What is Offshore Outsourcing?
The term outsourcing Opens in new window generally means that tasks and business processes are contracted to be performed outside the boundaries of the firm by an external firm located either domestically or abroad rather than performing it internally.
However, when the tasks and processes are performed by the firm’s own subsidiary abroad or is outsourced to a firm located in a foreign country through an arm’s length agreement, the term offshore outsourcing applies (Harrison and McMillan, 2006).
- Offshore Outsourcing refers specifically to the practice of outsourcing to suppliers in foreign countries, mainly to take advantage of wage arbitrage.
This practice consists in the arrangement whereby companies typically engage foreign suppliers to perform some or all business functions in a country other than the one where the product or service will be sold or consumed.
Brainard and Litan (2004) propose that offshore outsourcing can have an important effect on firms by helping them to accelerate the development of innovative products and services at far lower cost, an effect that allows companies to focus on other business activities while having some processes handled by outside experts.
Firms may outsource activities that are part of their strategic core competency (Prahalad and Hamel, 1990) and by divesting non-core functions, firms are able to focus their limited resources on activities that are critical to the business. In this context, competencies refer to a set of skills that cut across traditional functions such as production, finance, sales, etc (Quinn and Hilmer, 1994).
Dell Opens in new window is an example of a company that outsources for strategic reasons. The company regards marketing and sales as its core competencies, which focus on what matters to its customers, and outsources virtually all manufacturing. With a direct sales model, the company concentrates on speeding products through its highly efficiently supply chain, thereby reducing inventory time.
Offshore outsourcing occurs commonly in the manufacturing and service sectors. China has emerged as preferred destination for manufacturing offshoring since its induction into the World Trade Organization (WTO) Opens in new window in 2001. Similarly, India has become a major destination for technology-enabled offshoring of services, although there are other countries that are now emerging as alternate destinations.
In these countries, educated workers typically work for a much lower wage than their counterparts in developed countries. For outshore outsourcing to be economically viable, however, savings from the lower wage rate must exceed the additional costs of management and risk associated with offshore outsourcing.
The Pros and Cons to Offshore Outsourcing
Although the decisions to outsource have been traditionally driven by cost savings and are based on the assumption that the advantages of outsourcing outweigh its disadvantages, there are some significant risks that require careful consideration.
One of the major consequences of offshoring IT functions and services is that the outsourcing organization becomes increasingly dependent on the external service provider to perform certain essential functions (e.g. service support to customers), which can subsequently result in the loss of control over these functions or activities.
Other consequences include threats to intellectual property, customer dissatisfaction arising from poor quality of service, underestimating cost savings because of hidden costs, and so forth. For example, a survey of 431 U.S. and Canadian chief information officers conducted by the consulting firm Deloitte & Touche Opens in new window highlights that these companies were consistently disappointed with the IT service providers (Scheier, 1997). Another long-term study of 90 offshore initiatives found that over half of the offshore outsourcing initiatives failed to meet cost savings and contract performance targets (Foote, 2004).
Notwithstanding these risks, offshoring of services enables firms to achieve lower cost, higher productivity, and increased efficiency in production of services. In addition, offshoring of services offers many benefits for the consumers, including lower prices, and that the increased activity creates new job opportunities by way of increased demand for services. Although the pace of offshoring varies considerably from one industry to another, experts predict greater levels of offshoring will occur as firms learn to re-engineer their business processes.