The Financial Pros and Cons of Outsourcing - Report Example

1 Introduction Outsourcing has become a convention of business today and a useful as well as a profitable business strategy. Ever since the ninetiesit has been recognized that it makes economic sense to outsource a company’s non-core activity to enable it to use its resources on activities that it can perform best. Forrester Research report states that infrastructure management and application services expect a saving of between 12%-17% annually and this means that US companies alone are sitting on a $ 10 billion savings through outsourcing. (Forrester Research)1 (see Appendix). Beneifer Irani states that outsourcing offers freedom to pass on non – core, yet important sectors of its administration on companies that specializ in those very individual aspects. (Beneifer Irani)2 The advantage of outsourcing lies in the fact that it helps companies to cut costs and stay ahead in the competition. Indeed Companies can save up on operational costs to half by outsourcing. They get access to cheaper and more efficient labour and save up on training costs. They can also access better technologies at lower cost. Outsourcing also helps to increase productivity as they pay to a third party purely on output. It allows the company to concentrate on its core competency. Companies today want to make use of the outsourcing advantage in order to progress and stay abreast of the competition. The main disadvantage of outsourcing is that the company can get into serious trouble if the service provider is unable to provide the business or service due to bankruptcy, lack of funds, labour troubles etc. There is also a loss of control over the process that is outsourced and there may be a loss of quality. Unless the outsourced service is exclusively provided to one company, there is chance of the service provider failing one or the other principal and this can cause disruption in smooth flow of work. Outsourcing jobs to offshore destinations, is causing some unemployment as both high and low-end jobs are moving out. There is often a conflict between companies, national economies and individuals and it is difficult to reconcile all the stakeholders. 2 Financial Pros & Cons of Outsourcing The main reason for outsourcing work is to cut on costs. A detailed study across the board reveals a variety of financial savings that justify outsourcing. 1. The cost of the agreement can be retired and the tax base can be decreased by the amount of work paid for as outsourced work. This can be substantial in case of large companies. 2. Normal cost of hiring an employee and the wage tax to be paid for the duration he is on roll are eliminated. The company saves on paid leave which it would have otherwise paid to employees on roll. 3. Every new employee needs space, power and facilities thereby increasing running and manufacturing costs. There is substantial dollar savings by outsourcing. 4. Administrative costs are lowered owing to reduced hiring of new employees. 5. There is significant savings in investments required for tooling, erection of new facilities and acquisition of extra or different technologies. 6. A hidden but calculable cost is the excessive availability of management and workers to concentrate on core competencies. 7. A leaner organization is more flexible and will result in cost savings and reduced response time in case of emergencies. 8. Increase in competitiveness also reduces overall costs. The main financial drawbacks of outsourcing are 1. Loss of employment in the home office or manufacturing facility. 2. Loss of managerial control over the outsourced process resulting in loss of quality and customers. 3. Threat to security and confidentiality despite binding agreements especially where customer information is to be passed on to third parties. 3 To Outsource or Not to Outsource The company must consider outsourcing on the level of its core requirements. If an activity is considered a core activity then it should not outsource it to a third party as it is not likely to be handled by better people than the company has. The very fact that it is a core competency declares that the company is most competent to perform it. However core competency has separate meaning for individual companies. Companies transfer their non-core activities which are not critical in nature for economic gain, or for better quality, or both. Yet another reason could be that a new technology is being used elsewhere and the company seeks to take advantage of it without having to invest in it or train its employees on it. This is a strategic decision that will give some control to an outsider or third party. In such a situation the company might be outsourcing an entire service, a product line or even and entire plant for strategic value received by such a move. Normally in a manufacturing company the core activity is manufacturing the final product. A product is an assembly of components and parts that together make it function and deliver value to the customer. Thus the final assembly is the function that cannot be outsourced. This is true of products like Motor Vehicles, Aircraft, Machinery and other similar product. In these cases since the overall investment is very high the option that is practiced is that components or part manufacturing is outsourced but final assembly takes place at the outsourcing company plants only. A prime example is that of general motors which outsources several components and parts of its motor cars to vendors all over the country and some even to overseas suppliers. Boeing Aircraft does the same with a number of its parts produced by third party manufacturers. In case of consumer durable products, if the company is already enjoying brand equity, it is sometimes possible to let a third party produce the entire product with the company label to add capacity. This is a huge saving in investment as the cost of an entirely new manufacturing facility is saved. Further, in case of a product becoming obsolete the company saves the cost of investment that becomes redundant. A good example of such a company is Lever Brothers which introduces several new products each year, which regularly become obsolete over a period of time and are replaced by other innovations. They outsource the production but market it themselves under their own brand name. In a few cases like that of Coca-Cola the concept of outsourcing has gone to the extreme where it outsources the entire production to bottlers who pay a royalty to the company for manufacturing and marketing the products entirely by themselves. The same is the case with any other product that has short shelf life. Another good example is of electronic products whose shelf life is very short and distribution is worldwide. Thus HP outsources a lot of its products to Taiwan and other far eastern countries for reasons of logistics as a cost saving factor. Yet another non-core activity that is common to all kinds of companies is customer service and back-office operations. In case of customer ser vice it is becoming a common practice to handover these operations to a third party, usually located in a developing country or a country with comparatively cheap labour. The justification is that labour costs are pretty low here. A salary of $300-500 is small for an American but high for and Asian employee and this is where the company can benefit. (Beneifer Irani)3. However the only drawback here that needs to be judged is that the confidential information of the customer data base can be sold to rivals. The same is the case for back-office services which include accounting and legal activities that can be passed on to cheaper but qualified people in developing countries. 4 Conclusions In the case of manufacturing operations it must be said that the advantage of outsourcing the activities are enormous. In the current scenario where competition is fierce and brand loyalty can be put under severe strain on price factors, it is prudent and advisable to go for outsourcing. In the case of consumer products too huge saving potential is to be weighed against the possible misuse of information. However the benefits far outweigh the drawbacks when it is understood that fraudulent actions also take place in the company’s own offices and therefore in effect the risk is no lower or greater if the work is outsourced. The judge whether the activity is to be outsourced or not will depend on these factors and when applied will show financial benefits. The following Charts will help the management in focussing on outsourcing issues. Strategic reason for outsourcing Division of outsourcing activities Factors influencing outsourcing Structural Changes to be made internally to accommodate outsourcing 5 References 1 Forrester Research report Available at: http://www.networkworld.com/news/2007/083107-outsourcing.html 2 Beneifer Irani available at: http://ezinearticles.com/?Advantages-of- Outsourcing&id=110032 3 ibid 6 Appendix After a detailed analysis of various publications over the last two years, we isolated some of the widely quoted statistics on offshoring: According to the U.S. Department of Commerce, the value of U.S. exports of legal work, computer programming, telecommunications, banking, engineering, management consulting, and other private services jumped to $131.01 billion in 2003, up $8.42 billion from 2002. Imports of services - a category that encompasses U.S. outsourcing of call centers and data entry - hit $77.38 billion for the year, up $7.94 billion from 2002. Measuring imports against exports, the United States posted a $53.64 billion surplus in 2003 in trade in private services with the rest of the world. International Data Corporation (IDC) has predicted that the global IT-enabled services market will account for revenues of $1.2 trillion by 2006. By 2015, Forrester Research estimates that as many as 3.3 million U.S. jobs and $136 billion in wages could be moved to such countries as India, China, and Russia. Meta Group predicts that offshore outsourcing will grow by more than 20% annually, pushing it from a $7 billion market in 2003 to a $10 billion market in 2005. The group also foresees all application outsourcing services, including the offshore component, reaching $15 billion by 2007. A McKinsey and National Association of Software and Service Companies (NASSCOM) study estimates that the information technology and enterprise solutions (ITES) market in India is likely to reach $142 billion in 2009. This estimate contrasts with the current price tag of $532 billion to provide these services in the United States. The difference of $390 billion would be the net savings for the U.S. economy due to offshoring. The ITES sector has the potential to generate job opportunities for more than 1.1 million Indians by 2008. According to Deloitte Consulting, 2 million jobs will move from the United States and Europe to cheaper locations in the financial services business alone. The exodus of service jobs across all industries could be as high as 4 million. The consulting firm forecasts that three-quarters of leading financial institutions and investment banks will allocate tasks to developing countries in the next five years and that India will be at the top of the list. Global financial institutions will invest $356 billion in India for outsourcing projects. Among the different offshore locations, India has become the number one destination for most companies. Gartner, in its 2002 report titled, "IT Trends in India," wrote that the market opportunity for Indian vendors would grow to $25 billion by 2005. According to Gartner, the global BPO market grew by 13% between 1999 and 2000, to $119 billion, and it will reach $234 billion in 2005. Gartner also wrote in a report entitled "U.S. Offshore Outsourcing: Structural Changes, Big Impact" that 500,000 of the 10.3 million U.S. technology jobs could move offshore in 2003-04. Diane Morello, the author of the report, estimated that one in ten software services jobs are at stake at computer vendors and 5% of technology jobs are at stake in the wider corporate world. These assumptions led her to her estimate of 500,000 jobs being moved offshore. Indias software exports were estimated to be worth $9.5 billion in 2003, and the United States accounted for 60% of that total (almost $6 billion). According to Datamonitor, offshore deals made up just 1.4% of total outsourcing contracts in 2003. However, the value of offshore contracts rose 890% from 2002 to $1.66 billion. According to the financial services firm WR Hambrecht, offshore service represents a large market opportunity. The offshore BPO market is expected to grow at a CAGR of 79% through 2008 to a size of $24.2 billion. The offshore IT service market is expected to grow at a CAGR of 43% to $56 billion. The bottom line: By every estimate the offshore outsourcing trend is huge. India expects to create 2 million jobs in the next decade in offshore BPO. Guess where those jobs are going to be coming from. Available at: http://www.ebstrategy.com/Outsourcing/trends/statistics.htm Read More