Offshore Outsourcing

What Is Offshore Outsourcing?

The term outsourcing Opens in new window generally refers to the cost-saving strategy through which firms cut costs by transferring a portion or an entire organizational function to an external agency located either domestically or abroad rather than performing it in-house. However, when this function is performed by the firm’s own subsidiary abroad or is outsourced to a firm located in a foreign country through an arm’s length agreement, the term offshore outsourcing comes into play (Harrison and McMillan, 2006).

The National Academy of Public Administration Opens in new window (2006) notes that, in spite of the differences between these terms, the definitions tend to focus on the movement of employment and production of goods or services to offshore locations and imply an increase in imports.

Firms may outsource activities that are part of their strategic core competency (Prahalad and Hamel, 1990) and by divesting non-core functions, firms are able to focus their limited resources on activities that are critical to the business. In this context, competencies refer to a set of skills that cut across traditional functions such as production, finance, sales, etc (Quinn and Hilmer, 1994).

Amusingly, Dell is an example of a company that outsources for strategic reasons. The company regards marketing and sales as its core competencies, which focus on what matters to its customers, and outsources virtually all manufacturing. With a direct sales model, the company concentrates on speeding products through its highly efficiently supply chain, thereby reducing inventory time.

Offshore outsourcing can have an important effect on firms by helping them to accelerate the development of innovative products and services at far lower cost , an effect that has thus far been unmeasured.Brainard and Litan (2004)

The outsourcing of IT functions and services continues to be the dominant offshore activity, but firms are steadily expanding the functions and processes they are relocating to offshore destinations (Lowes, Celner and Gentle, 2004). The scope of these IT services includes: hardware maintenance and support, software maintenance and support, consulting, software development and integration, training and education, IT management, and business process and transaction management (Gartner, 2002).

As with the outsourcing of any business function or service, IT outsourcing involves the sharing or transferring of decision making powers and management control to the external vendor, which necessitates two-way information exchange, coordination, and trust between both parties.

Models of Offshore Outsourcing

Selecting an appropriate model for outsourcing to offshore service providers is an important aspect of a company’s outsourcing strategy.

Depending on the level of flexibility and control needed by the company, a number of potential contractual relationships are possible with the external vendors. They range from full ownership, which offers high control and low flexibility, to short-term contracts, which bring high flexibility and low control (Quinn and Hilmer, 1994).

The most popular models currently in use are joint ventures, captive centers, and outsourcing to offshore service providers. Each of these models is distinct in that they require different types of investments and carry different risks.

1. Joint Venture

In the case of a joint venture, the client company partners with a local firm either by assuming an equity stake or forming an independent company to which both parties contribute resources, and share in the revenues, expenses and management control. The idea is that both organizations would benefit by complementing each other’s strengths.

2. Captive Center

In the captive center approach, the client company sets up its own development center in an offshore location to access critical skills and take advantage of low labour costs. The client company, by leveraging its expatriate staff, sets up its own operations through hiring of local staff. Such a model enables the client company to have full operational control, while at the same time reducing risks related to security, intellectual property, etc.

3. Outsourcing to Offshore Service Providers

With outsourcing to Offshore service providers, Gartner (2005) has proposed a four-tiered Global Delivery Model (GDM) Opens in new window which provides benefits and challenges in terms of proximity to the service recipient, degrees of client interface, and potential for cost savings due to labor arbitrage.

According to Gartner, the key assumption in this model is that there is a risk-adjusted cost benefit as the delivery location of services moves further from the service receiver to take advantage of labor arbitrage in countries where labor costs are less.

At the same time, Tafti (2005) cautions that without the careful consideration of risks such as financial, legal and managerial control at the outset of an IT outsourcing venture, the benefits can be offset not only by financial losses, but also through the loss of individual privacy, data security and IT expertise.

There are three primary modes through which services can be leveraged in the GDM model:

• staff augmentation;
• project-based consulting and system integration; and
• service outsourcing.

In the project based mode, project risk and responsibility are shared between the service provider and client. With service outsourcing mode, the service provider assumes all the risk and responsibility.

Finally, under the GDM model, service providers can render services using either one or a combination of the following delivery options:

• Onsite: services are provided at the client’s location;
• Onshore: services provided from the provider’s location in the client’s country;
• Nearshore: services provided from a different country (e.g. Canada, Mexico) but in the same time zone as the client’s country (e.g. United States); and
• Offshore: services provided from a country several time zones away from the client’s location (e.g. India, Philippines).

The Pros and Cons to Offshore Outsourcing

With major advances in communication and information technologies in recent decades, many service sector activities, especially IT-enabled services, have become increasingly tradable and globalised. The globalization of services brings both advantages and disadvantages.

Offshoring of services enables firms to achieve lower cost, higher productivity, and increased efficiency in production of services; however, it displaces existing jobs and tends to put downward pressure on wages.

Despite concerns, many argue that offshoring of services offers many benefits for the consumers, including lower prices, and that the increased activity creates new job opportunities by way of increased demand for services. Although the pace of offshoring varies considerably from one industry to another, experts predict greater levels of offshoring will occur as firms learn to re-engineer their business processes.