Studying the Hidden Costs of Offshoring: The Effect of Psychic Distance

Sarah Deutsch & Mie Hørlykke Jørgensen

Student thesis: Master thesis

Abstract

In light of the increasing globalization and the growing phenomenon of offshoring an interesting field to study is the one of hidden costs and the implicit cost estimation failures of decision-makers. Organizations today are often caught off guard by post decision surprises, as the strategic decision to relocate activities across countries is associated with hidden costs. This thesis investigates the hidden costs of offshoring in the context of psychic distance, where psychic distance can be defined as the country specific differences that disturb the flow of information between actors. Hereby adding to the existing literature by examining how psychic distance affects the decision-makers’ ability to correctly estimate the costs of offshoring. It has been theoretically deduced that hidden costs occur in situations where the psychic distance among the included countries is high. In those situations decision-makers are likely to be subject to bounded rationality as it is difficult for them to predict the actual challenges when relocating activities to a psychic distant country. Offshoring involves relying on global project coordination, where the role of work interdependencies between globally distributed sites and managing across geographical, national and cultural borders is recognized to be an important and critical factor that requires significant time and effort. The decision-makers are exposed to new complexities, challenges and uncertainties when allocating resources and estimating the associated costs and benefits, thus cost estimation failures are more likely to occur. This thesis uses unique survey data on 158 Danish offshore implementations from the Global Operation Network to test the effect of psychic distance (between home and host countries) on cost estimation failures. The survey collected data on whether companies experienced hidden costs associated with relocation of activities abroad. Approximately 25% of the included offshore implementations experienced hidden costs under or after the offshore implementation – indicating that hidden costs in fact are a problem that affects many offshore organizations, and consequently an important subject to study. This thesis finds that decision-makers are more likely to make cost estimation failures in offshore situations where the geographical distance is high. Moreover, the findings to some extent indicate that the type of activity influences the effect of psychic distance on cost estimation failures. The rest of the psychic distance factors included in this thesis, cultural differences, language differences, political differences, time zone differences and economic development, were either found to be statistically insignificant or to have an inconsistent effect on cost estimation failures, and hence the actual effect could not be concluded. Therefore we feel confident in concluding, based on the analysis, that psychic distance should not prevent companies from relocating activities to foreign countries. Companies should nonetheless take the challenges associated with geographical distance into account when assessing offshore opportunities. A factor that might explain the lack of evidence found in this thesis is the new phenomenon of ‘born-global’ organizations. Recent studies point in the direction that the phenomenon of ‘born-global’ organizations decreases the importance of psychic distance. We therefore argue that the theory of psychic distance might be outdated. Consequently the theory needs to be adapted to fit today’s modern organizations.

EducationsMSc in Applied Economics and Finance, (Graduate Programme) Final Thesis
LanguageEnglish
Publication date2014
Number of pages101