of 3 - Center for Global Outsourcings

Introduction
Outsourcing/off-shoring of non-core activities has been recognized as a strategy for
direct/indirect cost reduction (Madison & Padmanabhan, 2005). Manager off-shoring prediction
errors can impact firm value. To date, few have examined the impact on firm value of manager
optimism/pessimism (anchoring) related to off-shoring decisions. Huang and Padmanabhan
(2011) (henceforth HP2011) show that firms can lose value if managers anchor. However, they
only examine the case where only one decision making manager is involved. In this paper, we
argue that if managers anchor in opposite directions, firms can offset the costs associated with
hiring the additional manager(s) by reducing off-shoring costs (management by committee).
Formally, we extend the single manager HP2011 theoretical model to include multiple decision
makers. Using simulation, we show that management by committee is preferable when offshoring
costs increase and managers prone to anchoring, do so in opposite directions.
We examine the impact of manager anchoring on firm value when two or more managers make
decisions by committee. We also address the issue of high (low) costs associated with loss of
technology, data security, and cash flow uncertainties, influence firm value when anchoring by
committee is present. Managerial anchoring increases firm level costs (HP2011). Here, we
show that management by committee will mitigate such costs to the firm. Using simulation
results, we conclude that firms must elect management by committee so long as the expected
cost savings from decreased total costs associated with mitigated managerial anchoring is
larger than the higher marginal costs of hiring the second manager. These cost savings are
found to be increasing functions of the off-shoring cost/total firm level cost ratio. In addition, as
loss of technology costs (or other monitoring costs) increases as a function of total costs,
management by committee becomes less important.
Literature Review and Rationale for the Study
The vast literature on outsourcing/off-shoring attests to the strategic importance of this task to
the firm. Benefits/costs of off-shoring are well documented (Madison & Padmanabhan 2006,
Levina & Ross 2003, and others). Off-shoring reduces labor/production costs, but increases
monitoring and loss of technology costs.
The Methodology and Model: Maximizing Shareholders’ Value with Off-shoring
We utilize the methodology of HP2011. Managers maximize the expected PVe,t (manager’s
expected value at time t) of free cash flows (FCF); the manager’s expected probability pe,t at any
time t (t>1) is a function of the same period breakeven probability pbe,t and the previous one
period expected probability pe,t-1. PVe,t is modeled as a an independent random variable with a
systematic component ηe,t and a random component εi,t: 2
PVe,t =ηe,t + εi,t = pe,t Cu+(1-pe,t) Cd+εi,t (1)
where : pe,t = β pbe,t+(1-β) pe,t-1,
, and εi,t=L (1-pe,t). (2)
where C0 = Initial cash flows associated with off-shoring, 3 Cu(Cd) = the PV of expected period 1
cash flows, with the subscript u (d) denoting high (low) cash flows. Cu>C0>Cd , and C
Cd . captures the ratio of cash flows at time 1 to the cash flow at time 0. 4 It is
assumed that the actual probability that free cash flow will increase at time 1 is p; L represents
PV of costs of possible loss of technology, managerial skill and data security, and expressed as
2 We assume that L is constant for this part of the analysis.
3 In addition, all costs are assumed to be expressed as a percentage of revenues of the firm.
4 α is assumed constant (period 1 and 2). Also, higher α implies higher volatility of expected cash flows
Tenth Annual International Daejeon, South Korea P a g e | 40
Smart Sourcing Conference June 28-29, 2012