Tuesday, January 30, 2007


When discussing outsourcing, it is first necessary to distinguish it from offshoring. The first is the transfer of a certain internal task or process outside of an organization - regardless of geography. Offshoring is the transfer of an internal task or process outside of the nation in question - but within the same organization. Thus, if IBM decides to move one of it's offices from the US to India, it is an example of offshoring. If IBM decides to hire another organization to do the work that is currently done in the office in question, it is an example of outsourcing. If IBM decides to hire another organization that operates in India to do the work that is currently done in the US office, it is an example of offshore outsourcing. Get it? The two terms operate on two different axes.

Please note how the terms are often used interchangeably in common parlance even though they have very different meanings.

Next, we consider the purpose of outsourcing - why do organizations do it? Well, as I understand it, the motivation is almost always some economic incentive - usually increased profit margin by means of lowering labor costs. Now, there is an important distinction that has to be observed in the intermediate end of lowering labor costs, so bear with me as a I make a quick fly over of labor costs:

An organization's labor cost are composed of multiple elements, including wages, salaries, health benefits, pensions, etc. I will gloss over everything but wages and salaries. Now, obviously, labor costs incurred by salaries are simply a matter of the number of salaried employees an organization has and what it pays each of them. Wages, on the other hand have the added variable of how many man hours are worked.

Depending on which type of employee (salaried vs. hourly), there are different concerns for the organization regarding labor costs: with hourly employees, there is much concern (particularly in such industries as retail) with having the appropriate number of employees on the clock with regard to the volume of business or production at any given time. With salaried employees, the concern is not so much with hours worked, but with the amount of work there is for them to do, after all, it doesn't make any sense to have a salaried employee for a task that only takes 25% of what would normally be considered a decent day's work.

Now, from these two very general concerns regarding labor costs, one can see two different motivations for (and ways of) outsourcing. With hourly positions, labor cost is a function of Wage * Hours. Thus, reducing either one of the variables reduces the labor costs. Thus, a typical goal of outsourcing is to reduce labor costs by reducing the wage paid to employees by filling positions with workers who are willing to accept lower wages (in terms of actual monetary units - not in terms of a ratio between wages/cost of living, etc.) for one reason or another. Conversely, the same goal could, in theory, be obtained by reducing the number of hours worked by employing more productive workers, but I doubt this actually happens all that much due to the fact that more productive workers usually demand higher wages, because they can.

This type of outsourcing, which is known as Task Outsourcing, is what I believe most people think of when they hear the term 'outsourcing.' They instantly think of a corporation of one size or another eliminating jobs in its home territory and "shipping" them somewhere else because of cheaper labor. There are also other connotations that normally accompany this term, most notably a drop in product/service quality, a cold or greedy motive and/or reasoning on the part of the organization leadership, thick accents on the other end of the telephone, etc.

There is another type of outsourcing,Break/Fix Outsourcing, though, that has to do with a situation to which I alluded with the salaried employee with 75% down time. To fill in more of the picture, think of a small organization that has, perhaps, 15 employees. While some of the employees don't need computers or desk phones to fulfill their tasks, most do. Thus, perhaps 12 or the 15 employees need computers and phones. They also need to collaborate with each other on various projects, share files, access the Internet and email, etc. Now, as I'm sure most readers will have already guessed, this is a case where there are going to be a lot of technical problems for the employees. Things are going to go wrong from time to time. New computers are going to need to be set up, old computers are going to need to be upgraded or repaired, new software will need to be installed, all of the computers will need to be networked, the organization's Internet connection will need to be managed, the organization's proprietary data will need to be secured, etc. Since most of the employees will likely only have average knowledge of computers and networking, there will be no one who can address these issues quickly, meaning that the organization will likely suffer a larger than necessary amount of down time, more lost productivity, high fees to have a technician perform service visits, risk having security breaches, etc.

To handle this, the organization would like to hire an IT person to be on staff to handle these types of issues. The problem is that the organization is so small that there is no way even a clever IT manager will be able to occupy his or her days addressing the organization's IT needs. Since IT managers/staffers are usually people who require full time employment, hiring some one part time is simply not an option. The question of whether the position would be hourly or salaried is mostly irrelevant since, as I said, the person would have to earn what amounts to full time pay one way or another. Thus, the organization has a problem: idle capacity - which in this case is made all the worse by the fact that it is the most expensive kind of capacity, labor.

Other types of idle capacity regard things like machinery, facilities, electricity, etc. For example, think of a pizza parlor that has a building, a number of ovens, etc. On Friday and Saturday nights, they do a lot of business and are quite busy - although they are able to keep up because they staff accordingly and have a sufficient number of ovens and tables, etc. On Monday nights, however, even if they staff at a lower level, they still have the idle capacity - the ovens aren't baking any pizzas, the lights are still on even though there are only 4 people in the restaurant, etc. At this point, the owner of the pizza parlor would probably be willing to accept a lower profit margin in return for greater revenue (since, more revenue, even with a lower margin, is still more than nothing). Thus, the reason why so many restaurants of all kinds have special pricing deals on certain weeknights. (For those of you in the area, think of Anthony's and BWW).

One of the options open to the organization in question is to outsource their IT needs to another company that specializes in providing IT support for such organizations. This IT vendor makes its money by providing products and services to a number of similar organizations. Each organization can't afford to hire a full time IT manager, but they would be able to afford a fraction of such an employee. That's what the outsource organization provides - "part-time" IT support at a proportional price. This type of outsourcing is not usually thought of but is quite important to the economy since it provides necessary division of labor. It is also, as far as I know, much less controversial since no real person ever loses a job as a result of it - rather whole new organizations spring up and employee people based on the need for such services.

Now, the reason I embarked upon this discussion of outsourcing was to bring up this article I read the other day. The author attempts to induce from historic precedents in Ireland and India that task outsourcing doesn't actually save money. This is a point that I've heard many times before, but I has always heard it associated with explanations such as lost sales due to increased customer frustration or lost product quality. What is interesting about this article is that it approaches the issue of whether or not task outsourcing is economically beneficial for the organization doing the outsourcing from a much more fundamental perspective.

While you should read the entire article (and, in so doing, discover that I shamelessly borrowed the author's IT example), I'll summarize the argument: when many organizations jump on the outsourcing bandwagon headed for wherever (whether it is Ireland, India, China, etc.), attracted by the prospects of lowering labor costs thanks to cheaper labor, they are increasing the demand for labor which, by definition, raises the price. In the end, they are forced to outsource again in order to pursue cheaper labor costs. Interesting point.


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