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Citation: Larsen, M.M., Manning, S. and Pedersen, T. (2013). Uncovering the hidden
costs of offshoring: The interplay of complexity, organizational design, and experience.
STRATEGIC MANAGEMENT JOURNAL, 34(5), pp. 533-552. doi: 10.1002/smj.2023
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Strategic Management Journal
Strat. Mgmt. J., 34: 533–552 (2013)
Published online EarlyView in Wiley Online Library (wileyonlinelibrary.com) DOI: 10.1002/smj.2023
Received 7 September 2012; Final revision received 13 September 2012
UNCOVERING THE HIDDEN COSTS OF OFFSHORING:
THE INTERPLAY OF COMPLEXITY, ORGANIZATIONAL
DESIGN, AND EXPERIENCE
MARCUS M. LARSEN,
1
* STEPHAN MANNING,
2
and TORBEN PEDERSEN
3
1
Copenhagen Business School, Frederiksberg, Denmark
2
College of Management, University of Massachusetts Boston, Boston,
Massachusetts, U.S.A.
3
Copenhagen Business School, Frederiksberg, Denmark and Cass Business School,
City University London, London, U.K.
This study investigates estimation errors due to hidden costs—the costs of implementation that
are neglected in strategic decision-making processes—in the context of services offshoring.
Based on data from the Offshoring Research Network, we find that decision makers are more
likely to make cost-estimation errors given increasing configuration and task complexity in
captive offshoring and offshore outsourcing, respectively. Moreover, we show that experience
and a strong orientation toward organizational design in the offshoring strategy reduce the
cost-estimation errors that follow from complexity. Our findings contribute to research on the
effectiveness of sourcing and global strategies by stressing the importance of organizational
design and experience in dealing with increasing complexity. Copyright
2012 John Wiley &
Sons, Ltd.
INTRODUCTION
Many firms find that the implementation of strate-
gic decisions can trigger substantial hidden costs
that negatively affect firm performance. For exam-
ple, a firm may find that the implementation of a
diversification strategy requires substantially more
coordination than initially expected. A firm may
also discover that knowledge transfer in the con-
text of internationalizing business activities is more
Keywords: hidden costs; offshoring; complexity; estima-
tion errors; organizational design
∗
Correspondence to: Marcus M. Larsen, Department of Strate-
gic Management and Globalization, Copenhagen Business
School, Kilevej 14, 2
nd
floor, 2000 Frederiksberg, Denmark.
E-mail: mml.smg@cbs.dk
costly than expected. By hidden costs, we refer
to the unanticipated costs of implementation that
arise in strategic decision-making processes (see
Dibbern, Winkler, and Heinzl, 2008; Reitzig and
Wagner, 2010; Stringfellow, Teagarden, and Nie,
2008). In this paper, we investigate the nature of
estimation errors due to hidden costs. In particu-
lar, we seek to better understand why certain costs
are hidden from managerial attention and thus not
accounted for in initial cost estimations.
We study hidden costs in the context of off-
shoring of administrative and technical services,
that is, the sourcing of business services support-
ing domestic and global operations from abroad
in internal or external arrangements (Contrac-
tor et al., 2010; Manning, Massini, and Lewin,
Copyright 2012 John Wiley & Sons, Ltd.
534 M.M. Larsen, S. Manning, and T. Pedersen
2008). The offshoring of service activities has
gained momentum in recent years. Today, many
western firms not only offshore standardized IT
and business processes but also more complex,
knowledge-intensive activities and product devel-
opment (Lewin, Massini, and Peeters, 2009). How-
ever, many firms have begun to realize that manag-
ing an increasingly globally dispersed organization
is more difficult and costly than initially expected
(Dibbern et al., 2008; Stringfellow et al., 2008). In
particular, decision makers often fail to accurately
estimate the costs of offshoring and are there-
fore surprised by unexpected—or hidden—costs
of implementing offshoring decisions.
Most research on offshoring to date has focused
on why firms offshore particular functions, the
governance modes they choose, the locations they
select to host offshored activities, and the outcomes
that they achieve (e.g., Lewin et al., 2009; Kedia
and Mukherjee, 2009; Mol, van Tulder, and Beije,
2005). In this paper, we focus on the organizational
design of offshoring, and the challenge of coordi-
nating and integrating offshoring activities in glob-
ally organized firms (Srikanth and Puranam, 2011).
In this regard, offshoring can be described as an
organizational reconfiguration in which originally
co-located activities are relocated across distances
in captive or outsourced arrangements, which must
subsequently be reintegrated (Mudambi and Ven-
zin, 2010). Consequently, firms are often presented
with new complexities and uncertainties, which
have an impact on decision makers’ abilities to
estimate the costs of offshoring.
Using comprehensive data from the Offshoring
Research Network, we argue that the increased
complexity that follows from offshoring involves a
number of operational challenges and related costs,
part of which are ignored or not anticipated when
offshoring decisions are made. As a result, we
observe a significant gap between expected and
achieved performance, as measured by the dis-
tance between expected and achieved cost savings.
However, we also argue that this relationship is
moderated by the organizational design orienta-
tions of firms’ offshoring strategies and by firms’
offshoring experience. Firms with strategies char-
acterized by a strong orientation toward an over-
all system of structures and processes, and firms
with prior experience are more likely to anticipate
and align offshoring complexity with correspond-
ing organizational structures and processes. Thus,
organizational design orientation and experience
nurture decision makers’ abilities to anticipate the
costs of complex organizations.
Our findings contribute to the growing stream
of literature on the operational challenges of off-
shoring (Srikanth and Puranam, 2011; Stringfellow
et al., 2008) by emphasizing the importance of
hidden costs, complexity, design strategies, and
experience. On a more general level, these find-
ings have important implications for estimation
biases in strategic decision making, and improve
our understanding of the role of experience and
organizational design orientation in relation to
those biases (e.g., Durand, 2003; Hogarth and
Makridakis, 1981; Kahneman and Lovallo, 1993;
Makadok and Walker, 2000; March and Simon,
1958). This research emphasizes the organizational
design of a firm and highlights how organizational
changes should be incorporated into strategic anal-
yses. This may stimulate future research on the
evolution of global firm designs and architectures
by stressing the role, magnitude, and consequences
of complexity in organizations (e.g., Ethiraj and
Levinthal, 2004; Nadler and Tushman, 1997; Sinha
and Van de Ven, 2005).
THEORY AND HYPOTHESES
DEVELOPMENT
Hidden costs, complexity, and bounded
rationality
Hidden costs can be understood as implementa-
tion costs that are not anticipated in the various
stages of strategic decision making. A key function
in strategic decision making—defined as the com-
mitment to important decisions in terms of actions
to be taken, resources to be devoted, or prece-
dents set (Dean and Sharfman, 1996; Eisenhardt
and Zbaracki, 1992; Mintzberg, Raisinghani, and
Th
´
eor
ˆ
et, 1976)—is the ability to estimate the costs
of implementing a strategic decision (Durand,
2003; Makadok and Walker, 2000). Often, how-
ever, firms find that unanticipated costs or ‘post-
decision surprises’ (Harrison and March, 1984)
erupt and challenge the strategic intent and ratio-
nale of the decision. In such cases, these costs have
been ignored or overlooked—thus hidden—by the
decision maker in the strategic decision-making
process. Hidden costs are thus ex ante unaccounted
for, which is why they materialize ex post as a
discrepancy between expected and realized costs.
Copyright 2012 John Wiley & Sons, Ltd. Strat. Mgmt. J., 34: 533–552 (2013)
DOI: 10.1002/smj
Uncovering the Hidden Costs of Offshoring 535
A direct consequence of hidden costs is a neg-
ative effect on a decision maker’s ability to esti-
mate the impact of strategic decisions, as important
costs are hidden from managerial attention. Previ-
ous research has emphasized that individual biases
may impact decision makers’ estimation abilities
(e.g., Kahneman and Tversky, 1984; Das and Teng,
1999), that routines may short-circuit individuals’
autonomous judgments (Nelson and Winter, 1982),
and that dominant logic may result in blind spots
in decision making (Prahalad and Bettis, 1986).
In this paper, however, we focus on the role of
the organizational context in decision makers’ esti-
mation abilities (e.g., Durand, 2003; Hogarth and
Makridakis, 1981; March and Simon, 1958) and,
in particular, on how organizational complexity
influences decision makers’ abilities to account for
costs of implementation. Thus, we seek to under-
stand the impact of complexity on the ability of
firms to anticipate the actual costs of a strate-
gic implementation. In this regard, we are able to
explain how decision makers systematically ignore
or overlook important costs in strategic decision-
making processes.
The organizational impacts and consequences of
complexity have long been part of the research
tradition (Langlois and Robertson, 1992; Loasby,
1976; Nickerson and Zenger, 2002; Rawley, 2010;
Simon, 1962; Williamson, 1975). Simon (1962:
468) defines complexity in systems as ‘a large
number of parts that interact in a nonsimple way.’
If organizations are viewed as networks of tasks
(Grandori 2001; Thompson 1967), then complexity
exists when a large number of tasks are interdepen-
dent. For example, an organization is complex if
change in one unit requires change in many other
units. Moreover, a growing number of interdepen-
dent parts in an organization increases combina-
torial complexity, as the addition of one element
results in an exponential increase in the number of
possible interfaces and interdependencies (Ethiraj
and Levinthal, 2004).
A firm’s complexity can affect its decision mak-
ing in many ways. For example, a firm that decides
to disaggregate its organization into a number of
smaller, semiautonomous units will experience a
rise in the total number of interfaces within the
organizational system. As organizational tasks and
activities require ongoing communication to coor-
dinate decisions and behaviors, interdependencies
arise along with a growing number of channels to
coordinate joint and interdependent organizational
actions (Thompson, 1967). This has consequences
for information-processing demand (Simon, 1955),
which, in turn, increases the likelihood of decision
errors (Levinthal, 1997). As such, increasing com-
plexity progressively creates difficulties for deci-
sion makers attempting to grasp and anticipate the
effects of emerging interdependencies on system
behavior and performance (Ethiraj and Levinthal,
2004; Zhou, 2011). Complexity limits the ability
of managers to rationally account for all impor-
tant decision factors (March and Simon, 1958),
which increases the risk that certain performance-
detrimental consequences will remain hidden in the
strategic decision-making process. Hidden costs,
therefore, relate to implementation costs that are
hidden from managerial attention at the point of
strategic decision making (see Ocasio, 1997).
The hidden costs of offshoring
We investigate hidden costs in the context of ser-
vices offshoring. Offshoring refers to the inter-
nal and external sourcing of tasks and services
from a location outside the home country in sup-
port of domestic and global operations (Contrac-
tor et al., 2010; Manning et al., 2008). Many
offshored activities are interlinked with domes-
tic processes and often require complex coordi-
nation (Srikanth and Puranam, 2011). This setting
is therefore suitable for investigating the interplay
between complexity and hidden costs.
A substantial body of research has demonstrated
that offshoring decisions are driven by a number
of factors, including expectations of lower labor
and production costs (Dossani and Kenney, 2003),
access to talent and qualified labor (Lewin et al.,
2009), and opportunities to learn (Jensen, 2009).
At the same time, however, there are also indica-
tions that the initial objectives of offshoring are not
always achieved and that offshoring decisions may
eventually prove more costly than expected (Dib-
bern et al., 2008; Massini, Perm-Ajchariyawong,
and Lewin, 2010; Stringfellow et al., 2008). For
instance, the multinational information technology
(IT) corporation Dell Inc. decided to backsource
its Indian service centers after encountering unex-
pected challenges of cultural and geographic dis-
tance (Frauenheim, 2003).
The concept of hidden costs can be related to
three streams of offshoring research (see Table 1).
The first stream focuses on the impact of hidden
Copyright 2012 John Wiley & Sons, Ltd. Strat. Mgmt. J., 34: 533–552 (2013)
DOI: 10.1002/smj
536 M.M. Larsen, S. Manning, and T. Pedersen
Table 1. Three streams of research on the hidden costs of offshoring
Theoretical focus Research question Examples/consequences
of hidden costs
Indicative literature
Performance
indicator
How might the practice of offshoring
eventually undermine anticipated
financial value?
• Costs of selecting a
vendor
• Barth
´
elemy (2001)
• Costs of layoffs • Overby (2003)
• Cultural costs
• Ramp-up costs
• Costs of managing an
offshore contract
Noncontractual
costs
How does international outsourcing
(in contrast to vertical integration)
create unexpected costs for firms?
• Reduce learning
capabilities
• Bettis et al. (1992)
• Reduce robustness • Hendry (1995)
• Reduce long-term
responsiveness
• Reitzig and Wagner
(2010)
• Reduce coordination
ability
• Undermine core
competences
Costs of
reconfiguration
and relocation
How does the global relocation and
reconfiguration of business tasks
and activities create unexpected
costs for firms?
• Coordination costs • Dibbern et al. (2008)
• Design/specification
costs
• Kumar et al. (2009)
• Control costs
• Stringfellow et al.
(2008)
• Knowledge transfer
costs
• Srikanth and Puranam
(2011)
costs on the financial value of offshore outsourc-
ing (e.g., Barth
´
elemy, 2001; Overby, 2003)—a
question of interest to business practitioners, in
particular. In emphasizing the challenges of off-
shoring, these practitioner-oriented articles have
attempted to specify and quantify the hidden finan-
cial costs of offshoring.
The second stream discusses hidden costs in
relation to strategic choices between international
outsourcing and vertical integration, where out-
sourcing—and the resulting loss of control and
transaction costs resulting from the shift of owner-
ship to an external partner—might erode firms’
capabilities and resources (e.g., Bettis, Bradley,
and Hamel, 1992; Hendry, 1995; Reitzig and
Wagner, 2010). For example, Stringfellow et al.
(2008: 166) label ‘invisible costs in offshoring
services work’ as ‘hidden communication-related
costs associated with the use of foreign service
providers.’ Reitzig and Wagner (2010) argue that
hidden outsourcing costs can disrupt incremen-
tal in-house learning processes. Dibbern et al.
(2008: 333) identify four particular types of unex-
pected ‘extra costs’ arising from outsourcing soft-
ware projects to third-party providers abroad:
‘(1) requirements specification and design, (2)
knowledge transfer, (3) control, and (4)
coordination.’
A third and more recent stream focuses more
fundamentally on hidden costs associated with
relocating and redesigning tasks and processes
within an orchestrated value-generating system;
that is, the costs of reconfiguring a firm’s internal
and external value chains (e.g., Kumar, van Fen-
ema, and von Glinow, 2009; Levy, 1995; Srikanth
and Puranam, 2011). According to this view, off-
shoring can be regarded as the process of reconfig-
uring value chain activities across dispersed loca-
tions regardless of whether outsourcing or an inter-
nal delivery model is chosen (Contractor et al.,
2010; Manning et al., 2008). Therefore, hidden
costs might arise from unanticipated organizational
needs, and can be related to areas such as knowl-
edge transfer, new interdependencies, training and
coaching, the protection of intellectual capital, or
the monitoring of performance of offshore units.
In this study, we address all three research
streams, but we focus in particular on the third
stream by examining why certain costs of reconfig-
uring a firm’s value chain in the implementation of
Copyright 2012 John Wiley & Sons, Ltd. Strat. Mgmt. J., 34: 533–552 (2013)
DOI: 10.1002/smj
