Outsourcing and the Economies of Scale - Essay Example

OUTSOURCING AND THE ECONOMIES OF SCALE The practice of outsourcing has become very common these days in the business world. It has become a powerful option for companies which are focused on growth. It has become a famous practice due to its seeming cost reduction measures and enhancement of service and competences in many businesses. It has been widely practiced in the circles of information technology service, human resource and other dynamic areas of business practice. It has grown to be a multi billion industry with an annual growth of about 10 percent. This paper will look closely at the concept of outsourcing and how companies those which have adopted the practice are fairing in the business area. (Brian 2003, p. 68) What is outsourcing? Outsourcing can be defined as the process of transferring responsibilities of a specific business functions from an “employee group” to a “non-employee group.” simply it is the transfer of functions from their function center in the organization to a function center outside the organization. It is integrated in many business strategies due to it’s seemingly benefit of cutting down cost through economies of scale. One of the most important features of outsourcing is the transfer of control. The buyer or the non-employee group doest not retain the power to instruct the supplier or the company on how the task is to be performed. Outsourcing differs from other forms of business control in that the company retains the power to dictate how it wants the whole process to be carried out. Both parties makes agreement on how the whole process will be carried out and what the process is supposed to achieve at the end of the exercise. (Thomas 1996, p. 15) It is based on mutual agreement which may be carried out physically or through other medium of communication. Outsourcing has been taking place across continents with companies moving to areas with low labour laws in a bid to exploit the benefits of cost reduction. However the concept of outsourcing has been claimed as not efficient by many people though many companies has reportedly adopted the benefits they have seen in the process. This paper will look closely into the aspect of outsourcing, it benefits and whether companies which have adopted the concept have achieved the benefit. (Mitchell 2007, p. 23) Benefits of outsourcing Many companies carry out outsourcing to meet the objectives that are drafted in its strategies. The motivation to outsource comes from the experience that a company had but the whole concept is implemented with an aim of achieving multiple benefits. At a glance most companies will pursue the concept with aims of reaping benefits like cost saving, a focus on competencies, having an access to modern technology, access to expertise, improved service delivery and solutions to politics Let us look closely at these benefits. (Jacob 2004, p. 78) (i) Management of internal staff If the outsourcing is well managed, it can enhance the development of the internal employees. In this case, contractors can be used to reduce the peak loads that take most of the employees’ time. The staff is left with time to pursue other career development matters. In the same case, contractors can be used to bring to the internal workforce new ideas and can also be used to train the staff. (Meyer 2006, p. 84) (ii) Sharing risk Outsourcing can also be used to share risk. This is called portfolio effect in the financial businesses. The concept here is that there is diversified portfolio that ensures that money is invested in different accounts rather than putting all the money in one portfolio. In case one market goes down, the investor is assured of another market invested in another area. Outsourcing gives a chance for multiple companies to share a risk in putting up a common structure from which all the companies will be benefiting. (Waltner 1998, p. 4) (iii) Saving costs It has been proved that outsourcing is a primarily a time and money saving strategy that can be adopted by a company. It would be of no use if a company engages in the concept of outsourcing knowing very well that it would reap no benefits in the process and that the process would achieve the same as the current one in use. If the in-house activity is efficient and achieving the set standards, a company would not find the reason for engaging in outsourcing. Studies have proved that outsourcing can lead to up to 15% saving in operation cost. This saving comes up from leverages that companies have access to and which are not found within the company. Some of these leverages which leads reduced cost measure include economise of scale, access to expertise, access to capitals and access to efficient technology. It is also understood that cost saving is also realized by converting in-house fixed cost like staff salary to variable costs which will give the organization time to concentrate on other services. (Richard 1998, p. 87) The theory of cost saving in outsourcing stipulate that economies of scale saves money since unit cost takes a noose dive as volume increases. It has also been stipulated that external service providers achieves economies of scale which is not available to individual firms, in cases when they put together the volumes of multiple companies. To get a more glimpse at this concept, take the example of a company which is manufacturing and specializes in a type of machining. The machining is the capital investment of the company and the main driving force for the business. But think of a situation where the company has more machines which will be more efficient and can produce more goods for any customer, then the company will produce more parts at a lowered cost. This company would relieve a company the burden of setting up a machining department in case it requires materials from the machining process offered by the company. (Lacity and Hirschheim 1993, p. 146) However it is good to understand that the concept of economies of scale is no limited only to the physical processes. There are other assets like money, relationships, and people which can be shared and which can lead to benefits of economies of scale. Take an example of a pharmaceutical industry. The companies in this industry carry out many clinical trials in the process of manufacturing their drugs. Clinical trials require the company to use the right kind of patients, but who are willing to be treated and participate in a clinical trial. In the process of creating a rapport that will lead to the company getting the right kind of people to use in the trials, a lot of money and time is spent in the process. The process also requires that the companies have the right kind of medical experts who are willing to supervise and carry out the research. This again takes a lot of time and resources for the company to find the right kind of medical expert willing to participate in the process. To make the whole process shorter and economical, these companies forge collaboration with the medical experts who in turn supply the companies with researched data and a well managed process. In the market one will find outsourcing industries that can manage these clinical trials for these companies. (John 1997, p. 43) However there are certain conditions that must exist in order for the company to enjoy the full benefits that comes with saving money. First of all the economies of scale must be practical. The process must prove that there is some economic advantage to large size before the process of outsourcing can pay off. This means that there must be seemingly a drop in unit cost as volume increases. Second these economies are able to be accessed across the corporate boundaries. This means that the company which out sources or the outsourcer must be able to put together volumes of multiple clients. For example, taking the example of data sourcing, it would be uneconomical for a company to fix its own fibre cable or lease a private satellite channel. But it would be economic if many companies to come together and share the fixed cost of laying the telecommunication infrastructure. Third, the savings that the company will makes from outsourcing must be enough to outweigh all the additions payments that the company will pay to other shareholders as profit. (Cummings 2006, p. 123) Have companies achieved economies of scale in outsourcing? As has been discussed earlier, many companies pursue outsourcing due to the economy of scale that brings about cost cutting measures. Although this has been the intentions of many companies pursuing the concept, this does no always turn to be true. Many companies find that they have gained no cost cut resulting to economies of scale while at the same time other companies find themselves making a huge cost cut from economy of scale. Take an example of the economy of scale that is supposed to come along outsourcing in transport and other logistics. It has been found that small and mid sized companies may not have economies of scale to enable them manage the logistic operations. This may restrict them from entering to the profitable markets. Hence for some of these companies, outsourcing may be used to increase their regional business. (Dore 2006, p. 56) The theory of economies of scale stipulates that large sized companies are likely to achieve lower average cost than their counterpart small sized companies. This is achieved through mass production and specialization of labour which brings about efficiency in the labour output. However, this may not be the case in outsourcing. This is sometimes a challenge and gives opposite results as compared to the actual cases. It has been found that small companies are likely to obtain lower costs than larger companies through employment of older technology, hiring at below market average wages and ensuring that there are tight controls in the production procedures. (Ian 2007, p. 35) Economies of scale have remained the main focus for many businesses in instituting cost cutting measures. Many companies have looked at outsourcing as the possible way out of bringing about the much need cost cutting measure that are needed in areas of maintenance, finance, and human resources. As was discussed earlier different companies have posted different results as far as economies of scale are concerned. A number of companies have showed that they have been able to put in place cost cutting measure through economies of scale. For example the BP oil company has posted reduced operating cost since 1991 through the use of outsourcing service. In 1991, BP recorded that it outsourced its finance and accounting functions from North Sea region. The company said that this was an important step in its operation which acted as a magic pill and also as an important ingredient of its success. Previously the company has been operating in its offices and had several departments responsible for financial and accounting operating. But once it set out to outsourcing, it was able to bring all its accounting and finance operation under one company which made it easier for the company to operate that made the operation very successful. (Braun 2004, p. 6) Another company, Thomas Cook, UK started outsourcing for finance, accounting and HR administration and information technology in 2002. It had more ambitions that cost cutting in outsourcing. The initial intention was to transform the business to ensure that it reduced the operation cost through instituting measures to ensure that there are economies of scale. The two companies were able to achieve clearly showed that they could transform their business through outsourcing and ensuring that there is economies of scale. But there are a whole range of problems that companies are currently facing in their pursuing of out sourcing. (Mario 1999, p. 90) One of the greatest challenges that these companies are facing is the issue of politics. Political instability has been one of the problems that has continuously affected the business climate and which translates to outsourcing business. For example, India has been a leading power house in outsourcing. During the change of government when Prime Minister Sonia Gandhi took over power, there was a lot of business instability which affected the operations of many businesses due to political uncertainty. It was evidenced that shortly after she was elected, many stocks plummeted due to fears of her leftist allies which many thought could have affected economic reforms. In many countries political back lash has been affecting business environment which has affected the operation of outsourcing companies. In such instances, companies may go to an extent of instituting new measures to cover the outsourcing deficiencies which in most case retards gains made on economics of scale. (Mann 2006, p. 24) Another challenge that companies face is cultural challenge that comes in the company. Take an example where a company outsource foreign workers into its workforce. The company will achieve the advantage of low cost of operation since it will pay wages sometimes below the market. But at the same time the management must be ready to cope with cultural and religious challenges on the part of the workers. Take an example of a British company that out sources the service of countries in Arab world and where there are daily target to be met. It is likely that targets scheduled on Friday will not be met since most of the workers will be worshiping. Another challenge that many companies are facing with outsourcing is the security problem. Once a company decides to outsource, it the other party becomes a part of the outsourcing company and hence there is no secret to hind. Unless there is a good follow up, the company may end up opening all its secrets as the other source demand for information. Many of these companies reveal that it has become difficult for them to keep business secrets to themselves and the security issue has become a big concern. With outsourcing taking a global aspect, the issue of insecurity in the whole globe is also a challenge to many companies using outsourcing business. Many companies in insecurity prone areas may find it difficult to coordinate any outsourcing business simply due to their location in regard to the security situation. (Hillary 2004, 90) Conclusion Outsourcing has been the recent sensation in the business would especially in the areas of human resource management and information technology. It has helped some companies achieve the intention of cost cutting through economies of scale. However at the same time it has come up with new challenges that these companies have to deal with. However it is projected that with the current trend in the growth of outsourcing it might be the future direction in business to institute cost cutting measures. References Braun, C 2004, Overview of Offshore Outsourcing; Braun consulting news, Vol. 7, no. 5, pp. 5-7 Brian, A 2003, Outsourcing and timing; American Libraries, Issue 28, no. 2, January 2003. Cummings, M 2006, Management information system, McGraw-Hill Books. Dore, L 2006, The challenges of outsourcing; Business Times, January 2006 Hillary, K 2004, Outsourcing to India, Wiley, New York. Ian, F 2007, Challenges in outsourcing; Journal of European Venture Capital, Vol. 2, no. 3, pp. 34-78 Jacobs, M 2004, The rise of outsourcing; Journal of Management Practice, Vol. 1, no. 2, pp. 15-27 John, A 1997, Outsourcing challenge in Librarianship; Wiley, New York. Lacity, M & Hirschheim, R 1993, Information systems outsourcing, Chichester, John Wiley and Sons. 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