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Outsourcing

Outsourcing is the practice of sending work to another entity (a second company or an individual not employed by the outsourcing company). The main characteristic of outsourcing is that the work contains functions that, up until the outsourcing, had been done by the hiring company. In this manner, it differs from a standard supplier relationship in which the hired company augments a capability rather than supplants it.

Offshoring is a specific form of outsourcing in which the company receiving the work is in another country.

Read more about this topic below.

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While outsourcing is a highly charged, political topic, the fundamental driver for it is cost. Business leaders have a responsibility to their shareholders. If the best way to produce a good or provide a service involves outsourcing, they must at least consider it.

There are many reasons to outsource, though fundamentally, it normally comes down to the cost of creating capacity or capability.

Reasons to Outsource

  • The company cannot meet demand and the cost of outsourcing is lower than the cost of adding capacity. This is especially important when demand increases might be temporary.
  • The company might be selling increasingly sophisticated products that exceed their capability to produce them.
  • The company might not want to invest in a particular piece of specialized equipment for a product that has low demand.
  • The company might not have the infrastructure to build products at a price that can compete in a crowded market. This is particularly true when the product is a commodity.

As mentioned earlier, offshoring is the act of outsourcing to another country. When the region has low cost labor or access to necessary natural resources, the benefit can be immense. Typically, offshoring benefits are analyzed similarly to local outsourcing.

Of course, as with any benefit, there are also costs to outsourcing. For this side of the cost/benefit equation, though, offshoring carries some unique issues.

Reasons Not to Outsource

  • Shipping costs can offset pricing gains. There is also significant fluctuation in shipping prices.
  • Minimum order quantities can be prohibitive. Inventory holding costs should be factored in, especially if the product has a short shelf life or if it is susceptible to obsolescence or pilferage.
  • Lifetime quantity guarantees may be required. This may hamper flexibility.
  • Product changes are more difficult and costly with external companies.
  • Time zone differences can make management a challenge. Your leadership team can become worn out if they are expected to be in close contact with teams half a world apart.
  • Communication (+ 6-Page PDF) can be a challenge. Language barriers are only part of the issue. Cultural differences add to the problem.
  • Political risk is inflated in some countries. This can disrupt shipments as well as put investments in jeopardy.
  • Morals can be tested. This can happen when a country has human rights issues, or when the local standard is to make ‘special payments’ to get through red tape.

Offshoring-Specific Problems

In addition to the direct costs, there are secondary costs. For example, employees might feel threatened if work is sent out, resulting in loss of production or high turnover. Customers may not like buying outsourced products, which can affect the top line.

Another significant risk is the loss of trade secrets. It is impossible for a company to un-learn what they know. It could get into murky legal ground if you cancel a contract. This is especially true for companies with strong processes but no patent protection

Emotions and Outsourcing

Outsourcing is extremely emotionally charged. It gets even more emotional when the recipient of the work is in another country. Be prepared for addressing this issue whenever work is scheduled to move. In continuous improvement, front line leaders and mid-level managers seldom make the decision to outsource—it is normally driven by the executive team. Choosing the specific work to be sent out, and follow on decisions to send more work, however, may fall upon supervisors and managers. In those cases, leaders should be prepared to address the personnel issues that develop. Keep in mind that some people will remain unconvinced of the need, regardless of the evidence for or against.

Because it is emotional, the question often arises as to whether outsourcing is good or bad. Keep in mind that people choose to do it all the time in their own life. They hire gardeners and maids. The take clothes to the cleaners. They bring in painters. All of these things are tasks people can do on their own. They are not inherently opposed to the concept of outsourcing—they are opposed to the risk to job security that it represents to them in the workplace.

Offshoring poses a trickier question about right or wrong. There are countless arguments for and against, and each side is convinced they are right. The arguments include the social responsibility issues of shipping jobs away when locals are unemployed, exploiting developing nations, and many other reasons. The fact is, though, that offshoring is here to stay, and as long as it is profitable, it will continue. Even companies that do not want to offshore, or buy foreign products must balance with the reality that their competitors are doing both. There is always a cheaper foreign labor market.

The thing is, though, that cheaper labor markets will continue to shift. As countries develop, the economic benefit of sending work to them diminishes. There is a cost to manage foreign workers. The time difference, lack of face to face meetings, and general efficiency losses mean that the cost has to be significantly less than in the local country. As wages rise across the board in the developing country, it becomes harder to fill some positions at wages that make them attractive to offshoring. This started occurring in India in 2007, with an expected shortfall of 500,000 IT professionals. Compounding the problem, students now have more alternatives for better pay as the retail, airline, and hospitality industries are beginning to offer more competitive wages.[1]

Bringing Work Back

With the shifting nature of the global economy. Few decisions are universal. Bringing locally outsourced work is not as susceptible to global shifts. Offshored work, however, faces pressure from shifting economic winds.

The term “reshoring” is now popular, and means that previously outsourced work is being returned to the US. Its prevalence, however, can be hard to pinpoint. Companies that send work overseas are likely to be tight-lipped about it. Those that bring it back tend to shout it out as a PR coup. In a 2012 study, though, the Hackett Group, an offshoring advisory organization, expected offshoring to slow as reshoring doubled by 2014.

In addition to that study, others by MIT and the Boston Consulting Group both saw a fairly significant number of companies claiming to have a plan to return work from China to the US. These numbers, though, must be taken with a grain of sale. As of early 2013, only a hundred or so companies were known to have actually reshored manufacturing work.[2]

Outsourcing and Continuous Improvement

There are two ways to resist outsourcing if you are an employee. The first is to loudly complain. The problem is that taking that approach has only limited effect, and tends to create animosity. The other option is to make keeping the work in-house more economically beneficial than the external company or foreign workers. This can be done by offering to take a wage cut, which is very unappealing to people. A more palatable way is to use continuous improvement to make doing the work within the company a better alternative than sending it out.

While there are some serious hills to climb, there are also some major advantages that the incumbent has. They know the process, are likely closer to the customer, and will be more flexible. They understand how the company operates. Turnover will generally be lower, and there will be no language issues (whether it is nomenclature or dialect). Not every decision comes down to price. Quality, reliability, flexibility, and other factors all carry weight in the decision making process.




[1] (Thanawala, 2007)

[2] (http://www.economist.com/news/special-report/21569570-growing-number-american-companies-are-moving-their-manufacturing-back-united)

  • Be careful when calculating the costs of outsourcing. Intangibles and risks (i.e. intellectual property) can raise the costs dramatically after the initial honeymoon period ends.
  • Be sure to include travel and management costs in your analysis.
  • Make sure to manage your intellectual property well. Once a company learns your trade secrets to produce a product for you, it can be hard to defend against them developing a rival product on their own.
  • Have an exit strategy, and include its costs in your calculations. Consider the risk of a hired company cancelling the contract or going out of business.

Any way you look at it, outsourcing and offshoring is hard to view as good news. While it is true that in extreme cases it may be necessary to save the company in a competitive market, it is more likely that it is simply a move to increase profit.

Rather than fight outsourcing, though, focus on one of two things. Make yourself indispensable to the outsourcing efforts, or make your processes more productive than anyone else’s. Both involve you embracing continuous improvement principles.

For the first strategy, support and improve the processes related to managing the outsourced work. Help establish kanban for ordering. Refine the communication process. Improve production processes, and document them well so they can be shared. Remember, you have one big advantage. You know your company and its needs. Capitalize on that advantage.

As for continuous improvement, few companies ever really get a workforce completely engaged, so their progress can be stifled. The more engaged you are in daily improvement, the faster your company will improve. And the more you improve, the less likely the cost equations will support outsourcing.

Any way you look at it, outsourcing and offshoring will not be viewed as good news by your team. You will be managing resistant team members (+ 9-Page PDF). And if you are planning on eliminating many of their jobs, you are holding a losing hand.

If at all possible, adopt a strategy of growing into outsourcing while preserving local jobs. Eventually, you’ll have your manufacturing shifted as a growing number of products move out while at the same time attrition reduces the size of the workforce. The delays in costs will be made up for by the strengthening of the relationship with your team.

If you let even one person go to outsourcing, though, the rest of the team will constantly walk around with the feeling that there is a target on their back. Best case, you will lose productivity from them. Worst case, they will leave for a less risky job, even if the risk was only in their mind.

Outsourcing Strategy

As you do move work out of the company, make sure to manage the risk. Send your simplest, most established products out and produce your most complicated and proprietary products in-house. You’ll end up having to do more work and shift around employees, but you’ll end up with a less risky configuration. I there is a problem with the vendor doing the work for you, they can be replaced more easily.

  • Outsourcing and offshoring are emotionally loaded activities and carry numerous hidden costs.
  • Make sure to have a risk assessment and an exit strategy when considering outsourcing.
  • Most people are inherently in favor of outsourcing in their personal lives, but fear the risk that it presents to their jobs.

Before considering outsourcing, be sure that you have done everything you can within the walls of your own company. Using Lean initiatives can dramatically free up floorspace, increase capacity, shorten lead times, and reduce costs.

Look over our Continuous Improvement Transformation Model at http://www.velaction.com/continuous-improvement-transformation-model/ to learn how to develop a continuous improvement culture that can help your company avoid outsourcing.

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