Outsourcing and Backsourcing under Demand Uncertainty: A Simplified Real Options Model

This paper examines the value that firms create by building outsourcing and backsourcing flexibility while operating under demand uncertainty. Unlike earlier studies, it provides an analytical investigation regarding the probability of switching to the outsourcing option and the expected time to make a switch. Employing a simplified real options model, it investigates the influence of three forms of flexibility, namely complete outsourcing, partial outsourcing, and outsourcing with flexibility to backsource (re-insource), under two opposing regimes (with high and low capital-to-labor costs). The paper makes four contributions. First, it shows that the probability of switching to the outsourcing option increases with higher demand volatility under high capital-to-labor costs, whereas the same probability decreases with higher demand volatility under low capital-to-labor costs. Second, it proves that partial outsourcing is not a viable choice in either regime. Third, contrary to the common perception that the value of flexibility increases with higher market volatility, it shows that the incremental benefits from the backsourcing flexibility can be decreasing with higher demand volatility. Fourth, it illustrates that backsourcing flexibility adds considerable value in only the high capital-to-labor costs regime and, as such, should only be a priority for firms operating under this regime.