Offshore Outsourcing

Introduction –

Offshoring refers to business processes that were originally performed ‘in-house’ being moved overseas. Alan Blinder, in 2006, noted that ‘We have so far barely seen the tip of the offshoring iceberg, the eventual dimensions of which may be staggering’. The next Industrial Revolution – the Information Age – revolves around advances in Information Technology that make many services now tradeable via the flow of packets of digitised information. Services that are easily delivered electronically can be moved offshore, while those that continue to rely on personal face-to-face contact will remain non-tradeable. Within a firm, this distinguishes front-office services involving direct customer contact that remains in-house with back-office services that may be performed – outsourced – in overseas locations.

Two years later, Youngdahl and Ramaswamy (2008) commented that offshoring was “perhaps the most important phenomenon transforming the workplace”. They highlighted India’s technology parks, where 250 engineers were developing IT applications for the Bank of America, the finance staff were processing home loans for another American bank, radiologists were interpreting CT scans for an American hospital, and seven PhD qualified molecular biologists were undertaking research for a pharmaceutical company. Similar examples could have been provided from Manila, Shanghai or Budapest. The offshoring movement had progressed far beyond call centres to increasing level of complexity in design, manufacture and service functions.

Outsourcing and Offshoring: The basic principles –

Improvements in the quality and reductions in the price, of information technology, combined with the increased technical skills of those in relatively low-wage countries have facilitated the growth of outsourcing and offshoring. Firms are now continually reassessing what is core to their business, and so, must remain in-house to maintain their competitive advantage, and what are auxiliary activities that can be contracted out or outsourced to firms or individuals locally or increasingly, overseas. The increasing division of labour, specialisation or fragmentation of the supply-chain/value-chain is a clear feature of the modern business landscape.

Firms are slicing up the firm’s value chain into constituent parts and deciding how and where each part will be produced. ‘Core’ segments remain in-house while other segments may be contracted out to other firms or subsidiaries either nationally or internationally. Yet, more and more parts of what used to be regarded as core activities are being outsourced as global competition. Initially, outsourced activities were low-skilled; but increasingly high-value functions such as R & D, design and engineering are, today, being performed outside the firm. While the main driver has been cost saving, and this is still very important, so is the access to knowledge and talented teams of people that are not available locally.

Each firm’s function – R & D, Marketing, Finance, Production – can be sliced into hundreds of sub-activities. Each of these sub-activities can be performed internally in the firm or outsourced depending on the direct cost, including the transaction costs of the organisation, communication, coordination and quality control issues, associated with dealing with firms or small groups of specialists that are not directly related to the firm in question. In addition, there are sensitive issues relating to intellectual property rights that need to be protected from imitation. This is part of a broader strategic concern that the ‘partner’ firm used for out-sourcing may enhance their capabilities and knowledge in the process and later prove a competitive threat to the incumbent firm.

The relationship between the firm and its contractual outsourcing partner is an evolutionary one and it may evolve in harmful ways. In such circumstances, it may be prudent to maintain several suppliers and to rotate the contracts around to reduce dependence on any particular supplier. With each supplier, there is a need to monitor and control the outsourced activities to prevent loss of proprietary knowledge that may be vital to the firm’s competitive advantage.

Alleged pitfalls –

Outsourcing can be performed domestically. It is when outsourcing is shifted offshore, that concerns arise. India is the most preferred location for much of the offshoring, because of its cost competitiveness and availability of talented personnel, followed by China and the Philippines. Other popular offshoring locations are Mexico, Poland, Hungary and Vietnam.

Farrell (2005) estimates that every dollar of spending that American firms transfer to India generates $1.46 in new wealth of which 33c remains in India. American firms save 58c for every dollar of spending on jobs they move to India. These cost savings can then be used for firm expansion, or for R&D or marketing purposes, to increase staff remuneration, or the benefits of the increased profits can be returned to the shareholders and taxpayers. These are the positives; but the headline debates concern the impacts on the jobs of locals that are exported. While US offshoring only accounted for 4 percent of all layoffs, 31% of whose jobs were displaced by trade were not fully re-employed and 55% of those that were re-employed were at best working for only 85% of their former wages.

A further potential concern is illustrated by Bettis et al (1992), relating to the “hollowing out” of American industry and the decline of Western manufacturing. Key components or complete finished products can be offshored at a delivered cost 10 to 60% below the cost of in-house manufacture. These authors worry about the surrender of core technological capabilities. Outsourcing decisions cannot be easily reversed. The strategic intentions of the foreign suppliers may be to become potential competitors in the future. Foreign supplier may acquire proprietary design information and if the relationship sours, they may use the acquired process and product technology to compete with the Western firm. The suggestion is that outsourcing should be focused on areas far removed from strategic competencies because as outsourcing decisions become closer to core competencies, the strategic risk increases.

Implications –

Offshore outsourcing of services (such as innovation, software development and engineering) can be viewed as welfare-enhancing international division of labour taken to the next stage – but it is not without its challenges and opportunities. There will be winners and losers. There is a collective responsibility in a humane society to soften the blows of trade restructuring via adjustment assistance. Education systems will be challenged to provide reskilling opportunities but also to focus on creating front office client focused management skills in a context where back-office jobs that can be delivered electronically will be in less demand locally. The challenge will be how to manage the process in an active and not passive way. If it is not managed strategically, capabilities and (net) jobs will be lost.

About the author: Dr John Lodewijks, Dean – Undergraduate Programs

Dr John completed a Bachelor of Economics from the University of Sydney (First Class Honours), Master of Economics from the University of New England and an M.A and PhD in Economics from Duke University, USA. After 22 years as an academic economist at the University of New South Wales, Australia, he was Head of the School of Economics and Finance at the University of Western Sydney for a further five years. After numerous other achievements, he is currently the Dean of Undergraduate Programs with SP Jain School of Global Management.