The Advantages and Disadvantages of Outsourcing

Introduction:

In present-day society, outsourcing is playing an increasingly crucial role in international business. Globalization has offered motivation for outsourcing owing to the pressures of cost competition. (John Child, 2005) So organizations are increasingly turning to outsourcing in order to develop their competitiveness, increase profits and focus on their core business. (Steve Burdon and Ajay Bhalla, 2005) At the same time, the liberalization of trade and the development of modern information and communication technologies have made outsourcing an easy option for the international organizations. (John Child, 2005)

This essay discusses the definition of outsourcing in the beginning and then explains the different types of outsourcing. The main body primarily analyses the advantages and disadvantages of outsourcing together with relevant examples, as well as some implications for the international managers in international business.

Definition of outsourcing:

Until now, there is still no official definition of the term “outsourcing”. According to John Child, “outsourcing refers to the contracting out of activities that need to be undertaken on a regular basis, which otherwise would be conducted within an organization.” (John Child, 2005: 179) Alternatively, outsourcing was defined as “products supplied to the multinational firm by independent suppliers from around the world” and “the extent of component and finished products supplied to the firm by independent suppliers” (Kotabe, 1992:103). Additionally, outsourcing has been described as “the reliance on external sources for manufacturing components and other value-adding activities” (Lei & Hitt, 1995:836). In general, definition of outsourcing includes almost any goods or services that a firm procures from outside organizations. For services, outsourcing transfers operational control to the suppliers. Specific services which organizations are seldom needed, like legal advice, is not a kind of outsourcing. (K. Matthew Gilley and Abdul Rasheed, 2000)

Types of outsourcing:

Similar to the definition of outsourcing, different people have their own opinions about the types of outsourcing. Though there are so many different types of outsourcing now, however, noted by John Child, they can be divided into two main categories: one is the outsourcing of core value-chain activities, such as manufacturing, distribution and information technology; the other is the outsourcing of support activities like human resource, research & development and facilities management. (John Child, 2005)

The two most common forms of outsourcing around the world today are manufacturing and IT. According to the statistics collected by the Engineering Employers Federation in 2003, 30 percent of British companies had moved their manufacturing to foreign countries and 49 percent of larger companies which have more than 500 employees had some business abroad. (John Child, 2005) Due to the cheap labor cost, China had become one of the largest manufacturing centers in the world.

India, where has the biggest number of IT experts in the world, is influenced by the British educational system, math and science has been significantly emphasized. There are one hundred and twenty thousand skilled IT experts added to the labor force every year. So now India is regarded as IT center in developing countries and many companies especially those locate in United States choose to outsource IT or software there. The excellent reputation it creates makes India a leading country in IT outsourcing industry. (John Sampson, 2009) On the same day of March 2003, three large British service companies——British Telecommunications, Thames Water, and Powergen declared to move their call center activities from Britain to India. (John Child, 2005)
Advantages of outsourcing:

1. Cost savings.

It is quite obvious that outsourcing will reduce the cost of the outsourcer. In most cases, outside manufacturers or service suppliers can provide at lower costs (because of economic of scale) than an inside organization, even within the same country. (John Child, 2005) For example, if a manufacturing enterprise makes an effort to organize a motorcade in order to transport the raw materials and finished products, there will be an extra cost of management because they do not have experience in the transportation area. Even worse, poor management of transportation will give rise to some problems which may lead to cost increase in production and marketing sections. However, if this enterprise outsources their transportation business to professional transport undertakings, those costs will be cut dramatically.

The accessibility of mature and up to date ICT enables outsourcers supervise outsourcing on a global basis. ICT integrates operations across continents in some services such as call centers, software development and maintenance, and administration of accounts. The globalization of outsourcing makes numerous enterprises locate in low-cost areas like China and India. (John Child, 2005)

2. Focus on core business

Organizations will concentrate more on their core business through outsourcing. It is impossible for firms to be familiar with all the business; they must realize what they do best and what exceed their capabilities. Outsourcing is an efficient way to increase an enterprise’s level of concentration and focus on its core competencies. Through outsourcing, resources such as capital, human resource and infrastructure can be optimized into core business, which will give the firm competitive advantages. Due to globalization, the business environment is changing so fast that a firm can hardly survive without firm-specific advantages. (K. Matthew Gilley and Abdul Rasheed, 2000)

Furthermore, when economic recession or financial crisis happens, companies will unavoidably cut their non-core business departments which can cause negative effects such as instability of the team and additional expenditures. But if the non-core business is outsourced to some professional organizations at the very beginning, the losses should be kept into minimum.

One representative example is the New Oriental Education & Technology Group Inc. which had landed on New York Stock Exchange and turned to be the most successful English training institution in China. At the beginning, New Oriental was just a small school that had a few teachers with huge ambitions and endless enthusiasm. With its expansion, non-core business such as the maintenance of computers and payroll functions were outsourced to the other companies, so New Oriental can focus on the core business——characteristic English teaching and excellent personnel training, which make them unique in the competitive education training market in China.

3. Enhance innovation capability

Though outsourcing Research & Development sometimes will lead to the leakage of firm-specific knowledge owing to the imperfect contract, there is still enough evidence that these activities are on the increase. Certain talents who can maintain the innovation engine of one company is badly needed. If there are not enough high-level analytical minds in the local talent pool, organizations will look outside to find scientists, engineers or inventors worldwide. Modern technologies are developing so fast that companies are generally restricted by the limited in-house capacity of product innovation, thereby using external knowledge providers to fill the gap is extremely significant. (Vinay Couto, Arie Y. Lewin, Mahadeva Mani, Stephan Manning, Vikas Sehgal, Jeff W. Russel, 2007)

4. Reinforce administrative control

New organizations may worry about the difficulty of governing internally. Delegating authorities to increasingly capable and knowledgeable employees will create advantages of innovation and flexibility, but it is also accompanied by the weakening of superior managerial control simultaneously. The reason is that traditional mode of control such as hierarchical reporting and prearranged plan is less feasible to work in a high innovative company. Thus, outsourcing can provide the company a new approach of control which relate to the performance of the unit within the company. If a department operates poorly in a certain period of time, there is a threat that it may be sold off or cut, with its work outsourced to another company as an option. (John Child, 2005)

5. Share risk There is a financial concept called "portfolio effect" which means that in investing, it would be best to diversify portfolio rather than invest all the money in the one stock. Through transmitting risk, the whole risk will be reduced. In business investment, this concept still works. Outsourcing enables several companies to share risk. (Dean Meyer, 2005) Take manufacturing as an example, if all the work of one organization is done by only one factory, a strike of workers or a labor disturbance will generate great losses. However, if the workloads are outsourced to several factories located in different countries, no matter what happen to one factory, operations of other factories will not be affected. Thus, the risk is decreased. (Dean Meyer, 2005) The same circumstance can be found in the film industry. The success of one film cannot be forecasted, and it is always a huge amount of money to make a movie. So the company which invests the money in shooting and cutting of the film can outsource the making of post process effects to another company, sometimes a third one for advertising and marketing, in order to share risks. 6. Get rid of operational problems

When some problems happen in a department of an organization which does not perform very well, outsourcing can provide a possible solution: either to add essential capacity or to bypass the problem area in a whole. If the poorly performing unit is unnecessary to the company’s core activities, it can be cut directly with little consideration. If the unit is crucial to the company, buy in products or services through outsourcing maybe helpful to solve its problems. (John Child, 2005) Disadvantages of outsourcing and implications for international managers:

1. Weak control.

Companies always lose control of some products or services through outsourcing which increases the uncertainty of the regular production. Deprivation of control in the process of outsourcing may affect the development of the whole business, even wreak long-term havoc. (Judy Artunian, 2006) It is expected that there will be a smooth working relationship between the company and sub-contractor automatically, but problems like this sometimes happen: after the waiting of 6 months, the company still do not get the products or services which are supposed to be done 3 months ago. Poor regulation and governance of the sub-contractor in the whole outsourcing project is the key reason. Because the process of outsourcing is not happened within the company, it will be quite difficult and costly to regulate and administrate every procedure. Therefore, some effective measures should be made in the contract. (Judy Artunian, 2006) While negotiating with an outsourcer, there should be an agreement on what the organizational structure is, how to develop a method of monitoring the work being done, and how to supervise the outsourced project on a daily basis. Persistent feedbacks must be offered by governance system to the company in regard of how the deal between the two companies is going, what values are receiving, what problems are encountering and how to tackle them. Only when those plans are established can the company has the opportunity of avoiding or at least reducing the negative effects of weak control of the sub-contractor. (Judy Artunian, 2006)

2. Exorbitant expectations

The outsourcing company has the ability to meet the prime goal of the contractor but when time goes by, it cannot achieve the level in other areas. (Judy Artunian, 2006) One example is that Japanese anime companies outsourced their basic drawing business to Chinese small studios in order to reduce cost. With the progressing of the projects, some new technologies in the anime industry appeared, but unfortunately, it was impossible for the Chinese small studios to catch up in a short time due to the lack of capital and innovation. So the frequency and quality of the anime cannot be guaranteed. That is why the Japanese side chose to terminate the contract unilaterally regardless of high penalties and legal fees.

So when considering vendors, low labor or raw material cost is not the only determinant. A whole evaluation of the vendors’ competences (the employees’ experience, proper practical skills and provided training, etc) is a must. The contractor should realize what they really hope for achieving by outsourcing. (Judy Artunian, 2006) Julie Giera, an analyst at Forrester Research Inc. in Cambridge once said: “Keep in mind that a cost-based contract might be appropriate for standard services like infrastructure management but not for specialized skills such as application development.”

3. Communication problems

Problems tend to be appearing when the outsourced activities involve or rely on communication between staffs and clients, especially between different countries which have dissimilar linguistic or cultural principles. (Judy Artunian, 2006) So do not outsource a task which needs comprehensible communication with the customers, if the staff of the sub-contractors’ company who offer that communication cannot be comprehended easily by the majority of people in that country. Furthermore, do not launch outsourcing to companies locating in a country where that kind of industry sector is not well understood or otherwise badly equipped to accomplish the task. (Judy Artunian, 2006) A typical example is Dell Inc., who outsourced its after sale services to offshore suppliers. After doing that Dell was troubled by numerous complaints from the English-speaking customers who claimed that they could not understand the operators because of the accents. So Dell had to shift most of its technical assistance services back to US so as to resolve this problem. (John Child, 2005)

4. Loss of staff morale

Outsourcing may cause another serious problem which affects the morale of employees in the companies. Too much outsourced staffs may evoke panic similar to downsizing, and employees who were sent abroad may doubt themselves about their capabilities and contributions to the company if there is not enough and proper consultation between managers and staffs. The suspicion of the security of employment will seriously affect the morale and the productive efficiency of the employees. So the consequence may be very tragically if experienced employees choose to job-hop to another company in the same industry or just quit this program. (John Child, 2005) Therefore, the original company will suffer a great loss through the leakage of vital tacit knowledge like know-how and know-who which need to be retained within the organization.
These negative effects can be eliminated as long as management takes the related staffs into confidence. A company requires experienced employees who own firm-specific knowledge badly with the purpose of cooperating with the outside sub-contractor. This will give them new responsibilities and opportunities. After planned talks and negotiations within the organization, the employees who are transferred to a professional vendor will feel motivated because their interests can be considered cautiously, and working for a successful external company is always attractive and challenging than just working in an internal company where they only do daily routine job. (John Child, 2005)

5. Poor contract

After a long time negotiation, two companies are going to sign an outsourcing contract eventually. But unfortunately, it is impossible to cover all the duties and responsibilities in all the clauses and sometimes the contract is not precise or complete enough. Though the so called incomplete contracts sometimes stand for reliance on trust between the contractor and vendor, it is probably that the vulnerable relationship will be broke down immediately when some serious problems really happen. (Willian M. Lankford and Faramarz Parsa, 1999) Moreover, incomplete contracts may increase the risk of potential opportunism of the sub-contractor and the chances of renegotiation which will cost a lot of extra money and time. Contracts should include flexibility clauses which help both sides to adapt to the fast-changing business environment.

One example is that the suppliers fail to meet the expansions in demand of customers. In 11st November, 2006, Sony launched its next-generation game console PlayStation 3 in Japan. The processor of PS3 was called Cell and it was developed through collaboration among Sony, Intel and IBM. It was proved that Sony underestimated the enthusiasm of huge fans. PS3 was so successful that a lot of people wanted to purchase it immediately. But restricted by the production rate of the processor Cell (it is so delicate and complicated) from the outside supplier, Sony did not have the opportunity to fulfill all the needs of clients in the first time. That is why Sony missed the excellent chance of the first strike in the new battle of the game console among Sony, Microsoft and Nintendo.

6. Overlooking exit strategy

Failing to plan or just not be aware of the significances of exit strategy in the contract may lead to severe consequences when some unexpected or irresistible problems happen to the sub-contractor. (Judy Artunian, 2006) Just imagine what great losses the contractor will suffer if the outsourcing vendor goes bankrupt suddenly because of the financial crisis. Unpredicted natural disasters will cause enormous damages to both sides of companies if there are no corresponding precautionary actions. To minimize the adverse impacts, it is extremely crucial to plan an exit strategy in the contract embodied with reversibility clauses.

Furthermore, make sure that there will be plenty of time to make the transition when an outsourcing contract comes to an end. The decision of find a new outsourcing vendor or just renegotiate with the original one needs time. So consider this essential factor from the outset. (Judy Artunian, 2006)

Conclusion: According to the analysis above, outsourcing is indeed a double-edged sword. If organizations want to survive in the fast changing business environment which full of fierce competitions, firm-specific advantages are quite crucial. Outsourcing, if used properly, can be a possible way of creating comparative advantages. But it is not always the case that outsourcing is beneficial to the contractors. So it is vital for the international managers to access the external companies before making any outsourcing decisions. Recognizing what the companies really want and how to deal with the complicated relationship between two sides are other factors international managers should consider. All in all, trying to eliminate the negative effects and maximize the positive effects of outsourcing as much as possible is the most essential mission for the managers.

References: Artunian, J. (2006). The seven deadly sins of outsourcing [online]. Available from http://www.computerworld.com/s/article/111167/The_Seven_Deadly_Sins_of_Outsourcing [Accessed 13th December 2010] Burden, S., and Bhalla, A. (2005). Lessons from the untold success story: Outsourcing engineering and facilities management . European Management Journal, 23, 576-582. Child, J. (2005). Organization : contemporary principles and practice. Oxford : Blackwell. Couto, V. et al. (2007). Offshoring 2.0: Contracting knowledge and innovation to expand global capabilities. Service Provider Survey Report. Booz & co. and Duke University. Gilley, K. M., and Rasheed, A, (2000). Making more by doing less: An analysis of outsourcing and its effects on firm performance. Journal of Management, 26(4): 763-790. Kotabe, M., (1992). Global sourcing strategy: R&D, manufacturing, and marketing interfaces. New York: Quorum. Lankford, W. M. and Parsa, F. (1999). Outsourcing: a primer. Management Decision, 37(4): 310-316 Lei, D., and Hitt, M. (1995). Strategic restructuring and outsourcing: The effect of mergers and acquisitions and LBOs on building firm skills and capabilities. Journal of Management, 21(5): 835-859. Meyer, D. (2005). 4 Advantages to outsourcing [online]. Available from http://www.sourcingmag.com/content/c051011a.asp [Accessed 13th December 2010]. Sampson, J. (2009). Different countries have different types of outsourcing help [online]. Available from http://www.articlealley.com/article_872631_64.html [Accessed 13th December 2010].

References: Artunian, J. (2006). The seven deadly sins of outsourcing [online]. Available from http://www.computerworld.com/s/article/111167/The_Seven_Deadly_Sins_of_Outsourcing [Accessed 13th December 2010] Burden, S., and Bhalla, A. (2005). Lessons from the untold success story: Outsourcing engineering and facilities management . European Management Journal, 23, 576-582. Child, J. (2005). Organization : contemporary principles and practice. Oxford : Blackwell. Couto, V. et al. (2007). Offshoring 2.0: Contracting knowledge and innovation to expand global capabilities. Service Provider Survey Report. Booz & co. and Duke University. Gilley, K. M., and Rasheed, A, (2000). Making more by doing less: An analysis of outsourcing and its effects on firm performance. Journal of Management, 26(4): 763-790. Kotabe, M., (1992). Global sourcing strategy: R&D, manufacturing, and marketing interfaces. New York: Quorum. Lankford, W. M. and Parsa, F. (1999). Outsourcing: a primer. Management Decision, 37(4): 310-316 Lei, D., and Hitt, M. (1995). Strategic restructuring and outsourcing: The effect of mergers and acquisitions and LBOs on building firm skills and capabilities. Journal of Management, 21(5): 835-859. Meyer, D. (2005). 4 Advantages to outsourcing [online]. Available from http://www.sourcingmag.com/content/c051011a.asp [Accessed 13th December 2010]. Sampson, J. (2009). Different countries have different types of outsourcing help [online]. Available from http://www.articlealley.com/article_872631_64.html [Accessed 13th December 2010].