Outsourcing and offshoring are often used interchangeably in today's world. The previous doesn't necessarily mean offshoring since a company can outsource its activities to another company, located within the geographical boundaries of the same country. This practice became common once vertical and conglomerate mergers started replacing the more traditional, horizontal mergers. The reason cited was that of core competence, wherein the "acquirer" continued to focus on its main operations, and outsourced certain activities. The purpose was to maintain the acquirers' competitive advantage. "Porter's Five Forces" were the guiding principles behind this strategic decision. The reasoning was that a firm should not abandon its competitive strategy; a strategy in this case being differentiation. By focusing on its strategy, the company could maintain its competitive advantage.
Porter's Five Forces
This concept was developed by Michael Porter, and the following five aspects provide a framework for industry analysis:
- Bargaining power of buyers
- Bargaining power of suppliers
- Rivalry among competitors
- Threat of new entrants
- Availability of substitutes
Offshoring started in the early 1950s. Manufacturing was one of the earliest activities to be outsourced. The shoe and electronic goods' manufacturers were amongst the first ones to benefit from it. Japanese consumer electronics, especially radio transmitters, were designed in the US, but the parts were produced and assembled in Japan. The guiding force behind this decision was cost reduction. It was possible to produce goods in Japan and ship them off to the US at a cheaper rate than carrying on the entire production process within the country. This was also in line with Porter's Five Forces. In this case, the firms followed a cost strategy. Today, Japan is following a similar model when it comes to its electronics industry. The Japanese design the product while manufacturing is done in countries like Malaysia.
The Advantages of Outsourcing/Offshoring
Offshoring has become synonymous with outsourcing. The companies outsource to vendors located in countries like India, China, and Malaysia, in order to avail benefits of specialization and cost reduction. The companies benefit in the form of higher Net Profit After Taxes and consequently, their return on investment (ROI) is higher. ROI is calculated using the following formula: ROI = Net Profit After Taxes ÷ Total Assets
These jobs are mainly operational in nature and require some basic training that is provided by the outsourcing company. Customer service and a few back-office finance and accounting jobs come under the purview of a BPO. Some processes related to human resource are also a part of the vendor's service list. "Call Center" is a popular acronym for a customer service center.
These processes require a relatively higher level of skills. Generally, KPOs employ college graduates. Employees have a certain skill set and are expected to acquire specialization in a specific area. Most people feel that BPOs and KPOs are responsible for a large number of layoffs in the US. However, it can be argued that these jobs constitute the lower rung of the corporate ladder. The residents of developed countries typically have access to a better system of education and generally, aspire for better jobs, both in monetary and non-monetary terms. People working for KPOs do require some specialization, but these jobs do not require strategic decision-making and advanced degrees. The compensation is also not sufficient to entice the US citizens to seek similar employment.
The availability of highly qualified engineers in India has made the country a popular outsourcing destination for IT services. IT industry requires an advanced degree like engineering and has sparked off some controversy. However, it can be argued that, for a long time now, the younger generation in the US has been focusing on finance and medicine. These jobs rank among the highest-paying jobs in the US. The present financial situation has created an uproar, and some people now view outsourcing as the root cause of all evils. Every industry goes through cycles. Recession (sometimes, followed by depression) followed by recovery is the norm. In due course of time, the US economy will recover, the finance industry will receive a boost, and the benefits of this practice will be realized.
Offshoring and Free Trade
The theory of comparative advantage was proposed by the famous economist, David Ricardo, who advocated the principle of Free Trade. He explained the situation when a country needed two goods and could produce only one of them due to limited resources. In this situation, the country would be better off producing the good for which it had a relative advantage and offshoring the production of the other good. The country could then trade for the good it was not producing. This would result in the country, maximizing its total output or GDP. A logical extension of this idea to many goods and countries is what outsourcing is all about.