Shareholder wealth enhancement through outsourcing strategies that increase the total cost but leave revenues unchanged

Abstract

This article focuses on outsourcing contracts which, while shifting internal processes and activities to an external party, substitute a fixed cost by a variable cost. Given this, the standard Capital Asset Pricing Model of finance theory is used to show that some of these outsourcing contracts may enhance a firm's value despite increasing the total cost, while leaving revenues unchanged. This is because the substitution of fixed by variable cost reduces risk, as captured by the CAPM beta, and hence lowers the cost of capital used in the valuation of the firm. The article first derives value elasticity (the percentage change in firm value to the percentage change in fixed cost) for an outsourcing contract that displaces fixed cost by variable cost on a one-on-one basis, and shows that such a total cost preserving substitution of fixed by variable cost will always increase the value of the firm. Subsequently, the article shows that for a given reduction in fixed cost, the variable cost can be increased by an iso-value factor a greater that unity (this implies that the total cost will increase) such that the firm value is unchanged. Any contractual arrangement by which the variable cost increase lies between unity and a will therefore, despite an increase in the total cost, always result in an increase in firm value. This has important implications for firms that outsource, and for vendors, while designing and negotiating an outsourcing contract.