Strategic Finance and the Outsourcing Decision

For a long period of time, the term outsourcing has been associated with cost reductions. Outsourcing is generally considered to be an operational tool or at best a tactical tool. However, this has changed in the past few years.

There are many companies across the world which have outsourced or offshored some of their functions and cost reduction was not the major driver behind these decisions. The concept of outsourcing has evolved from the tactical front and now have some strategic aspects as well. In this article, we will have a closer look at the strategic aspects of outsourcing decisions.

Defining Outsourcing

The term outsourcing is generally meant to denote the fact that work has been sent out of the company and will be performed by a third party. This third party may or may not be located in a country that has low-cost labor. However, for the most part, it is located in a country that is cheaper to operate in. For the purpose of this article, outsourcing will also include offshoring. This means that the company does not outsource work to a third party but instead sets up its own shared services center in low-cost countries.

Why Offshoring is a Strategic Decision?

Over the years, many companies have started offshoring their business. This means that instead of outsourcing work to a third party, they set up their own center and outsource work to that center. This can be said to be strategic in nature for the following reasons:

• When a company uses third-party outsourcing companies, they are generally using them for the short run. This means that today third-party suppliers of service are cheaper in a particular country, then the work will be outsourced there. However, tomorrow, if a cheaper alternative emerges, then the work will be outsourced to the cheaper countries.

  By contrast, when a company sets up their own office in a particular country, they are generally in it for the long run. This means that even though labor cost arbitrage is an added advantage, it is not the main deciding factor.

• Companies often make the offshoring decision because of the availability of cheaper and better-quality resources. For instance, it is a known fact that there is a shortage of Science, Technology, Engineering, and Math (STEM) personnel in the United States.

  Over the years, American companies have had to rely on visa regimes in order to get the required personnel immigrated and then provide them with jobs. In the short run, this may be a cheaper and less complicated option. Hence, if we just go by the net present value calculations, this may be a preferred option

• However, American companies have realized that if they take the tough initial decisions and set up their own shop in low-cost countries such as India, they get better access to the talent pool at lower prices. They no longer have to rely on complex immigration procedures which can change at the whim of a nationalistic government. This is the reason that many companies have started their own offshore offices via a partner company. It is true, that this partner company is a separate legal entity and can be closed and moved to another location if required. However, this is not what happens in most cases. There are many examples of shared service centers that have now been successfully operating in companies like India.

Outsourcing is also Becoming Strategic

With the change in the requirements of the customers, outsourcing companies have also realized that they can no longer survive by only providing labor arbitrage. Companies are not looking at lower costs only. Instead, they want a system wherein they can rely on their partner for value-added services. This is the reason why outsourcing companies are trying to move up the value chain by providing turn-key strategic solutions.

Earlier, the service provided was operational. This meant that the requirement gathering and planning were done by the client. They would clearly define a task and then provide it to the outsourcing company who would execute it at the lowest possible cost. Hence, the client would most probably be billed for the number of man-hours that were used to execute a project.

However, over time, outsourcing companies have started providing strategic services. This means that companies can now outsource their entire functions. For instance, companies can simply hand over their technology function to a third-party organization.

The job of requirement gathering, selection of tools, and implementation of the latest versions of the software will then be the responsibility of the outsourcing company. Hence, they will perform the same job as the client’s own shared service center but will try to do so at a lower cost. In such cases, the clients are billed per project instead of being billed per hour of work. This is because the client no longer decides the scope of work or the number of man-hours which it will take to accomplish.

The bottom line is that the outsourcing decision is no longer an operational or a tactical decision. Instead, this decision has become strategic in nature as illustrated by the article above. Hence, the tools and techniques of strategic finance need to be deployed before deciding whether or not outsourcing and offshoring should be used by a company.