Depending on who you are talking to, the idea of outsourcing can promote some very positive or negative reactions. ‘Off-shoring’ and ‘unfair competition’ are thrown against ‘specialization’ and ‘lower costs’. Whether you are considering product development, the provision of specialist services or the handling of back office activities, there are a number of pros and cons that need to be considered.
What is outsourcing?
Outsourcing is defined as ‘the process of paying to have part of a company's work done by another company’. It can therefore cover a wide range of business activities and is usually undertaken as a cost-cutting or efficiency optimization measure. Investopedia states that was first recognized as a business strategy in 1989 and became an integral part of business economics throughout the 1990s and makes the point that ‘the practice of outsourcing is subject to considerable controversy in many countries. Those opposed argue it has caused the loss of domestic jobs, particularly in the manufacturing sector. Supporters say it creates an incentive for businesses and companies to allocate resources where they are most effective, and that outsourcing helps maintain the nature of free market economies on a global scale’.
Typically then, a firm will have a project or an ongoing activity that it wishes or needs to undertake but which, for example, it does not have the necessary in-house skills to undertake, does not form part of its core activities, or which it does not have the resources to fully undertake. The firm will search for another company that specializes in the area and seek to outsource the particular activities to them. The IT sector is one of the main areas – along with Human Resource and finance – that thrives on outsourcing.
Benefits of outsourcing
There are a number of advantages of outsourcing:
- Greater access to expertise. By working with firms who are specialists in a particular area, a company can gain greater access to the relevant skills and knowledge in a quicker timeframe. This can include access to cutting-edge tools and concepts and insight into the developments within the sector that would otherwise not be available. Using an outsourced firm can also give access to a wider pool of expertise and talent, as the contractor will have access to these within its own sector – access that the contracting firm would not be able to gain.
- Greater efficiency. One of the key tenants of economic efficiency, going back to Adam Smith and the Wealth of Nations in the 1770s, is that specialization can increase efficiency and that greater efficiency can increase economic returns – that is, at a company level, by specializing on its core activities, a company is better able to gain a competitive advantage and increase financial returns. By thus avoiding diverting resources into non-core activities and relying on specialized outsource companies to provide these non-core activities (which are core for the contractor company), greater productivity can be generated.
- Reduced costs. One of the primary benefits of outsourcing to hire a dedicated team is that the contracting firm does not need to employ more people to undertake temporary or non-core activities. Given that staff costs make up a large component of ongoing expense for a company, this can substantially reduce costs. As a factor, this should not be underestimated: in the EU, for example, firms need to add an extra 24% in non-wage costs (from 6% in Malta to 33% in France).
- Developing partnerships. Outsourcing can help a company develop relationship with partner companies, whether domestically or abroad. This in turn can generate further business opportunities.
The downsides to outsourcing
There are, however, some disadvantages to outsourcing:
- Lack of direct control. While the relationship between the outsourcing firm and the contractor will be determined by a contract or by a service level agreement, there is a level of reduced control that comes from outsourcing.
- Changes in requirements. Business requirements change, this is a fact of life. But if you need to change the contracting agreement between a company and the contractor, this can be difficult to do if – for example – you are in the middle of a several year-long agreement, or it can result in increased costs for the change in service to be accepted.
- Increased communication issues. Contracting out some of your activities or product development can result in increased communication problems, with staff in both companies having to understand two different companies’ ways of communicating. This can lead to misunderstandings and, in some cases, cause serious problems if there is not the goodwill to resolve issues.
- While product development, for instance, with a specialist contractor can result in a world class product, by definition in an outsourcing relationship you are in the hands of the contractor, to a degree. This means that if the quality of the product is not that which you wanted or which you had agreed with a stakeholder, you will often not be able to solve it yourself and will need to work with the contractor to do so – and that will often involve addition costs.
The decision on whether to outsource, for example for product development or to hire a dedicated development team is one that each company needs to assess for itself. There are considerable advantages in terms of gaining access to expertise and skills and keeping costs controlled. But at the same time there are potential risks of which a company needs to be aware. With effective management and good communication, these risks can be substantially reduced – but both sides in the relationship need to be aware of the need for this and take steps to ensure that the outsourcing runs effectively.