Business Essays - Outsourcing Process Product

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Outsourcing Process Product

Concept of Outsourcing

Outsourcing is subcontracting a process, such as product design or manufacturing, to a third-party company, (Overby, 2007). The decision to outsource is often made in the interest of lowering firm costs, redirecting or conserving energy directed at the competencies of a particular business, or to make more efficient use of labor, capital, technology and resources. Outsourcing became part of the business lexicon during the 1980s.

According to Overby (2007) outsourcing involves the transfer of the management and/or day-to-day execution of an entire business function to an external service provider. The client organization and the supplier enter into a contractual agreement that defines the transferred services. Under the agreement the supplier acquires the means of production in the form of a transfer of people, assets and other resources from the client.

The client agrees to procure the services from the supplier for the term of the contract. Business segments typically outsourced include information technology, human resources, facilities, real estate management, and accounting. Many companies also outsource customer support and call center functions like telemarketing, customer service, market research, manufacturing, designing, web development, content writing, ghostwriting and engineering.

According to Okonkwo (2007) outsourcing is contracting with another company or person to do a particular function. Almost every organization outsources in some way. Typically, the function being outsourced is considered non-core to the business.

An insurance company, for example, might outsource its janitorial and landscaping operations to firms that specialize in those types of work since they are not related to insurance or strategic to the business. The outside firms that are providing the outsourcing services are third-party providers, or as they are more commonly called, service providers.

Although outsourcing has been around as long as work specialization has existed, in recent history, companies began employing the outsourcing model to carry out narrow functions, such as payroll, billing and data entry. Those processes could be done more efficiently, and therefore more cost-effectively, by other companies with specialized tools and facilities and specially trained personnel, (Stein, 2005).

Currently, outsourcing takes many forms. Organizations still hire service providers to handle distinct business processes, such as benefits management. But some organizations outsource whole operations. The most common forms are information technology outsourcing (ITO) and business process outsourcing (BPO).

Business process outsourcing according to Stein, (2005) encompasses call center outsourcing, human resources outsourcing (HRO), finance and accounting outsourcing, and claims processing outsourcing. These outsourcing deals involve multi-year contracts that can run into hundreds of millions of dollars.

Frequently, the people performing the work internally for the client firm are transferred and become employees for the service provider. Dominant outsourcing service providers in the information technology outsourcing and business process outsourcing fields include IBM, EDS, CSC, HP, ACS, Accenture and Capgemini.

Some nimble companies that are short on time and money, such as start-up software publishers, apply multisourcing -- using both internal and service provider staff -- in order to speed up the time to launch.

They hire a multitude of outsourcing service providers to handle almost all aspects of a new project, from product design, to software coding, to testing, to localization, and even to marketing and sales.

The process of outsourcing generally encompasses four stages, which are:

  • strategic thinking, to develop the organization's philosophy about the role of outsourcing in its activities;
  • evaluation and selection, to decide on the appropriate outsourcing projects and potential locations for the work to be done and service providers to do it;
  • contract development, to work out the legal, pricing and service level agreement (SLA) terms; and
  • outsourcing management or governance, to refine the ongoing working relationship between the client and outsourcing service providers.

In all cases, outsourcing success depends on three factors such as executive-level support in the client organization for the outsourcing mission; ample communication to affected employees; and the client's ability to manage its service providers.

The outsourcing professionals in charge of the work on both the client and provider sides need a combination of skills in such areas as negotiation, communication, project management, the ability to understand the terms and conditions of the contracts and service level agreements (SLAs), and, above all, the willingness to be flexible as business needs change.

Process of outsourcing

Deciding to outsource: The decision to outsource is taken at a strategic level and normally requires board approval. Outsourcing is the divestiture of a business function involving the transfer of people and the sale of assets to the supplier. The process begins with the client identifying what is to be outsourced and building a business case to justify the decision, (Overby, 2007).

Supplier proposals: A Request for Proposal (RFP) is issued to the shortlist suppliers requesting a proposal and a price.

Supplier competition: A competition is held where the client marks and scores the supplier proposals. This may involve a number of face-to-face meetings to clarify the client requirements and the supplier response. The suppliers will be qualified out until only a few remain.

This is known as down select in the industry. It is normal to go into the due diligence stage with two suppliers to maintain the competition. Following due diligence the suppliers submit a "best and final offer" (BAFO) for the client to make the final down select decision to one supplier. It is not unusual for two suppliers to go into competitive negotiations, (Stein, 2005).

Negotiations: The negotiations according to Stein (2005) take the original RFP, the supplier proposals, BAFO submissions and convert these into the contractual agreement between the client and the supplier. This stage finalizes the documentation and the final pricing structure.

Contract finalization: At the heart of every outsourcing deal is a contractual agreement that defines how the client and the supplier will work together. This according to Overby, (2007) is a legally binding document and is core to the governance of the relationship.

There are three significant dates that each party signs up to the contract signature date, the effective date when the contract terms become active and a service commencement date when the supplier will take over the services.

Transition: The transition will begin from the effective date and normally run until four months after service commencement date. This is the process for the staff transfer and the take-on of services, ((Overby, 2007).

Transformation: The Transformation is the execution of a set of projects to implement the service level agreement (SLA), to reduce the total cost of ownership (TCO) or to implement new services. Emphasis is on 'standardisation' and 'centralisation' (ibid).

Ongoing service delivery: This is the execution of the agreement and lasts for the term of the contract.

Termination or renewal: Near the end of the contract term a decision will be made to terminate or renew the contract. Termination may involve taking back services (insourcing) or the transfer of services to another supplier, (Overby, 2007).

Concept of Productivity

Productivity has become a household word as almost everyone talks about it. Yet, the term ‘productivity’ means different things to different persons. As a phenomenon, it ranges from efficiency to effectiveness, to rates of turnover and absenteeism, to output measures, to measure of client or consumer satisfaction, to intangibles such as disruption in workflow and to further intangibles such as morale, loyalty and job satisfaction.

To put it bluntly, the definition of productivity is complex and this is because it is both a technical and managerial concept. Productivity is a matter of concern to government bodies, trade unions and other social institutions not minding the disagreements over its conceptualization by different groups and individuals.

Hence, discussing productivity at all levels is common because of the direct relationship between productivity and the standard of living of a people. It is perceived that the more different are the goals of the different individuals, institutions and bodies that have a stake in productivity as a problem, the more different their definitions of productivity will be.

The least controversial definition of productivity is that it is a quantitative relationship between output and input (Iyaniwura and Osoba, 1983, Antle and Capalbo, 1988). This definition enjoys general acceptability because of two related considerations. One, the definition suggests what productivity is thought of to be in the context of an enterprise, an industry or an economy as a whole.

Two, regardless of the type of production, economic or political system, this definition of productivity remains the same as long as the basic concept is the relationship between the quantity and quality of goods and services produced and the quantity of resources used to produce them (Oyeranti, 2001).

Oyeranti, (2001) defined productivity as a ratio of some measure of output to some index of input used Put differently, productivity is nothing more than the arithmetic ratio between the amount produced and the amount of any resources used in the course of production. This conception of productivity goes to imply that it can indeed be perceived as the output per unit input or the efficiency with which resources are utilized (Samuelson and Nordhaus, in Oyeranti, 2001).

Olaoye in Oyeranti (2001) observed that productivity as a concept can assume two dimensions: namely total factor productivity (TFP) and partial productivity. The former relates to productivity that is defined as the relationship between output produced and an index of composite inputs; meaning the sum of all the inputs of basic resources notably labour, capital goods and natural resources. Eatwell and Newman (1991) captioned total factor productivity as ‘multi-factor productivity’.

For the latter, output is related to any factor input implying that there will be as many definitions of productivity as inputs involved in the production process whereby each definition fits a given input. For example, when output is associated to per man-hour or per unit of labour, this definition of productivity is a partial one and it relates to labour productivity. Partial factor productivity is equally known as average product. Symbolically, if Y stands for output, and Fi for any individual factor, we have APF = Y/Fi where APF is the average product. It only measures how the output per unit has changed over time, ignoring the contributions from other factors to the detriment of production process reality.

Current economic realities (liberalized and dynamic markets, constantly changing customer preferences, new structure of production and work, etc.) are leading to a rethinking of the notion/concept of productivity. Whereas traditionally, productivity is viewed mainly as an efficiency concept (amount of outputs in relation to efforts or resources used), productivity is now viewed increasingly as an efficiency and effectiveness concept, effectiveness being how the enterprise meets the dynamic needs and expectations of customers (buyers/users of products and services) i.e. how the enterprise creates and offers customer value.

Productivity is now seen to depend on the value of the products and services (utility, uniqueness, quality, convenience, availability, etc) and the efficiency with which they are produced and delivered to the customers.

The broader conception of productivity is incorporating wider definitions of what the outputs and inputs are of the production-distribution process. The social and ecological impacts are now increasingly considered as outputs of the production process in addition to the traditional physical and value measures of outputs. Similarly, the social and ecological costs are now also being recognized as inputs in the productivity equation.

With increasing concerns on the social and ecologic impacts of the operations of enterprises, the definitions of what are inputs and outputs are changing. Social and ecological inputs and outputs are increasingly being factored-in in the efficiency and effectiveness performance of the enterprise.

Productivity improvement must now focus on value creation rather than on minimization of inputs, (Tolentino, 2004). Higher customer value is created when the products and services meet customer needs for utility, timeliness, esteem, service, etc. This is what customers buy and pay for. With the rapid advance of technology and greater access to information, customer expectations are constantly changing and becoming more demanding.

For long term productivity and competitiveness therefore, enterprises must constantly innovate (come-up with new and better products and develop better ways of doing things), be flexible and agile, respond rapidly to the increasingly sophisticated customer needs which are constantly changing, and be able to anticipate and adjust to the very dynamic market conditions.

Outsourcing and its impact on productivity

As early as the 1960s, Baumol (1967) argued that one of the major reasons for the growth of the services sector could be linked to services outsourcing in the manufacturing industries (ten Raa and Wolff, 2001). The fact that manufacturing industries to an increasing extent could outsource their less efficient service activities, and focus on their core competences, led to significant productivity gains in the industry, and increased the already existing productivity gap between the manufacturing industry and the service sector – a phenomenon that was later called “Baumol’s disease”.

Not all services sectors, however, are affected similarly by ICT services sometimes noted as an example of a sector that may contribute to improved productivity growth, (Wölfl, 2005).

Siegel and Griliches (1992) investigated if outsourcing of services by manufacturing industries led to an overstatement of manufacturing productivity. However, when examining the acceleration of manufacturing TFP and outsourcing of services they found only a weak link. While replicating these results, a later study by ten Raa and Wolff (2001) also provided indirect evidence supporting the theory of Baumol’s disease.

Their findings suggest that manufacturing industries had been especially successful in outsourcing relatively inefficient services over 1987-1996, but that increasing services inputs observed alongside with the TFP growth recovery over 1977-1987 could stem from both outsourcing and a general substitution of service activities for material inputs.

Fixler and Siegel (1999) provide some insights into outsourcing and its productivity impact on the services sector. Their empirical evidence suggests that outsourcing led to short-run reductions in services sector productivity, but that productivity improvements can be expected, especially for business services, once outsourcing of services by manufacturing firms will subside relative to production capacity in the services sector. They also argue that productivity in the services sector will increase as outsourcing by service firms increases, although they provide no direct evidence of this.

Over the second half of the 1990s, the United States experienced a strong economic expansion and an increase in productivity growth. There is little dispute that this was primarily driven by large IT investments facilitated by falling hardware prices, and the transformation of economic activities that these investments brought.

Mann (2003) argues that although technical change is the most important driver of IT hardware price declines, international trade and the globalisation of IT hardware production also played a major role.

More specifically, she estimates that over 1995 to 2002, the international fragmentation of IT hardware manufacturing led to a price decrease between 10% and 30% of IT hardware. This translated into a higher productivity growth of 0.3 percentage points per year corresponding to an accumulated USD 230 billion in additional GDP. Moreover, IT capital deepening and IT diffusion are now fuelling an increasing demand for IT services and software, which has allowed new business areas and economic activities to emerge.

Mann argues that as offshoring in IT services and software production increases, prices will fall considerably in these areas too, which in turn will foster further productivity increases as the economy adopts a higher degree of pervasive computing. Moreover, since the price elasticity of IT services’ demand is higher than that of IT hardware demand, the potential increase in productivity could even be greater than it was in the 1990s.

Some of the earliest attempts to estimate the effects of fragmentation on plant productivity using micro-data include Görzig and Stephan (2002), and Girma and Görg (2002, 2004). However, while both studies focus directly on outsourcing as an explanatory factor of productivity, neither of them make the distinction between domestic and international outsourcing.

Görzig and Stephan (2002) examine a panel data set of about 43 000 German manufacturing companies over the period 1992-2000. They estimate firm performance measured by both the returns per employee, which could be interpreted as productivity, and the return on sales.

Three different measures of outsourcing are employed, and are all related to internal labour cost. The first is “material inputs” which reflects make-or-buy decisions by the firms and therefore resembles material outsourcing to external suppliers. The second is “external contract work” meant to reflect subcontracting, and the third is “other costs not related to production” capturing outsourcing of services.

Generally, Görzig and Stephan find a positive and significant effect of all three measures of outsourcing on firm performance, measured as returns per employee. This effect is strongest for material outsourcing, but negative for services in the short run.

Moreover, they find that increased subcontracting and outsourcing of services reduces firm profitability, whereas firms engaged in material outsourcing tend to do better than those that do not outsource. Based on this they conclude that, on average, the level of subcontracting and outsourcing of services that firms have engaged in is above the optimal level. Despite the significance of these results, it should be noted that most of the variation in performance across firms can be attributed to firm-specific characteristics, and therefore remains unexplained.

Girma and Görg (2002, 2004) address the impact of outsourcing on both labour productivity and TFP for three separate UK manufacturing industries over the period 1982-1992. They use plant-level data, including larger establishments with more than 100 employees, in the chemical, electronic, mechanical and instrument engineering industries.

Outsourcing is measured as the cost of industrial services received by an establishment relative to the total wage bill, where industrial services include machine maintenance services and engineering and drafting services only.Thus, compared to other studies, Girma and Görg apply a more narrow measure.

The impact of outsourcing on productivity levels is positive and significant for plants in the chemical and engineering industries, and about three times stronger in the latter. The effect of outsourcing in the electronics sector is negative but insignificant. Girma and Görg also include an interaction term for outsourcing and plant ownership and find that the productivity effect is more pronounced in case of foreign ownership, especially for plants in the engineering sector.

Calabrese and Erbetta (2004) analysed the effects of outsourcing on firm performance in the Italian automotive suppliers sector over the period 1998-2001. Their sample includes 465 plants from the Piedmont region in Italy. Contrary to most other empirical studies using micro-data, their methodology is based on “static” ANOVA analysis of firm performance according to firm categories depending on the degree of outsourcing.

They also apply a “dynamic” ANOVA analysis looking at changes in the outsourcing categories between 1998 and 2001. Three measures of outsourcing all expressed relative to total operation costs were used. The first relates to material outsourcing, the second to services outsourcing, and the third is an integration variable measuring costs of personnel, depreciation and amortisation.

The theoretical rationale for expecting an effect from international outsourcing on plant level productivity is fairly straightforward. Assume that goods are produced in a multistage production process, which for each good involves different stages from basic upstream production to the eventual completion of the final good in the downstream stages.

In this set up, one may expect three different types of effects. In the short run, the plant engaging in outsourcing has access to internationally traded inputs which may be available at lower costs or at higher quality than those available domestically. Hence, increasing use of internationally traded inputs may result in a direct boost in productivity for the plant, shifting its production function outward.

Secondly, in the longer run, international outsourcing may also lead to changes in factor shares, which may have implications for productivity. Assume, for example, two types of labour, skilled and unskilled, where the former has a higher marginal product than the latter. Assume that the less skill intensive upstream production stages are produced with only unskilled labour, while more skill intensive downstream stages use only skilled labour.

If the plant outsources some or all of the upstream production abroad (due to, for example, lower factor prices for unskilled labour in the foreign country) there will be a reallocation of production in the plant towards more skill intensive downstream production.

This, ceteris paribus, will lead to a rise in average labour productivity in the plant (given that wage rates for high skill workers exceed those for low skilled workers). The opposite effect can be expected, if for some reason, the plant outsources more skill intensive downstream stages of the production process.

Thirdly, there will be general equilibrium effects associated with the plant level outsourcing activity. International outsourcing changes the relative demand for factors of production in the domestic economy, which will affect relative factor prices in the economy.

Labour productivity in the Italian automotive industry has generally been in decline over the period, yet Calabrese and Erbetta find that material outsourcing seems to have lessened the decline significantly. This indicates a positive effect on labour productivity from material outsourcing.