Outsourcing is defined as “having work that was formerly done inside the organization performed by an external organization” (Beaumont & Sohal, 2004, p. 689) or “the act of transferring some of a company’s recurring internal activities and decision rights to outside providers as set forth in a contract” (Greaver, 1999, p. 3). Perhaps illogically, the term is usually applied to services, not manufacture of components, and to continuing business functions, not projects. Lonsdale and Cox (2000, pp. 445-449) summarize the history of outsourcing, noting that it has supplanted once fashionable enthusiasms for conglomera- tion, horizontal integration, and vertical integration. Offshoring is having business pro- cesses performed overseas, primarily to exploit low labor costs; it conventionally includes wholly-owned overseas subsidiaries. The terms client and vendor.are the firms respectively obtaining and supplying services through an outsourcing agreement. In this chapter, the archetypal client and vendor are American and Indian firms respectively (for brevity, the term “firm” encompasses all organizations, profit and non-profit). The client’s customers.
may be affected by offshoring.
Coase (1937) asked why, given that the market allocates resources efficiently, do firms ex- ist? There are several answers: Some assets (such as a large oil refinery) are immobile, have high fixed costs and low variable costs, have a narrow range of applications, and have few or no external potential buyers or sellers of inputs and outputs. Such assets are inoperable without a cluster of peripheral assets and high levels of skill and knowledge in the firm and its suppliers. There is no perfect market for such assets; investment in them is only practi- cal in a planned environment that provides a guaranteed market for a high volume of very specific outputs and guaranteed supply of specific components. Information technology has weakened some of these reasons (applicable mostly to physical processes). In particular, immediate, accurate, and convenient transfer of data among organizations at nearly zero marginal cost enables data and information processes (interpreted broadly) to be performed out-of-house.
A related question is: “Why do firms choose to outsource some activities and retain oth- ers?” There are myriad reasons (see Table 1 and Table 2), but outsourcing is fundamentally a compromise between vertical integration (associated with cumbersome hierarchies and bureaucratic procedures) and reliance on market mechanisms. The latter entails administra- tive costs (identifying appropriate vendors and verifying their competence, communicating changing requirements to them, providing feedback, and monitoring their performances), communication costs (transferring data and information between vendor and client), and risks (of vendors failing or being unable to meet specifications, or clients failing to pay).
Deciding whether to outsource depends on comparisons of the long-term costs, benefits, and risks of different modes of supply. A long-term outsourcing relationship with a trusted vendor may be preferable to securing supply by backward integration, or developing or retaining an in-house capacity. An organization will always outsource some activities (the supply of water and electricity), but in-source others such as employee assessment or stra- tegic planning.
Table 1. Reasons for adopting outsourcing
Reason Comment
Reduce processing costs By accessing lower input costs, economies of scale, or expertise
Focus Outsource non-core activities and concentrate on areas of competence. Identifying core activities may not be straightforward (Quinn & Hilmer, 1994).
Access expertise On taking responsibility for a client’s human resource management, a human resource executive consultant opined that she expected to cut costs by between 20% and 50% by using proven systems and applying experience without lessening service quality (personal communication, March 2004). Vendors are advantaged by knowing about their industry’s costs and service quality standards. Client function managers may not know that their costs exceed the industry average.
Avoid internal cultural differences
The IT department having anomalous working conditions and compensation (attributable to the need to retain competent staff) may cause resentment among other employees.
Financial and cost restructuring
Outsourcing can be used to manipulate cost structures and cash flows. Instead of purchasing delivery vehicles (a capital cost), outsourcing can be used to re-express deliveries as an ongoing expense.
Benchmark internal operations
It is very difficult for top management to determine whether the firm’s IT department is as efficient as those of their competitors. Outsourcing some IT functions may give some insight.
Eliminate an unsatisfactory department
Top management may be dissatisfied with the IT department and/or feel unable to control it. Relations between IT and other departments may be so strained that the best course is to close down the department and rely on vendors. The mere threat of outsourcing may improve performance.
Uneven resource requirement
It may be economic to meet base load for call center services or delivery from the firm’s own resources and use outsourcing to meet peak or unanticipated demand.
Fractional resource requirement
A small firm without enough demand to employ a lawyer full-time will outsource its legal requirements.
Risk avoidance Firms can avoid financial uncertainty by using a fixed cost per transaction. If a new computer system is proposed, management may prefer to eliminate risk by accepting an outsider’s quote than have the work done in-house and risk time and cost overruns.
Careers A firm with a small IT department will not be able to offer careers in IT, and may therefore be unable to retain competent IT staff. It may be difficult for managers to assess the performance of the IT department.
Avoid legal constraints Offshoring, especially to Third World countries, may make it possible to avoid the costs of First World legislation pertaining to pollution, unionization, discrimination, or work practices. This is best exemplified by the U.S.’s rendition of prisoners.
Ideology and fashion The current Australian government has an ideological commitment to outsourcing, opining that the private sector is intrinsically more efficient than the public sector.
Offshoring may be the “flavor of the month” among executives.
Table 1. continued
Reason Comment
Dependence Outsourcing a critical business function may make the client uncomfortably dependent on the vendor. The client should ensure that, in extremis, a critical process could be resumed in-house.
Confidentiality Keep confidential data in-house. The dangers of misuse are multiplied if data is available to two organizations.
Intellectual property It may be strategically disadvantageous to give other firms access to intellectual property or learning opportunities. An American automotive firm engaged a Japanese firm to manufacture carburetors. The arrangement was satisfactory in the short-run. However, the Japanese firm used this opportunity to develop design and manufacturing expertise, eventually becoming a formidable competitor.
Table 2. Reasons for not adopting outsourcing
Loss of distinctive competencies
Outsourcing may atrophy in-house skills. A firm that outsources stimulating legal work or systems development may not be able to attract or retain creative staff.
Loss of flexibility A three-year outsourcing contract may reduce the ability to adjust to changes in the client’s environment or to exploit new technology.
Personnel and change problems
Staff made redundant by outsourcing may have to be dismissed or redeployed.
This may create anxiety among remaining staff.
Information asymmetry A practiced vendor has the experience to accurately assess the cost of performing an outsourced business process and estimate how technology will affect that cost over time. A less well-informed client may be disadvantaged in negotiation.
Project management risk Poor methodology (especially in specifying requirements and failure to detect that the proposed vendor is incompetent or unscrupulous), negotiation, or monitoring may result in project failure.
Cultural differences May create misunderstandings and communication failures
Negotiation difficulties The operation is so complex that it is impossible to agree on and codify performance criteria.
Complexity A computer application may be so interwoven with other applications that it cannot be separated out and handed to a vendor.
Table 2. continued