' countries than 'low-context' countries.  The more global the marketscape becomes, the more important 'high-context' markets become to firms from 'low-context' countries.  It may prove to be a fundamental strategic mistake if firms from 'low-context' countries rely on a high level of outsourcing of 'back-office' service activities in providing their service bundles in 'high-context' countries where customer would prefer more personal service experiences.