Outsourcing 1

Outsourcing Sean P. Dixon Business 630: Managerial Accounting Oscar Lewis June 27, 2011

Outsourcing 2 Introduction The global market is a competitive place for businesses of todays world. In order for a business to be successful, it must advantage of any business aspects through which they can gain and maintain a competitive edge over other companies in the same line of business. One such business aspect that has become popular is outsourcing. Outsourcing gives companies the opportunity to hire an outside company to complete some of its production and/or service at either a reduced cost or increased productivity rate, or both. Outsourcing, however, does not always indicate an increase in profits. A business needs to decide if outsourcing is the right answer for their company by considering many positive and negative factors. Outsourcing Companies need to have a complete working knowledge of outsourcing to determine whether or not it would benefit the business. According to BusinessDictionary.com, outsourcing can be defined as contracting, sub-contracting, or externalizing non-core activities to free up cash, personnel, time, and facilities for activities where the firm holds competitive advantage (2011). To expand the definition further on the popular topic of outsourcing, BusinessDictionary.com states that, firms having strengths in other areas may contract-out data processing, legal, manufacturing, marketing, payroll accounting, or other aspects of their businesses to concentrate on what they do best and thus reduce average unit cost (2011). Outsourcing is often an integral part of downsizing or reengineering/reorganizing, and may also be known as contracting out. Dean Meyer has an article titled 4 Advantages to Outsourcing that is posted on the SOURCINGmag.com website. His article includes four points that must be taken into

Outsourcing 3 consideration when determining whether or not a company would benefit from outsourcing. The four advantages to outsourcing that Meyer discusses are: y y y y Advantage #1: Outsourcing can save you money Advantage #2: Outsourcing can help you share risk Advantage #3: Outsourcing can help accommodate peak loads Advantage #4: Outsourcing can help develop your internal staff Dean Meyers article explains each advantage separately in detail. The first advantage of outsourcing he explains, which is the saving money advantage, happens because economies of scale save money when unit costs go down as volumes increase. External service providers can achieve economies of scale unavailable to individual firms when they combine the volumes of multiple companies (2005). In other words, if a company can produce its units (whether product or service) at a cheaper cost, then each unit is producing more profit. Outsourcing some or all of a companys production is how the cost is lowered per unit. Before any money can be saved through the use of outsourcing, Meyer (2005) says that certain stipulations need to be met and those stipulations are the following: 1. Economies of scale must exist outsourcing must prove that unit cost will, therefore increasing profit per unit. 2. The economies must be accessible across corporate boundaries outsourcing companies will only agree to become involved as long as they know that they will have multiple clients for their business. 3. The savings must be sufficient to outweigh the additional cost of paying other shareholders a profitmany companies feel that outsourcing is only good as long as profits show a minimum increase of at least 20% after all costs and fees.

Outsourcing 4 The sharing of risk is the second advantage of outsourcing that Meyer discusses. The portfolio effect, as described in Meyers article, is a term used in financial circles by which companies share risk. In investing, its best to diversify your portfolio rather than put all your money in one stock. By spreading your risk, you reduce your total risk (Meyer, 2005). This same principle can be used in regards to outsourcing. Diversifying by the way of outsourcing will allow a company the elasticity to remain successful even in the wake of possible mistakes (Meyer, 2005). Outsourcing can help accommodate peak loads is the third advantage discussed in the article. According to Meyer, outsourcing can be used to minimize fluctuations in headcount that could result from peaks and valleys in demand (2005). A company needs to determine the point at which outsourcing will be better decision financially over trying to keep all production inhouse if this outsourcing scenario is to prove successful. The fourth and final advantage that Meyer discusses is outsourcing can have the advantage of allowing a company to develop its internal staff. There are two strategies that are helpful in achieving this advantage of outsourcing; they are: 1. Contractors may be used at different times to handle either peak loads, off-load less interesting commodity, or end-of-life work. With the contractors handling these issues, the internal staff is then free to pursue new, developmental opportunities. 2. Consultants and vendors can be used to bring in new ideas and to train internal staff. The first point mentioned above allows the companys employees to be able to complete more complex operational tasks by using contractors for the simple day-to-day and theboring/mundane tasks. The second point mentioned helps company employees increase their skill set and/or productiveness by having the company bring in consultants (Meyer, 2005).

Outsourcing 5 However, since each company is different, they need to analyze the four above-mentioned stipulations to see if outsourcing will be good fit and provide the desired outcome for the company. The four stipulations, as long as they are met, can combine to prove successful at indicating that the company may actually benefit from some level or outsourcing. According to R. McIvor (2011), implementing a successful outsourcing strategy requires a framework. The logic of this framework can be applied to a range of business processes, including manufacturing, logistics and design. Effective outsourcing involves analyzing a number of key dimensions, which include relative capability in the process, contribution of the process to competitive advantage and the potential for opportunism from outsourcing the process. It is important to consider these dimensions when discussing outsourcing decisions. Relative capability position Understanding why one firm differs in performance from another is a key issue in competitive strategy. One firm can gain an advantage over another because they can conduct certain organizational processes in a superior manner relative to their competition. In the outsourcing decision, determining whether the organization performs certain processes relative to competitors, and indeed suppliers, is a key issue (McIvor, 2011). Analyzing this dimension is important to determine whether an organization can achieve a sustainable competitive advantage by performing a critical process internally on an ongoing basis. An organization that can perform such a process uniquely well should then continue this process and carry it out internally. Part of this analysis involves understanding the sustainability of a superior performance position. Contributing to competitive advantage Companies need to determine if the process contributes to competitive advantage is central to the outsourcing decision. McIvor states that processes that are critical to competitive

Outsourcing 6 advantage and in which the organizations possess a strong capability should remain internal and receive a considerable level of strategic attention to maintain such a position (2011). He continues on to say that processes that are critical to competitive advantage have a major impact upon the ability of an organization to achieve competitive advantage either through the ability to achieve a lower cost position and/or create higher levels of differentiation than competitors. Processes that are not critical to competitive advantage have a limited impact upon the ability of an organization to achieve competitive advantage (McIvor, 2011). While it is pertinent that these processes need to be performed well, any performance improvements achieved in such processes likely won't be a source of competitive advantage because customers don't see them as key differentiators when they decide to buy the product (McIvor, 2011). Potential for opportunism Organizations need to consider the potential for opportunism from vendors when deciding to outsource. According to McIvor (2011), the following are indicators of opportunism: * The presence of investments in physical or human assets dedicated to a particular relationship will create switching costs for an organization. * This problem is exacerbated if there are a small number of capable suppliers in the supply market. Such conditions make the organization prone to opportunism during the contract and at the time of contract renewal. * Uncertainty both in the business environment and in the requirements of the organization may mean that it is not possible to write complete contracts and renegotiation, and frequent amendments are required as circumstances change. * Complex interdependencies between processes increase the potential for opportunism due to the need for coordination and mutual adjustment.

Outsourcing 7 * Difficulties with measuring supplier performance also can create problems in the relationship, as the organization must expend additional resources to monitor supplier performance. McIvor (2011) also states that a number of strategies can help organizations deal with supplier opportunism in outsourcing. Those strategies are: * The high potential for opportunism may lead the organization to retain the process internally. * It is possible to deal with the potential for opportunism by adopting an appropriate relationship strategy. In an outsourcing situation where there is low level of investment in specific assets and relative certainty in requirements, a short-term contractual arrangement can be adopted. * A potential sourcing strategy involves reducing the complexity of the process by redesigning it into a number of more nonspecific processes that can be provided by more than one supplier. This, in turn, will reduce the level of uncertainty in the transaction (McIvor, 2011). However, outsourcing is not always a guaranteed or sure-fire way for a company to increase productivity and/or reduce production costs; this is true with any business concept. There are some disadvantages to outsourcing that need to be considered by companies. The disadvantages can be broken down into three categories, which are economic, business strategy, and human resource management. The three disadvantage categories are outlined in the article Disadvantages of Outsourcing which is authored by K. Sholastica. The article explains that while outsourcing can occur within a nation, people of today refer to outsourcing as giving out work to foreign companies, which are based in nations where labor cost is low, such as China, India, and Brazil (K. Sholastica, 2010). The way Sholastica defines outsourcing bases his article on the theory that outsourcing is used to help a company save money. There are two main effects that are included in the economic disadvantages of outsourcing; they are: 1. a reduction in the number of available jobs in the companys home

Outsourcing 8 nation, and 2. the company may lose some foreign exchange as a result of the outsourcing (Sholastica, 2010). The business strategy includes two disadvantages of outsourcing; they are: 1. the possibility for compromised product/service quality, and 2. outsourcing becoming a possible grudge factor (Sholastica, 2010). A company that does the outsourcing of their production and/or service may run the risk of outsourcing to another company that does not have the same high quality standards as the company doing the outsourcing. The company doing the outsourcing is trusting that the people doing the actual work will hold up to the companys quality standards. Sholastica explains this phenomenon in better detail by stating that the quality of the output tends to be compromised as a result of unawareness of the American culture among the working people, which often results into the development of cultural barriers and a certain grudge among the people doing the work and their customers (2010). When considered from a human resource perspective, outsourcing can produce certain disadvantages. Oftentimes, the employees who are actually completing the work are on the other side of the world from the clients for whom the work is being completed. Due to that geographical factor, some disadvantages may arise. According to Sholastica (2010), the time difference forces the outsourced workers to work throughout the night, which can have an effect on their health as well as their constitution. Another disadvantage is that the work in many circumstances is of a clerical nature, leading to many arguments by philosophers claiming that outsourcing kills off the ability of an entire generation to think properly. Personal, religious, and political differences between employee and client may arise, thus being another disadvantage. Many examples exist in todays business world of companies large and small that have decided to outsource differing levels of their business. The technological giant known as International Business Machines Corporation, or IBM, is one such example. According to

Outsourcing 9 Hechinger, the IBM company agreed in 2003 to take over most of the computer operations of auto-parts maker Visteon Corporation in an outsourcing deal that the companies say is likely to be valued at more than $2 billion over 10 years (2003, p. B.3). In large companies such as IBM, outsourcing has proven valuable, according to Hechinger (2003), because it frees them from making huge investments for information technology that they may not need in the future. This is a condition that would be a huge selling point for companies aiming to land contracts with companies looking to outsource. The deal that took place between IBM and Visteon was one of IBMs larger deals in outsourcing. The company has identified outsourcing as a major driver of its growth. Services, including outsourcing, have become IBMs fastest-growing line of work. IBM has won other major outsourcing contracts, including one with JP Morgan Chase & Co. The Business 630 class of Managerial Accounting dealt with the topic of outsourcing in week 6. The discussion example pertained to the Hans Products company and whether it would be beneficial financially for the company to make or buy the S-6 part for its production line. Conclusion As stated previously, the global market is a competitive place for businesses of todays world. Companies must take advantage of any business aspects through which they can gain and maintain a competitive edge over other companies in the same line of business. Outsourcing has become that popular business aspect. Outsourcing gives companies the opportunity to hire an outside company to complete some of its production and/or service at either a reduced cost or increased productivity rate, or both. Since outsourcing, however, does not always indicate an increase in profits, we conclude that a business needs to decide if outsourcing is the right answer for their company by considering many positive and negative factors.

Outsourcing 10 References BusinessDictionary.com (2011). Retrieved from WebFinance, Inc. website: http://www.businessdictionary.com/definition/outsourcing.html Hechinger, J. (2003, February 12). IBM Gets $2 Billion Outsourcing Job. The Wall Street Journal (Eastern ed.). p. B.3. Retrieved from http://proquest.umi.com/pqdweb?did=287888721&sid=1&Fmt=3&clientId=74397&RQT =309&VName=PQD McIvor, R. (2011). Outsourcing Done Right. Industrial Engineer, 43(1), 30-36. Retrieved from http://proquest.umi.com/pqdweb?index=9&did=2247629531&SrchMode=1&sid=2&Fmt =4&VInst=PROD&VType=PQD&RQT=309&VName=PQD&TS=1309219928&clientI d=74379 Meyer, N. D. (2005). 4 Advantages to Outsourcing. Retrieved from SOURCINGmag.com website: http://www.sourcingmag.com/content/c051011a.asp?action=print

Sholastica, K. (2010, September 23). Disadvantages of Outsourcing. Retrieved from Buzzle.com website: http://www.buzzle.com/articles/disadvantages-of-outsourcing.html