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When does outsourcing make sense? | Chain 2 Excellence

Chain 2 Excellence
NITIE's Supply Chain & Operations Interest Group

When does outsourcing make sense?

August 6, 2012 by c2xnitie in Supply Chain updates. Wikipedia defines outsourcing as the process of contracting a business function to someone else. The definition is fairly straight forward without much room for misinterpretation. However, when you talk about outsourcing, the image that most often comes to mind is moving jobs from US to developing countries in Asia. While in some cases it can be outsourcing, in other cases it might just be offshoring and the two terms are not interchangeable. But if we ignore the technical differences, the idea behind both the concepts are quite the same. They are both geared towards making a company more competitive by lowering costs or reducing risk. And in this post, I will describe a simple framework to analyze the decision of offshoring and outsourcing without missing any important factor or getting lost in nuances that often dont matter. Every business exists for a purpose. The purpose is usually to help consumers get a job done. Toyota, for example, exists to enable consumers to do the job of travelling from point A to point B in a fast, economical and comfortable way. Starbucks is there to help consumers to do the job of socializing and fulfilling their craving for coffee. But in order to enable consumers get the job done, the organizations themselves have to get certain jobs done. Going back to our example, Toyota needs to product cards and Starbucks need to grow or procure coffee. And in order to be successful they need to answer two fundamental questions: 1. Who does their job? 2. Where is the job done?
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When does outsourcing make sense? | Chain 2 Excellence

The answer to these two simple questions decides the strategy that they need to follow regarding outsourcing or offshoring. Who does the job? The answer to this questions decides whether a company should outsource or not. A company can choose to do the job in-house or it can decide to get it done from someone else outside the company in which case it is said to be outsourced. Sometimes, parts of activities are outsourced and at other times entire business processes are outsourced. Now, an important question is when does outsourcing make sense. Or rather, what factors lead you to outsource certain activities. If you look at literature on this subject, you will find that there are numerous reasons citied often resulting in a laundry list. Lack of structure makes a laundry list difficult to evaluate when you are in front of a client discussing outsourcing options. Instead, I prefer to distill all the reasons into two broad categories that are necessary and sufficient to decide whether to outsource or not and yet simple and logical to follow. The two questions you need to ask are: 1. Are the cost advantages greater than cost incurred to outsource? 2. Is the risk to business due to outsourcing acceptable? Cost Advantages from outsourcing can come from following factors: Cheaper labor and lower asset cost . Asia, Latin America, Central America and Eastern Europe are most often cited as destinations for outsourcing manufacturing or services due to lower labor cost in those regions. Additionally, the cost to set up business (land acquisition, construction, etc) are also lower. Economies of scale due to pooling. This effect is most pronounced in manufacturing when fixed costs are high and pooling across organizations result in lower per unit cost for all. A good example is semiconductor foundries in Taiwan. TSMC and UMC are one of the biggest pure-play semiconductor foundries that manufacture ICs for other companies. They make billions of dollars of investment in building fabs but are still profitable because now they pool order from semiconductor companies that are fabless. Foxconn in China is another example that manufactures electronic components and goods for a wide variety of companies on a contract basis. Expertise due to learning curve. The idea, also known as experience curve, was examined and popularized by BCG in 1960s. The theory says that an organization reduces its cost by 25% every time it doubles its production. Though the exact figures may not hold for all industries alike, the concept is still valid. As a company increases production, it learns how to better use its equipment, how to standardize and optimize processes and how to better use equipment. Employees gain expertise and become more efficient resulting in higher productive and increased cost savings. Lower fixed cost . In outsourcing, the company only pays for the variable cost of production and does not incur upfront fixed cost for setting up the operations. As a result, the barriers to entry are lowered. Companies that earlier found the business unviable
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When does outsourcing make sense? | Chain 2 Excellence

could now enter and also be competitive. Risk to business from outsourcing includes the following factors: Activity should not be key business function. While outsourcing has its benefits, business managers must not forget the risks it brings with itself. In fact, the most common theory taught in business schools is that a company must focus on its core competency and outsource the rest in order to be competitive. While this is a pretty simple rule to follow, often times executives forget this rule when they see the profits, higher share price and better year end bonuses by doing less themselves(outsourcing). Further, in the face of stiff competition, keeping operations in house might seem difficult as compared to the cheaper outsourcing option. So what they end up doing is misusing the theory by changing the definition of their core competency. And you know it when you hear executives say We are moving up the value chain. More often than not, such arguments are flawed. There are numerous examples to illustrate this phenomena but the best I ever heard was from Clayton Christensen. He described it with the story of Dell and AsusTek, a Taiwanese contract manufacturing firm. In the beginning, Dell had most parts of the value chain namely motherboards, computer assembly, supply chain, product design and Branding, done in-house. And it outsourced manufacturing of printed circuit boards, a non-core activity, to AsusTek. However, over time Dell pursued higher margin activities and moved up the value chain while leaving the lower margin activities to AsusTek. It first outsourced manufacturing of motherboard, then assembly, then supply chain and eventually product design to AsusTek. Dell justified outsourcing by showing improved profitability that came with decreasing costs while keeping the revenues constant. However, the risk in this strategy was evident when AsusTek decided to manufacture and sell laptops under its own brand thereby becoming a competitor for Dell. This would not have happened if Dell did not constantly changed the definition of its core competency and non-core activities. Protecting intellectual property and trade secrets. Outsourcing should be done as long as IP and trade secrets are adequately protected as they provide valuable competitive advantage. Weak IP protection laws can significantly undermine the benefits of lower cost destination. Novartis, for example, decided to shift its focus for R&D from India to China in 2007 after it lost a patent battle over its blockbuster cancer drug that it attributed to poor IP laws. Maintain quality and reliability. One of the biggest concerns while outsourcing is whether the low cost contracting firm will be able to maintain the product quality and reliability and not damage the firms brand in the long run. Clear guidelines need to be set on the minimum acceptable quality and adequate monitoring needs to be done to limit the risk. On the other hand, there should also be shared rewards for achieving higher standards. Similarly, reliability can be managed by having multiple suppliers or having insurance to limit the downside in case of disruption. Diversify business risk by spreading operations in multiple regions. As a result, catastrophe in one region will not be fatal for business as a whole. The unfortunate incidents of 2011 earthquake and tsunami in Japan has reminded business leaders of the importance of diversifying operations across regions. Toyota, for example, witnessed a 21% drop in YoY sales due to parts shortage. Given that Toyota has a just in time system, the situations would have been better if they had a more geographically diversified network of parts suppliers. Diversify business risk by outsourcing to multiple suppliers. There are benefits of outsourcing to single supplier such as
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When does outsourcing make sense? | Chain 2 Excellence

greater co-operation, lower costs, limited risk to loss of IP or trade secret. On the other hand, the benefits of having multiple supplier is that you are no more dependent on a single supplier and therefore business risk of one supplier does not affect you as much. Further, price competition among the suppliers could result in better price and improved quality. The choice of single or multiple supplier will depend on individual business needs and priorities and the factors listed above can help evaluate the options. Improved balance sheet . Outsourcing can help an organization improve its balance sheet by reducing capital expenditure (CapEx) and increasing operational expenditure (OpEx) because now it does not incur high cost in setting up fixed assets. Instead it pays only the variable cost for every unit produced and the fixed assets are moved to the balance sheet of contracting firm. This lowers business risk by not locking the firm into a chosen strategy and lending greater flexibility in changing direction if there is a need. Human rights concerns. Outsourcing of activities does not absolve the company of actions carried out to by contractor to execute the activity. This has been made obvious time and again. Recent human rights violation at Foxconn has forced Apple to respond to media allegations that it is turning a blind eye to exploitation of workers in Foxconns manufacturing facility in China. While Apple responded by establishing independent audits and publishing results along with a list of all its main suppliers, the damage to its reputation could be material if such incidents reoccur. Similar incidents of lack of corporate responsibility surfaced when Nikes suppliers employed children in Malaysia, Cambodia and Pakistan. Though it might be argued that such malpractices require better enforcement of law by the local authorities where the suppliers operate, the firm contracting out to these suppliers are often held equally responsible in practice. Often times, you will come across reasons for outsourcing that are logical but not sound as they do not pass the above two tests. For example, one reasons that is often cited as an important factor in making the outsourcing decision is whether a company has the capability or expertise to carry out an activity or not. And if it does not have the capability, then it might consider outsourcing. Now it sounds logical to outsource when you cannot achieve the results yourself. However, I consider this line of reasoning flawed. If the activity involves a core business function or an aspect of business that could be strategically important in future then outsourcing will increase the business risk. The company will be better off acquiring that capability now by either investing in it or going through the pain of learning through trial and error. So, the two factors are necessary and sufficient to evaluate any option. Whenever you come across alternative reasons for outsourcing, I suggest going back to the two fundamental questions I listed above and check the validity of the argument. Where is the job done? Once the decision to do a job in-house or outsource has been taken, the next question is where to do the job. If a company traditionally manufactures in US, then the question for them is whether to continue producing in US, or move operations to nearby countries such as Mexico (near-shore) or Asia (off-shore). Note that this decision needs to be taken irrespective of who carries out the operation your company or a contracting firm. A simple way to understand the combinations is the following table that shows all the six possible combinations.
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When does outsourcing make sense? | Chain 2 Excellence

(http://c2xnitie.files.wordpress.com/2012/08/imageweb.jpg) Again, the questions to ask when evaluating moving operations to near-shore or offshore are same Are we saving cost? Are we keeping business risk to acceptable levels? However to choose between near-shore and offshore, two additional questions has to be asked: 1. Is there time to market pressure? Businesses which require time to market in days instead of weeks need to consider near-shoring options instead of offshoring. Close proximity to market not only reduces one way shipping time but also reduces round trip time in business where raw material is sourced from home country due to trade agreements. For example, under CAFTA, cloth imported from US, stitched in Dominican Republic or Honduras and then exported back to US does not attract tariff. As a result, many corporations in apparel industry find these countries in Central America attractive destinations of manufacturing without compromising on time to market. 2. Are there cultural or time zone concerns for service delivery? Moving call center operations for a firm with customer base in Germany to Eastern Europe is a more viable option than moving it to India because of the language barrier. Even for English speaking countries such as US, moving call center operations to India does not always yield good results. Instead moving call center operations to Mexico might make more sense due to cultural and time zone similarity. Even in case of software development, many companies are finding cities that fall in same time zone to be more practical for coordinating activities than cities that fall on the other size of the globe. For example, IBM operates development center in Mexico, Brazil and several other South American countries to serve customers in US in order to benefit from lower cost of engineers without creating significant coordination problems due to varying time zone. About these ads (http://en.wordpress.com/about-these-ads/) Blog at WordPress.com. | The Oxygen Theme.
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When does outsourcing make sense? | Chain 2 Excellence

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