Outsourcing developed a very high dynamics among the small companies in the 21 century “In the United States, payroll is already outsourced 46% of the time and tax 30% of the time” (Hagel, 2013). According to WTO, “The novelty of 21st trade lies in the quantitative dimension. To illustrate what is really new, it is useful to put 21st century trade into the broad context of globalization” (2011, Baldwin, p.4). There comes a question why should the companies outsource and what they should not outsource? The answer to this question lies in many dimensions with the key tendencies in the field of the International Trade and Finance.
The “the quantitative dimension” (2011, Baldwin, p.4) of international trade actually gives a general direction to the question why the companies should outsource? The answer is threefold:
1. Scale faster.
3. Allows you to focus on critical processes and parts of your business (2013, Hess, Lecture 4).
Scale faster: For the last five decades the international trade is growing very fast, however many companies especially the start-up-business fail performing well right because of the fast growth and losing controls. To win the precious time, to adjust to the new conditions, and to continue expanding, the companies’ decide to scale. For example the European provider of touristic business has decided to scale to the other destination, say India. The business already has some experience in European countries and plans to scale even further to Mexico. The board of managers has to decide what to do next: a) to go and study the laws, language, customs and hotels etc. in India or b) just to outsource these activities to the small local businesses. So in this case, scaling goes together with outsourcing. Because, the company has to outsource its activities to the small local service companies and to create the new model to scale it even further say to Mexico.
One of the techniques the company can apply is the focus group technique. Focus group research is a research in a group of 6 to 10 people. The necessary condition is that people don’t know each other, have similarities as education, social status, income etc. Several discussions should be taken with different interest groups: the representatives of the community, social groups etc. The group discussing is organized by a Facilitator and assisted and recorded by a Scribe. (2004, Group Discussions/Focus Groups). The main purpose of such research is “to study the generation of meaning, as opinions are debated, qualified and potentially modified.” (2009, Focus Group).
In other words the quantitative decisions require from companies the fast growth to satisfy the growing consumer demand. However not always a company may have an opportunity to scale and grow organically. In many cases organic growth encompass too many stakeholders, processes and controls to be established. One solution about this situation is scaling through outsourcing. Because a company can outsource a business to the well established companies, best in their field characterized with use of the advanced technologies to organically grow. The focus group can facilitate a process as a part of scaling because the scaling also includes the traditions, customs, local laws, preferred approaches etc.
Cheaper: The quantitative dimension suggests outsourcing the production functions to the countries with the cheaper production process as to China. The other services subject to outsourcing primarily are:
a. Services which do not utilize the companies fixed costs, which are cheap as products about which company has neither experience no equipment as protected by patents equipment etc.
b. Low technological services as work with data, payroll etc.
c. Administrative and marketing services such as contacting the clients by phone, sending-emails, scheduling and conducting the brand promotion meetings.
d. Support services such as training personnel, consulting on the health or financial issues.
e. Diversity programs, to different groups such as LGBT etc.
Maintain focus on critical processes and parts of your business:
- Identification of the activities necessary to complete the product. For example a company is employing the workers involved into the monotonous labor, and the minimum payment is reasonably high for the given locality as with the Nike sportswear.
- Finding out the value-added and the non-value added activities. By scrutinizing the situation the company may find different margin in cost of the same work made in the Vietnam and the U.S.A. The conclusion is clear this work is non-value added in the developed countries due to the high cost of labor.
- Work on the value-added activities or outsourcing the non-value added activates to the offshore. As a result the company may take a decision to outsource production of Nike sportswear to Vietnam. Moreover the well trained workers produce the sportswear of the same quality.
The quantitative dimension suggests that some services, having a highly qualitative nature, are the taboo for outsourcing. Even if the following services are cheaper to outsource they should be rarely outsourced:
1. Quality controls.
2. Financial controls.
3. Control of the customer (2013, Hess, Lecture 4).
These services are the subject of the company’s strategic focus.
Quality controls: For example, imagine, a company decides to outsource the quality controls to the other distant company. The distant company has failed to control quality and the reason is beyond the agreement conditions, and the company has no contingency plan to prevent the failure to control the quality well.
What will happen with this company whose product’s quality didn’t much the customer demand in the globalized world?
The international communication services such as internet, telephone, Skype will spread information on any distances instantly.
Social media such as Facebook, YouTube or specialized discussion forums will leave the poor records with the customers’ dissatisfaction.
The competitors would set the analytical post to the newspapers to plummet the company’s stock.
Financial controls: A company with the complex and various production processes decided to outsource its financial controls to the other well reputed distant financial management company. The same company has to allocate the overhead using the activity based costing (ABC). However, the distant manager didn’t consult the necessary production manager and didn’t set correctly the right activity and a cost driver. As a result the overhead can be allocated to the other activity. This issue will impact planning, operating income finally by creating the cash flow problems and production collapse due to unavailability of the free funds.
Control of customer: If a company outsourced control of customer it may fail controlling the defected products and the following important costs:
-prevention costs incurred to prevent production of the defective products or services, include detection of the defects. The prevention costs have the long term effect and once a company failed to train the workers or to inspect the raw materials it will incur losses.
-Appraisal costs – the costs of detection the defective products before delivery to the customers.
-Internal failure costs – related to the costs of the defective products subject of scrapping, reworking or alterations.
-External failure costs – different kind of warranty services such as repairs, replacements etc.
The other control of customer is control of customer satisfaction. Because the customer can be unsatisfied through the whole range of the reasons such as cheaper, or higher quality competitor’s product, better services, compliance with the standards or environmental protection etc.
In other words a company should focus on the critical processes and the parts of its business by leaving in-home the value added processes. If the process is not value-added because of the expansive labor, problems with supply of the raw materials or any other reason it should be outsourced to the places where it will be the value added activity. Such activities as the quality controls, financial controls and controls of the customer may not be outsourced because they are not belong to the quantitative dimension, rather to the qualitative one.
The question related to outsourcing must be carefully scrutinizing and should be discussed between the president of the company the vice president of operations, financial officer and accountant. Such the meetings usually end with a decision to make the differential analysis of several alternative courses of actions. Differential analysis compares difference between the costs and revenues of the alternatives. Analyzing the differential revenues and costs, a company can take the making or buying products decision.
For example a company producing the bicycles produces one bicycle for 115 U.S.D., while the outside manufacture can offer the lower price, say 75 U.S.D. The company should take a making or buying decision. The President of the Bicycle Company gives a task to an accountant to confirm that the decision to outsource is the correct decision. However an accountant doesn’t confirm this opinion and instead asks a time to study the different alternatives using the make-or-buy decision to finally decide to make or to buy the bicycles.
The accountant takes to analyze the variable and the fixed costs.
The first alternative encompasses:
The company's variable costs changing with the number of the bicycles and will include direct materials, direct labor and manufacturing overhead. The company's fixed costs are staying the same; irrespective of the level of production are the costs of the factory equipment, factory equipment lease, factory building rental and the supervisor salaries.
The second alternative includes:
Variable cost to purchase the bicycles from the supplier. The fixed costs will remain the same because in most cases the costs of factory equipment lease, factory building rent are the subject of the long term agreements. If the supervisor works only for the salary, this cost can be eliminated, however if a supervisor also has a long time contract this costs may not be eliminated.
The second alternative will have the sunk costs; they are the factory equipment lease, factory building rent and the salary of the supervisor.
After scrutinizing the situation the decision is unlikely to be to advantage of the decision to outsource, because of the higher total production cost of an alternative to outsource.
In other words, the company should carefully scrutinize the situation from the financial point of view before taking a decision to outsource. Using the differential analysis of the alternatives, differential revenues and costs the company should calculate the total production cost. If the total production costs differ only slightly, sank costs can be the first indicator against the decision to outsource.
Problems of international economics
The main problem of the international economics is fast and quantitative growth and outsourcing is one of the solutions to these problems by giving the companies extra-time to better and more organically adopt to the stakeholders and to the environment. So growth is not the linear process, described in economic theory with the ceteris paribus in the inputs. Nobel laureate Robert Solow suggested that such model doesn’t represent reality (1994, Solow, pp. 45–54). Fast growing companies are doomed to face the diminishing marginal returns and decrease in profits. The revenues may grow the costs as well even faster and profitability decrease.
And the problem starts arising after the company comes to the inorganic growth. Fast growing companies very often meet a difficulty in growing organically.
Nevertheless the American development model still sticks to an opinion that growth is all, or “grow or die” (2013, Hess, Lecture 1).
The conflicting opinions arise from the linear and nonlinear growth.
The first opinion is - the company should grow constantly increasing its market share. By correctly scaling growth this model will work however there are no many companies who managed to survive sustaining a kind of the linear growth.
Inevitably at some point the company will be in the bottleneck of scarce resources, as qualified labor, raw materials or time etc. The outsourcing is given to help to such companies. Outsourcing focused on the unique local resources, culture, knowledge can sustain growth and turn it to the organic. With time the company can absorb the necessary knowledge, experience attitudes and scale using this model even to the other countries.
The other opinion is practicing the sustained and the organic development from the beginning instead of “grow or die” is “improve or die” (2013, Hess, Lecture 1). This opinion has the theoretical base of diminishing marginal returns. One of the examples is about the company Nike, when the company outsourced is production activities to Vietnam and started wildly using the child labor, case became public. As a result, people stopped buying the goods of a Nike and the company revised its model. In the second model scaling has a priority in scaling of the corporate values first arriving to the sustainable solutions and only than taking the decisions to grow and outsource.
Personal option on the issue.
I think the decision to outsource is a strategic decision and a company should adhere first of all to the focused strategy.
The focus should be first of all on the cash flows because the company can’t grow lineally due to many internal and external factors and the cash-flow may be a critical and result in a failure success or failure. The differential analysis is a must for the company to know the total production costs of different alternatives with one of the alternatives is to outsource.
The focus should not be on the continuously lineally growing strategy. In case of fast growth a company can fail to establish the production controls, process controls and the controls over people.
Instead the growth is an ongoing process and a decision to outsource is not simply a decision to hire the cheapest labor with no opportunity to defend their rights, however company should outsource some of its non-value added activities to transform them into the value added.
This transformation should be not linear, however introduced on the step by step basis. By reaching the sustainable goals and creating the sustainable model the company can scale such a model into the other areas.
The “the quantitative dimension” (2011, Baldwin, p.4) of international trade sets out requirement to scale faster, cheaper, focusing on critical processes and parts of your business specifies which work can be outsources and which shall not be outsources.
So the company should outsource the works with low fixed costs and no long term contracts on the lease of equipment, rent of the premises or managers working according to the long term labor contracts. Such costs should be avoided because they are the sunk costs in future, increasing the total production costs and resulting in the negative cost increase from outsourcing.
Outside of the “the quantitative dimension” (2011, Baldwin, p.4) lie the qualitative works, critical and key for a company. These works can guarantee the sustainable future of a company as well as undermine its all many years’ efforts in a week or in a month. These works must not be outsourced and the company should work at constant improvement of the processes, labor resources and the controls.
Only the companies with the clear business model, controls over the cash flows, planning and clear goals can inspire the labor force, to work better to waste less resources can think about growth and outsourcing.
In fact a company may reach ROI by increasing Operating profit margin and Asset turnover (ROI = Operating Profit Margin x Asset Turnover) in two ways:
One way is by outsourcing the production facilities to the countries with the cheap labor and resources to increase the Asset turnover (Sales/Average operating assets) and sales. However in this case the high rate of waste and low qualification of labor may cause decline in Operating Profit Margin (Operating Income/sales) and only a slight increase in ROI or even a negative increase in total.
The other way is to maintain production in house instead of outsourcing to reach the high proficiency of workers, high quality of products, and the high worth of the brands by improving the Operating Profit Margin (Operating Income/sales). However in this case a company may still has unresolved problems of supply of the raw materials and reasonable costs of the labor resources.
In fact any company must think both about acquiring the cheap labor and the raw materials and by outsourcing the production and about training the workers, adapting to the local laws, approaches customs, culture to keep the brand high, production efficient and waste low.
Only this approach can prove to be efficient and organic friendly to environment and to the stakeholders, and only this business model can steadily grow, contribute to the customer satisfaction by keeping the brand future promising.
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