Explaining the Growth of Business Service Firms

The tendency for firms to externalize or outsource functions and activities previously produced in house (internalized) is one of the best known hypotheses used to explain the rapid relative growth of business services. It has its origins in research on the importance of complementarity and economies of scale for decisions by firms about whether to externalize or internalize service functions. The problem facing all firms, irrespective of sector, concerns whether to ‘make’ or to ‘buy’ specified service inputs. Few firms can avoid making these decisions because the inputs provided by business services can improve organizational efficiency and add value to a good or a service at different stages in the production chain. The more advanced or complicated the production process, the more significant the decisions about business service inputs. By choosing to ‘buy’, usually on a contractual basis negotiated in advance, the firm is likely to be able to command the services of an expert employed by a firm specializing in a particular activity such as advertising, website construction and maintenance, or advanced computer software installation and configuration for firm specific tasks.

Changing business practices and enhanced competition have also been important drivers behind the growth of business services. Changing business practices as an explanation is, of course, related to the process of externalization if only because strategic downsizing and cost cutting especially by large client companies meant that many firms no longer had sufficient staff to internalize business service functions. The result was the creation of large numbers of new independent business service firms. Much of the research into the drivers behind the growth of business services has revealed that cost driven externalization was not a major factor behind the growth of business service firms. The most important factor was demand for specialized technical expertise combined with a myriad of noncost and cost driven factors. Drawing upon a range of studies that have been undertaken on business services over the last 15 years it is possible to identify ten factors that have contributed to the growth of this sector of the economy (the first four factors list ‘cost driven considerations’ and the last six points list ‘noncost considerations’):

  1. Transaction costs. According to the transaction cost literature firms will turn to the marketplace for a range of services in cases where external provision is less expensive than internal provision. This explanation for employing business service firms represents a ‘pure’ form of cost driven externalization. The price comparison between internal and external provision of business service expertise may be based on an actual comparison of cost differentials or be a perception that external is cheaper than internal provision.
  2. Flexibility. Firms employ business service firms where there is a requirement for different types and quantities of expertise, information, and knowledge. In this instance it makes comparatively limited sense for the firm to employ full time staff, but instead to depend on external provision.
  3. Risk reduction. By employing external providers of expertise clients are not exposed to the risks associated with full time employees. Clients do not have to provide training and invest in building or maintaining in house functions and during economic downturns clients can reduce their use of external expertise.
  4. Concentration on core skills. This is the well known debate concerning firms concentrating on what they do best rather than trying to run in house departments designed to provide peripheral business service expertise; peripheral in this instance to the company’s core activity.
  5. Lack of expertise. A firm may not have the required expertise. In this case the firm can decide to establish an in house department or draw upon external expertise. The difficulty and cost of establishing inhouse provision may encourage companies to consider employing external experts.
  6. New services. The developing market for the supply of business services produced new skills and expertise that were rapidly incorporated into client’s business requirements. Related to this is an increased awareness by clients of the types of expertise available.
  7. Third party expertise. In some circumstances a client will require an independent evaluation of work undertaken in house or by another firm. This may take the form of an evaluation of a program of work or confirmation that an internal decision is correct.
  8. Growing complexity of management. As business becomes increasingly competitive and global, client companies, to remain competitive, have to access sophisticated design, consultancy, and marketing expertise. Enhanced global competition and increasing complexity of products and services has resulted in an increased demand for expertise that increasingly does not reside inside firms.
  9. New technology. New technology frequently requires alterations to working practices that may be beyond the expertise and experience of a company’s employees.
  10. New regulations. New regulations (health and safety, employment, environmental) may be introduced that require expertise that is only required for a short period of time.