We study the implications of vertical integration on innovation performance using firm-level data on Australian manufacturing. We use the data to distinguish between low-cost-oriented and innovation-oriented outsourcing. Outsourcing without innovation lowers costs at the expense of damaging the future chances of innovation, while innovation-oriented outsourcing leads to higher costs but increases the likelihood of future innovation. For firms that innovate and outsource, the probability of

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... e innovation is 49 per cent compared to 8 per cent for those who outsource without innovating. Comparing across firms that innovate, simultaneously outsourcing increases the probability of future innovation by 5 per cent. Innovation-oriented outsourcing is accompanied by firms shifting expenditure to research and development. Our results offer strong support that outsourcing may be used not just as a cost-cutting strategy, but as part of comprehensive firm strategy to innovate and improve.