Summary by Anita Reed
Ph.D. Program in Accounting
University of South Florida, Spring 2002
Internal Auditing Main Page | Decision
Theory Main Page | Outsourcing Main Page
Purpose-Motivation
Outsourcing of non-core business functions has been a growing global phenomenon as firms move to streamline their operations and concentrate resources on core competencies. The internal auditor (IA) function has traditionally been maintained in-house as part of the management control system (MCS) but current research indicates an increasing trend towards outsourcing this function. This trend represents a "significant shift in the economics and conduct of IA services and a change in the structure or some firms’ MCS". The authors’ goal is to empirically evaluate the characteristics of firms that outsource in order to understand the specific factors associated with a firm’s decision to outsource the IA function
Contribution
Through the use of archival data, the authors develop empirical models using transaction cost economic theory that explains 50.0 percent of the variation of outsourced IA in the sample of firms, and they then combine this with qualitative data collected from the chief financial officers to offer increased insight into the factors that impact a firm’s decision to outsource the IA function.
Theory
The organizational theory of transaction cost economics (TCE) underlies and informs the research. TCE operationalizes the firm as a set of internal (bureaucratic) activities and external market (contract) relations and defines the boundaries of the firm as the limit of transactions governed by internal processes. Any transactions that are market mediated are external processes. TCE models transaction costs, including resource based strategies, to predict which activities are internalized and which are market mediated.
TCE provides four attributes that determine transaction costs:
Asset specificity - the degree to which the assets needed to perform the activity are not transferable to other activities i.e. are unique to certain activities, including human expertise and knowledge of sources of competitive advantage
Environmental uncertainty – expected variation in the demand for activities
Behavioral uncertainty – the inability to monitor activities
Frequency – the volume or rate at which activities are conducted
Hypotheses
H1: Firms internalize IA resources and activities that require firm-specific investments (e.g. expertise, training and knowledge) and support the firm’s strategy. Conversely, firms outsource IA resources and activities that are more generally applicable.
H2a: Firms that experience high levels of environmental uncertainty will internalize IA. Conversely, firms that experience low levels of environmental uncertainty will outsource IA.
H2b: Environmental uncertainty and asset specificity interact to affect outsourcing IA.
H3a: Firms that experience high levels of behavioral uncertainty will internalize IA Conversely, firms that experience low levels of behavioral uncertainty will outsource IA.
H3b: Behavioral uncertainty and asset specificity interact to affect outsourcing IA.
H4a: Firms that use IA services frequently will internalize IA. Conversely, firms that use IA infrequently will outsource IA.
H4b: Frequency and asset specificity interact to affect outsourcing IA.
Sample
The sample consisted of a random sample of 600 publicly traded firms with more than 500 employees (stratified by industry) from the Compustat industrial files. The sample firms included only those that had information available regarding sales, assets and either R&D or advertising expenses for 1995 as well as number of employees. In addition, the CFO or an equivalent firm executive responded to a survey to collect the qualitative data.
A total of 198 responses (33 percent response rate) were obtained, with 83 of these complete and used for analysis. This is an overall usable rate of 14%.
Method
The survey included multiple measures of the following variables:
Outsourced IA-the proportion of outsourced IA hours to total IA hours.
Asset Specificity-defined above
Environmental Uncertainty-defined above
Behavioral Uncertainty –defined above
Frequency-defined above
In addition, the survey included a section of open-ended questions that allowed the respondents to describe reasons for and types of IA activities that are candidates for outsourcing and to provide insight into the reasons why certain elements of the IA function are outsourced or not outsourced.
Industry of the firms was classified by one-digit SIC codes.
Analysis and Results
Univariate tests of differences in means of the firms, stratified by "do outsource" or "do not outsource" indicate that firms that do not outsource IA have significantly higher asset specificity and experience significantly more behavioral uncertainty.
OLS (ordinary least squares) regression models were developed to test the hypotheses. The base model is on pg. 57, and the results are as follows:
H1: Supported, asset specificity is significantly and negatively associated with outsourced IA.
H2a: Not supported. Environmental uncertainty does not explain variation in outsourcing.
H2b: Not supported. No evidence of the predicted interaction is found.
H3a: Not supported. Behavioral uncertainty does not explain variation in outsourcing.
H3b: Not supported. No evidence of the predicted interaction is found.
H4a: Supported. The composite measure of frequency is significantly associated with outsourcing.
H4b: Supported. The predicted interaction between frequency and asset specificity is found to be significantly associated with outsourcing.
Additional analysis was conducted, with no change to the initial results. This is an indication that the base model is a stable representation of the survey and archival data.
Analysis of the open-ended section of the qualitative data provides further insight into the rationale employed for selecting IA functions to outsource or for deciding not to outsource the function. The majority of the comments address asset specificity, indicating that the IA function is more valuable as an in-house function and is used for building and maintaining firm-specific knowledge and management training. Firms that outsource address such issues as confidence in nondisclosure agreements with their service provider for protection of proprietary information, reliance on providers’ general knowledge and expertise and providers’ knowledge of foreign culture and language. Table 5 on page 64 provides a summary of the comments.
Conclusion
The qualitative data indicate that the decision to outsource IA is a complex decision, with emphasis on asset specificity, behavioral uncertainty and strategic needs. This qualitative data supports the results obtained from the empirical models, which explained 53 percent of the variation in the sample, particularly the variables of asset specificity, frequency and their interaction. TCE theory is found to provide a reasonable basis for explaining decisions to outsource IA functions.
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