How Outsourcing Works


Many companies are increasingly outsourcing the manufacture of goods.
Many companies are increasingly outsourcing the manufacture of goods.
Dimas Ardian/Getty Images

A manager for the fictitious Smith & Co. manufacturing faced a dilemma. The company's newest product in development showed great promise, but also represented a departure from the company's in-house expertise. To design and engineer the product, Smith & Co. would require an entire new line of engineers with specialized skills and equipment. However, the cost would take a chunk out of the company's projected profits.

That wasn't the manager's o­nly issue. The product included a component that Smith & Co. didn't manufacture. Adding that equipment, and training workers to use it, would take time -- too much time. The market was ready for their product now. The delay would cost the company.

What could the manager do? He might turn to outsourcing to solve these problems and help his company succeed.

Outsourcing is when a company hires another individual or company to perform a specialized task, whether it's making a product or providing a service such as human relations or information technology.

Think of an individual home owner, for instance, who needs his house painted. He could go out and buy paint brushes, rollers, scaffolding, ladders and insurance and then, take the risk that he can do a good enough job -- and not fall off the scaffolding! He'll also be stuck with the expense of purchasing all that equipment for a task that he only needs to do once every few years.

Or, he could just hire a painting contractor. The decision to outsource works in the same way.

Many countries, including the United States, outsource frequently. As of 2004, U.S. companies had outsourced anywhere between 300,000 to almost 1 million jobs [source: BusinessWeek]. Goldman Sachs projected that number would grow to 6 million by 2014.

What exactly is outsourcing, and how does it apply in the business world? Is it more economical to outsource locally versus overseas? And, which business functions are most likely to be outsourced? Go to the next page to find out.

What is Outsourcing?

­Many companies choose to outsource overseas because of lower labor costs.
­Many companies choose to outsource overseas because of lower labor costs.
© Strdel/AFP/Getty Images

When businesses need expertise or skills that they don't have within their organization, they often turn to outsourcing to solve their problems.

Outsourcing means just what it says -- going "out" to find the "source" of what you need. These days many business outsource for what they need to serve their customers, both internal and external. An external customer is the entity that ultimately purchases a company's product or services, while an internal customer is the company's own employees or shareholders. Business can obtain both products like machine parts, and services like payroll, through outsourcing.

 Outsourcing probably can trace its roots to large manufacturing companies, which hired outside companies to produce specialized components that they needed for their products. Automakers, for instance, hired companies to make components for air conditioning units, sound systems and sunroofs. In some cases, they moved entire factories to foreign countries.

The big shift in recent years, however, is service outsourcing, which refers to

companies hiring outside businesses to provide specialized work and expertise.

Outsourcing offers many advantages. For instance, outsourcing allows companies to seek out and hire the best experts for specialized work. Using outsourcing also helps companies keep more cash on hand, freeing resources for other purposes, such as capital improvements. It's also often cheaper in terms of salaries and benefits and reduces risks and costs.

Outsourcing can also help a business focus on its core components without distractions from ancillary and support functions. Another advantage -- such as the one involving the fictitious Smith & Co -- involves speed and nimbleness. It's sometimes quicker and more efficient to hire a specialist to do something than it is to bring your company up to speed.

Many large companies use outsourcing to fill roles in their organization that would be too expensive or inefficient to create themselves. Smaller companies also turn to outsourcing, though the cost savings is sometimes diminished.

Outsourced manufactured components can include building components for aircraft, computer networks or automobiles.

Outsourced service functions can include:

  • Call centers
  • Payroll and bookkeeping
  • Advertising and public relations
  • Building maintenance
  • Consulting and engineering
  • Records
  • Supply and inventory
  • Field service dispatch
  • Purchasing
  • Food and cafeteria services
  • Security
  • Fleet services

This list makes it easy to see why outsourcing has impacted practically all sectors of the business world. Nearly every business has at least one or more of these functions.

However, outsourcing has some inherent disadvantages. The company often has less direct oversight and control of the product or service it's purchasing, which can threaten the relationship between the company and its customers.

Communication can cause problems. Outsourcing overseas can lead to language barrier issues. Outsourcing, especially offshore, is sometimes criticized, which can mean bad public relations for a company. Security issues, such as keeping proprietary information private, also can arise. Hiring an outside company presents challenges to the hiring company.

Outsourcing's impact is, therefore, far reaching. Check out the next page to learn more about the economics of outsourcing.

The Economics of Outsourcing

­For large call-centers such as this one in Israel, it's often more cost-effective for companies to outsource.
­For large call-centers such as this one in Israel, it's often more cost-effective for companies to outsource.
© David Silverman/Getty Images

As with most business trends, outsourcing has its roots in simple economics.

Take the case of the fictitious Smith & Co. Manufacturing we discussed earlier. For the company to hire a new line of engineers and equip them it would spend considerable resources planning the venture.

  • Where would they work?
  • How many employees do we need?
  • Where do we find them?

Companies would have to address those questions before hiring, training, housing and equipping the engineers. And once hired, the engineers must be paid. Benefits like medical insurance and retirement contributions typically cost another 30 percent to 40 percent of an individual's salary. If the venture collapses under its own weight, the company's unemployment insurance also will take a hit.

Putting all this together takes time, and time, as the old saying goes, is money. Using this approach, Smith & Co. would have to be well assured that such a massive investment would pay off steadily over many years to justify it. In many cases, companies would rather be less adventurous with their capital.

On the other hand, if Smith & Co. can find an existing engineering firm with the precise expertise their new product requires, they can save time, money, risk and resources. The new product can launch faster and cheaper, meaning more profits for the company and its shareholders.

Smith & Co. is one example of how outsourcing can impact a company and its workers favorably. The practice is criticized, however, when existing company employees lose their jobs when companies choose instead to outsource them. Outsourcing jobs to companies located overseas is typically singled out for particular condemnation, pitting workers against companies and prompting political debate over regulation of such ventures.

Some critics have said outsourcing overseas results in Americans losing their jobs. There are plenty of examples, however, of overseas outsourcing saving domestic jobs, as well. A BusinessWeek article from January 2006 detailed a Midwest printing and packaging company that partnered with an India-based engineering firm in a bid to increase efficiency and its competitiveness and keep the production facility in the United States.

According to The Heritage Foundation, a conservative think tank, the most dire predictions estimate that 3.3 million service jobs will become outsourced to a foreign country by 2015. However, over the past decade Americans lost 7.71 million jobs each quarter. Outsourcing, therefore, amounts to a tiny fraction of jobs lost in the United States. The group also reported that studies show countries with policies that encourage economic freedom strongly correlate with high per-capita production, and the very nature of outsourcing -- getting more production output from lower production input -- leads to a higher standard of living and more economic growth.

Also, the group reports that companies in other countries are also outsourcing to the United States. The Organization for International Investment reports the number of jobs sent to the United States has grown by 82 percent while the number the United States outsourced overseas grew by just 23 percent. The jobs coming into the United States often pay more than those it outsources overseas, the group reported.

So, when does it make sense to outsource locally versus overseas. Turn to the next page to find out.

Outsourcing Locally vs. Overseas

Many companies use outsourcing to help lower their costs like this company based in Israel, which provides telemarketing services for America Online.
Many companies use outsourcing to help lower their costs like this company based in Israel, which provides telemarketing services for America Online.
David Silverman/Getty Images

We said earlier that one of the main advantages to outsourcing is that it allows companies to access the world class talent -- that is, a company could hire the best widget engineer, not just settle for the available one.

But when does it make sense to hire someone overseas, as opposed to one across the street or even a nearby city? It's a balance of several things.

In general, companies typically cite factors such as quality commitment, price, reputation, business culture compatibility and location when selecting a vendor for outsourcing. Additional factors like understanding goals, constant management of the business relationship, well-written contracts and strong communication are also important for the ongoing success of an outsourcing relationship.

The choice to go offshore or hire locally can hinge on these factors as well as language compatibility, the labor pool's skill and size, security and privacy, the local education systems ability to support the labor pool and the legal culture and stability of a country.

People who live and work near one another or at least within the same state or national boundaries will have more in common in terms of language, business culture and background. This can make communications and management easier. Also, it's simply easier to conduct on-site meetings and inspections when one doesn't have to travel overseas to do so. If the particular expertise a company is seeking can be found nearby at a good price, it seems logical most companies would select that option.

As always in business, however, price can be a major concern. Outsourcing overseas can be less expensive for a company and is just one of the advantages to going offshore for outsourcing needs. This is true for several reasons.

Wages in many countries are lower than in the United States. Labor is one of the prime costs in manufacturing or the service industry, so that alone can mean a substantial savings to a company. In the case of manufacturing, raw materials may also be less costly in certain countries. Also, foreign countries may offer a more business-friendly regulatory environment, lower corporate taxes and tax shelters and financial incentives for American business to invest in their countries.

Often when a company opens a factory overseas it ends up selling the products made there in that country. This allows the company to access a foreign market more economically.

Overseas outsourcing shows no signs of slowing down. NetworkWorld.com reported in January 2008 that research firms predict more overseas outsourcing companies will open this year, giving companies in both the United States and Europe more selection. The research firm Gartner predicted offshore spending to increase by 60 percent for European companies and 40 percent for U.S. companies.

India is a leader among countries that receive outsourcing work from overseas. But other countries, including Russia, China, Ireland and South Africa are also elbowing their way up the list, the article stated.

In the next few sections, we'll look at some of the fields that are beginning to rely on outsourcing more and more.

Animation Outsourcing

Many U.S. cartoon shows such as The Simpsons, shown here at their big-screen debut, are finished by overseas animators.
Many U.S. cartoon shows such as The Simpsons, shown here at their big-screen debut, are finished by overseas animators.
Michael Buckner/Getty Images

If you or your children watch cartoons, you're likely benefiting from outsourcing. An industry group recently estimated the worldwide animation production market is between $50 billion and $70 billion [source: rediff.com].

Many entertainment companies, from Disney to MTV to Cartoon Network to Warner Bros., outsource many of their animated features to studios offshore. Shows like "The Simpsons" and "Futurama," along with feature-length animated movie releases may have been conceived in the United States, but brought to life overseas.

This isn't a new trend. It started decades ago when Hollywood studios began sending pre-production work to lower-priced overseas studios, where the work was polished and completed. India, South Korea and the Philippines were often destinations for this work.

Studios in these and other countries perform all kinds of animation work, including traditional hand-drawn cel, 2-D, 3-D, special effects, modeling, caricatures, medical animation and the recently popular CG format. The extended boom has spawned hundreds of animation companies employing thousands of artists, animators and technicians using state-of-the-art equipment and techniques such as SGI, SFX and other motion-capture software and facilities.

India has been a consistent leader in U.S. animation outsourcing. In 2004, the National Association of Software and Services Companies estimated the country's total animation production sector's revenues at about $250 million.

Its population boasts a large number of English-speaking workers, which is an important advantage when working with English-speaking animated characters. It also helps prevent language barrier issues. The country also has a large domestic animation market, so it has a high number of top-notch studios coupled with a large pool of talented but reasonably priced technicians and engineers.

Price is another India selling point. One survey placed the per-hour cost of Indian animation at $60,000 while the same cost in the United States would cost about $250,000 to $300,000 [source: Asia Times].

At one point, a $100 million full-length animated film made in America could be made in India for about $20 million.

Some overseas studios that once relied on their pricing to gain a toehold in the U.S. animation market are now instead pitching top quality work as their main selling point. An October 2007 article in Variety told how a studio called Rough Draft Korea is thriving by "consistently producing the highest-quality animation and on schedule."

Still, price remains an important point. Some industry watchers think China will become a strong player in the animation business through its large labor pool and high number of artists.

Besides outsourcing animation services, many companies also outsource their information technology functions. Learn more about IT outsourcing on the next page.

Outsourcing Information Technology

Information technology services are one of the frequently outsourced areas.
Information technology services are one of the frequently outsourced areas.
Amro Maraghi/AFP/Getty Images

As anyone who works with computers knows, having a good support person on hand is a valuable asset. Companies also are turning to outsourcing for their information technology service needs.

Information Technology, or IT, involves creating and supporting computer-based information systems, including networking, software and hardware. The field is in high demand as more businesses come to rely heavily on IT systems.

The demand for outsourcing IT services is growing worldwide. CNET News in 2005 reported that the global market for IT outsourcing topped $84 billion in 2004 and predicted it would grow by about 6 percent each year through 2010. The U.S. market, placed at $33.8 million in 2004, would grow at 4.2 percent during that time.

The research firm, Gartner, predicted India's domestic IT services market would reach almost $11 billion by 2011. Such growth prompted industry giant IBM to announce in February 2008 that it would open a new IT services center in India by mid-year. Reuters reported that the center would employ about 3,000.

The growing demand for outsourcing IT services stems from the costs companies incur by keeping such functions in-house.

There are many advantages to outsourcing IT services. By shopping around, a company often can find a good match for the exact services it needs. It's often cheaper than keeping the function in-house, both in terms of staffing, training and lost time. The cost savings also allows companies to concentrate on competing in their core business arena.

However, there are some disadvantages. Outsourcing IT services doesn't always bring the instant 30 percent savings many studies cite, especially among smaller companies where economies of scale are not present.

Also, entering into an agreement with a poor quality company might trap the hiring company into a cycle of dependence from which it's difficult to escape. The cost of extricating itself from such an agreement may be substantial in terms of lost time and employee morale. Some business may lose some control over this area and communicating with an organization outside your own can be a hassle. And in the end, some IT services vendors may simply oversell their true capabilities.

Outsourcing IT services is a growing trend as is outsourcing human resources functions. Find out more about human resources and outsourcing on the next page.

Human Resources Outsourcing

Many companies outsource corporate human resource functions including recruiting and hiring.
Many companies outsource corporate human resource functions including recruiting and hiring.
Photographer: Maxexphoto | Agency: Dreamstime

For most business, personnel is its largest cost. People are talented, dedicated and valuable, but they're also expensive and sometimes complicated to manage. It's no wonder more businesses are turning to outsourcing for their human resources needs.

A human resources vendor can recruit and screen potential employees, manage their benefits and payroll after they're hired, navigate government regulations and employment laws and even handle disciplinary actions, all at an employer's direction.

A human resources outsourcing firm can improve efficiency and help align a company's workforce with its long-term goals. When a company chooses to outsource human resources, it purchases not only the services but the vendor's expertise and experience in selecting top-quality employees who are well suited for their role.

Outsourcing human resources allows the company to shed the paperwork and business processing aspect of its workforce. It also can choose to turn over recruiting responsibilities to the vendor, which can be an expensive time-consuming chore. Human resources vendors will also manage employee benefits, such as payroll, customer service, Family-Medical Leave Act administration, defined benefit administration, performance reviews and retirement contribution administration.

It's up to the company to choose a service level. On one end of the spectrum, a company may outsource a handful of selected repetitive services such as managing annual open benefits enrollment, administering flexible spending accounts or conducting background checks on prospective employees. This sometimes is called "discreet services."

On the opposite end is total human resources outsourcing, in which a company turns over virtually all human resources functions to an outside vendor. This can include recruiting, payroll, in-house communications and customer relations. The vendor also might consult with the company on long-range workforce recruitment planning and training.

Some disadvantages to outsourcing human resources can include a sense of distance between the company and its employees, dissatisfaction among employees with the vendor and a poorly matched vendor alienating a company's employees through poor practices.

As markets continue toward globalization and technology improves, outsourcing will continue to grow. Companies continue to re-evaluate and re-invent the way they do business, and outsourcing goods and services is often a consideration. Despite some political opposition, the practice continues to offer cost-benefit incentives, which can help companies all over the world be more competitive.

For lots more information about outsourcing and related topics, check out the links on the next page.

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