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 a different country.

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.
• A specialized company might be able to do simple tasks much more cost effectively than you can. Think janitorial services. Many companies outsource that task but have the technical ability to clean its own facilities. Cleaning services are just more efficient at it. Put simply, you have limited resources, and want to focus them on your product and customers.

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, but there are more variables and the risk tends to be higher.

Reasons Not to Outsource

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.

• 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 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.
• Intellectual property can be hard to protect. Once you give away your know-how, you can never take it back. In many countries, legal remedies are suspect, and you can end up competing with companies that you trained when they end up producing products very similar to yours.
• Geopolitical risk can rise. When an industry offshores en masse, the local capability can be decimated. In a crisis, companies can be left without any viable options locally.

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 offshored 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 and a former supplier decides to compete with you directly. 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 to address 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 for 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. There is also the argument that outsourcing can help the recipient country develop faster and increase its economic might. Bottom line, it is a messy, complicated decision that should not be made in haste.

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, and it poses an ethical dilemma for many people.

Bringing Work Back

With the shifting nature of the global economy, few decisions are permanent. Things change. Technology advances. Sometimes it means that the technology or know-how to do work yourself changes your economics and you decide to take the work back in.

Sometimes that means outsourcing costs rise. Cheap labor markets will shift over time. As countries develop, the economic advantage of sending work there diminishes as salaries increase.

Geopolitical forces may also reshape the ease of doing business in a country. Trade wars can dramatically complicate a business plan and can spike costs in unforeseen ways.

As a result of these forces, 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.

NOTE: The COVID-19 pandemic in 2020 created a big drive to start producing more critical products locally. It also highlighted unexpected weak points in the supply chain, where things like packaging materials created product shortages where the main components were all available. Finally, it showed how production of a product with a widespread, complex bill of materials could be halted by just a few shortages from hotspots around the globe.

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. Nobody is going to offer to take a wage cut, so a more palatable option 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. Not every decision comes down to price. Quality, reliability, flexibility, and other factors all carry weight in the decision-making process.

Words of Warning About Outsourcing

• 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. 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 because of 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. If there is a problem with the vendor doing the work for you, they can be replaced more easily, and you will be keeping your most important trade secrets under your own control.

Key Points About Outsourcing

• Outsourcing and offshoring are emotionally loaded activities and carry numerous hidden costs.
• Make sure to do a risk assessment and have 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. The reasons your family outsources its dental needs and garbage collection are not that far off from why your company might outsource some of its work.

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.