Is Outsourcing A Good Idea?

On p. 277 of your text, the network organization is defined as ". . . a small core organization that outsources major business functions. This approach allows organizations to concentrate on what they do best and contract out other activities to companies that can do those activities best." Other organizations which are not network organizations can also decide to outsource some of their activities. During the last decade or so, outsourcing has become increasingly popular because (a) it helps firms focus attention on their core activities and avoid getting sidetracked by secondary activities, and (b) it reduces costs. The Bank of Montreal (BMO), for example, outsourced its human resource processing services to Exult Inc., which now manages payroll and benefits administration, employee records, HR call centre services, and other functions that used to be performed in-house at BMO. The new arrangement means a 20 percent reduction in HR costs for BMO, and it also frees up BMO managers to concentrate on more value-added work.

Outsourcing decisions like the one at BMO involve moving jobs from one company to another within Canada, but most outsourcing involves moving jobs from Canada to a foreign country (often called offshoring). Because of this, much concern has been evident about Canadian job losses. But outsourcing may actually be beneficial to Canada. If you wonder how that could be possible, the reasoning goes something like this: Canadian companies outsource certain kinds of work in order to take advantage of low-cost foreign suppliers. This allows Canadian companies to reduce their costs and increase their productivity which, in turn, helps them to be more competitive in global markets. Greater competitiveness of Canadian firms in international markets means more success, more jobs, and a higher standard of living for Canadians.

What about the Canadian workers who lose their jobs when companies outsource work to foreign countries? An interesting study conducted by the Peterson Institute for International Economics found that only one in 25 laid-off workers lost their job because of outsourcing. But even if we accept the argument that outsourcing doesn't actually hurt a lot of Canadian workers, there are still other concerns about the practice of outsourcing. For example, a 2006 study by the Toronto-based Centre for Outsourcing Research and Education found that less than 50 percent of companies that have tried outsourcing are satisfied with it. One of the reasons is that members of the "stay-back team"â€"the individuals who are responsible for managing the new outsourcing relationshipâ€"are under pressure to not only cut costs, but also to increase the quality of the services that have been outsourced. A study by Dun & Bradstreet found that one-quarter of all outsourcing relationships fail within two years, and one-half fail within five years. In addition, many executives feel that suppliers too often don’t understand what they are supposed to do, that they charge too much, and that they provide poor service. Moreover, when disruptions occur in the supply chain, the costs to both parties can be high. For one thing, replacing failed outsourced operations can be very expensive, especially if the firm wants to go back to performing the outsourced activity itself. Another risk is the loss of control over both operations and information.

A fairly dramatic example of some of these problems is that of Boeing Co., which is having many problems getting its new 787 Dreamliner jet airplane to the market on time. In April 2008, Boeing announced that it was pushing back the new jet's market debut until the fall of 2009. The company is now likely to deliver just 25 planes in 2009 instead of the 112 that it was supposed to deliver. Originally, Boeing was supposed to deliver the first 787 to All Nippon Airways in May 2008, but it had recently pushed back that date to early 2009. Now the date has been pushed back until much later in 2009. These delays will cost Boeing millions of dollars in penalties for failure to deliver the new aircraft on time to the 50 different airlines that have placed orders for nearly 900 of the new jets. It will also harm Boeing's reputation for reliability.

Why did these problems develop at Boeing? One culprit is outsourcing. To reduce development costs for the 787, Boeing decided to have different parts suppliers build different sections of the plane. These parts suppliers are located all over the world. For example, the nose section is made by a subsidiary of Toronto-based Onex Corp., the rear fuselage section is made at a factory in South Carolina, the middle fuselage section is made in Italy, and the wings are made in Japan. The idea was that these various sections (subassemblies) would then be assembled at Boeing's Seattle, Washington production facility.

To make this system work, a great deal of discretion was given to the various makers of these subassemblies. But several major problems have arisen: (1) the first 787 subassembly that was sent to Seattle by a supplier was missing literally thousands of parts; (2) parts suppliers have had trouble handling tasks that Boeing employees knew how to do because of their many years experience in building airplanes (for example, Boeing engineers discovered that the "wing box"â€"which connects the plane's wings to the fuselage and also holds fuelâ€"wasn’t strong enough, so hundreds of fasteners were added to strengthen it); (3) suppliers outsourced key tasks like engineering to still other companies; and (4) subassemblies have not been completed on time (for example, the Italian company got behind schedule because it had difficulty getting approval to build its factory in an olive grove).

Boeing is just one company that has experienced problems with outsourcing. Numerous reports of tainted products made in Chinaâ€"for example, children's toys, toothpaste, and seafoodâ€"have been reported in the news during the last year. When problems like these arise, a company's reputation suffers because it looks like the company is more interested in low-cost production than it is in high product quality. Higher costs may be the end result because of lawsuits and recalled products.

There are several things managers can do to reduce the risks associated with outsourcing. Most generally, they must clearly stipulate how the outsourcing process is going to work and the amount of authority and responsibility that suppliers have. For example, the company doing the outsourcing must determine whether it is going to give the supplier the right to do further outsourcing. It must also stipulate performance expectations for the supplier, and specify how the product is to be made. Terrapin Communications Inc. has outsourced production of its main productâ€"a high-tech bracelet called Safety Turtle which has an alarm that goes off if it is immersed in water â€"to Baja Technology Inc. in Zhuhai, China. Safety Turtle is designed for use by children, seniors, and people who work near water. The outsourcing agreement states that Baja must follow detailed instructions when making the bracelet (for example, Baja cannot substitute parts, and they must adhere closely to the bill of materials). Other things which can be done to reduce the risk of outsourcing problems are monitoring procedures the supplier uses when making the product or providing the service, visiting the supplier to inspect the premises, talking to the people who are actually making the product or deliver the service, and ensuring that needed information flows from the supplier back to the company.

In spite of all these potential problems, outsourcing is likely here to stay because of the increasingly global nature of business and because competitive pressures to reduce costs are so intense. In the automobile business, for example, companies like Ford and GM have to compete with highly efficient foreign companies and must therefore cut costs wherever possible. Superior Industries Internationalâ€"a California-based company that makes aluminum wheels for Ford and GMâ€"got blunt messages from both Ford and General Motors to match the price that Chinese wheel suppliers were charging or they would buy the items from a company that could match the price. Since 85 percent of Superior's business was with Ford and GM, it had little alternative but to start outsourcing some work to Chinese factories in order to lower its costs. To do this, Superior got involved in a joint venture with a Chinese company near Shanghai to build aluminum wheels.

Wages in China average about 90 cents per hour compared to $22 per hour in North America. Even after taking into account the large distance between China and North American markets, the cost of Chinese-made radios, cables, brakes, and wheels is still 20 to 40 percent lower than products made in North America. This is causing jobs in the North American auto parts industry to disappear at a rapid rate. This trend has just started; since Ford and GM currently buy less than 5 percent of their parts from China, there is room for dramatically increased amounts of outsourcing. The implication for jobs is not positive.

Foreign companies that receive outsourced work are continually refining their own strategies to become even more competitive. For example, one of the best-known examples of outsourcing is the call centre industry in India. Outsourcing is very important to Indiaâ€"it brings in over US$40 billion to the economy of India and employs 1.6 million peopleâ€"but some big changes are now occurring because Indian wages are rising and companies wanting to do outsourcing are starting to look at other, even lower-wage locations such as Vietnam and the Philippines. Indian companies like Wipro and Infosys are responding by performing more sophisticated services with higher profit margins. Wipro now offers to manage all of a company's information technology (IT) needs rather than just troubleshooting for the company’s IT department, and Infosys has entered the management consulting field. These companies are also opening offices in other countries. Tata Consultancy Service has offices in Canada as well as in several South American countries, while Wipro has offices in Canada, the U.S., and the Middle East. All of this change means that a Canadian company with an Anglo-German parent firm might outsource its IT functions to a firm in India, and that firm would send the actual work to the Czech Republic. That’s globalization in action.

Questions for Discussion

1. What is outsourcing? Why do Canadian companies outsource work?
2. Do you think that Canadian companies are treating Canadian workers unfairly when they outsource jobs to foreign countries? Defend your answer.
3. "Canadian companies really don't have any alternative but to outsource. If they don't, they will not be cost-competitive and will lose out in the global market. If that happens, all Canadians will be hurt." Do you agree or disagree with this statement? Explain.

Sources: Dave Carpenter, "Turbulent Time for Boeing As Jet Delayed Again," Winnipeg Free Press, April 10, 2008, p. B7; J. Lynn Lunsford, "Boeing Scrambles to Fix Problems with New 787 Jet," The Wall Street Journal, December 7, 2007, pp. A1, A13; Jeff Buckstein, "Navigating the Outsourcing Minefield," The Globe and Mail, November 7, 2007, p. B10; Marcus Gee, "Moving On Up In The Outsourcing World," The Globe and Mail, September 26, 2007; Barrie McKenna, "Outsourcing May Not Be The Real Job Killer," The Globe and Mail, May 22, 2007, p. B8; Shane Schick, "Outsourcing Breeds Its Own Middle Management," The Globe and Mail, December 14, 2006, p. B13; John Partridge, "Agency Predicts further Outsourcing," The Globe and Mail, April 26, 2005, p. B5; Norihiko Shirouzu, "Big Three's Outsourcing Plan: Make Parts Suppliers Do It," The Wall Street Journal, June 10, 2004, pp. A1, A6.

Answers to Questions for Discussion

1. What is outsourcing? Why do Canadian companies outsource work?
Outsourcing involves identifying specific activities (for example, tech support or payroll) and contracting out that work to other companies (either foreign or domestic). More and more activities that managers formerly thought should not be outsourced are actually being outsourced.

There are several reasons that Canadian companies outsource work. First, they may outsource work that is necessary, but not their primary focus. For example, the Bank of Montreal outsourced payroll and benefits administration to Exult Inc. While payroll and benefits administration work must be done, that work is not BMO's primary focus. By outsourcing that work BMO personnel are freed up to do other tasks that are more central to BMO's core competency. A second reason is expertise. If a company does not have technical or managerial expertise in a certain area, it can outsource that work to a company that does have the expertise. A third reason is cost savings. Canadian companies often outsource certain aspects of their production to low-wage countries because significant cost savings can be achieved. Once that happens, the company has the flexibility to reduce the prices of its products and therefore be more competitive. Of course, other companies in the same industry have an incentive to do the same thing so they can survive in a highly competitive market.

2. Do you think that Canadian companies are treating Canadian workers unfairly when they outsource jobs to foreign countries? Defend your answer.

There are two quite divergent opinions on this issue. One view is that Canadian companies are being very unfair when they outsource jobs to foreign countries because when they do that, unemployment increases, consumer spending declines, and the Canadian economy suffers. The opposite view is that Canadian companies are actually being very fair and reasonable when they outsource because they are using their limited resources in the most efficient way possible. This, in turn, increases their productivity and the likelihood that they will be successful. The more successful they are, the more likely it is that they will survive, grow, and create more jobs. The case can be made that both of these views have some merit, with the key point being the time frame that is considered. There is no question that in the short-run, job losses are evident when work is outsourced to foreign countries. But in the long-run, the effect may not be negative since (as noted in the paragraph above) Canadian companies will become more efficient and more successful and will likely hire more workers. To make this point clearer, it may be useful to introduce the issue of the effect of automation on unemployment. On the surface, it seems that automation (i.e., replacing human workers with machines) will increase unemployment. And indeed, for the specific workers that are replaced by machines, it does increase unemployment. But in the long-run, automation increases productivity and company success, and that leads to more employment. Note that in spite of the fact that there is more automation today than there was 80 years ago, there are a lot more people employed today than there were 80 years ago.

3. "Canadian companies really don't have any alternative but to outsource. If they don't, they will not be cost-competitive and will lose out in the global market. If that happens, all Canadians will be hurt." Do you agree or disagree with this statement? Explain.

Student answers will, of course, vary. Those agreeing with the statement will likely argue that free trade and the globalization of markets are good things and are the wave of the future. They will point to the increased standard of living for many people in China and India and the rapid development of those economies in recent years. For these students, outsourcing is simply an inevitable outcome of a globalized economy.

Those disagreeing with the quote might argue that management is never really forced to do anything. Rather, management needs to be strongly committed to a certain course of action, and that commitment may not involve outsourcing. They might also express concerns about the downside of globalization (e.g., low wages paid to workers in developing countries, people in developed countries living well at the expense of people in developing countries, etc.). Those who disagree with the statement might also say that management should figure out ways to be competitive internationally without laying off a lot of Canadian workers. In the discussion it is important to emphasize the logical implications of both positions, rather than simply arguing about which position is right.

During this discussion it will be useful to ask students the following additional questions to get them thinking in more detail about the outsourcing issue: a. If outsourcing transfers jobs to low-wage countries, what should we expect to see happening in the economies of those countries?

b. What factors might influence a company to stop outsourcing and return to the practice of in-house production of goods or services? c. Would a company ever outsource an activity to a country with costs that are higher than its own?