Outsourcing to convert fixed costs into variable costs: A competitive analysis

Outsourcing of production, services, and various economic activities is a pervasive phenomenon across industries. One of the key economic benefits of this popular practice, as mentioned by its sellers and buyers, is that it allows the outsourcing firm to reduce its fixed costs such as expenditures on equipment, information technology, fixed salaries of employees, etc., and convert those into a variable cost in the form of the purchase price that the outsourcing firm then pays the outside industry. This paper examines the strategic implications of this role of outsourcing in an oligopolistic setting. We show how these strategic considerations imply that, even absent any cost savings from outsourcing, competing firms can find it profitable to outsource. Furthermore, in such a setting, one firm may outsource while the ex-ante similar competing firm may not outsource. We also examine how consumer and social welfare are adversely affected when outsourcing plays this fixed-cost-to-variable-cost conversion role in an oligopolistic setting.