On feasibility and profitability of outsourcing, pt. I

Outsourcing.

Word with a lot of meanings, interpretations – and emotion. It’s the “big evil”; ripping “us” of work. It’s: “low quality”. It’s an ingenious solution to a lot of traditional investment problems; and all between.

In this article I’d like to point out that the word is used in the sense of getting part of necessary labor force from an outsourcing agency; there’s another common use for the word “outsourcing”, too: completely tearing down non-core organization units in a company and buying the resource from a specialist. Thus the first case is more about production (costs) strategy and seizing opportunities in shorter production runs in the industry, whereas the latter is about corporate strategy.

Outsourcing and unions in the news

Just recently Boeing had trouble with the labor unions of airplane mechanics and manufacturing people; there has been in the planning a roll-out of a completely new Boeing jumbo aircraft, but seems right now that this deal will slip the company’s regular workforce due to striking. Is it big? It’s actually a deal that may decide the very existence and the future of the company.

What happens when a corporation cannot get local workforce, or it has trouble with production due to strikes or other disturbances?

It might outsource. Note; “it might“. Not always.

There are reasons not to (and there are also barriers to using outsourcing, even if it would be economically sensible). Some reasons not to use outsourcing have to do with negotiation politics, law, or plain sense of what is ethical and what is not. However, outsourcing nowadays is a valid alternative to overcome bottlenecks in production.

Thus there are plenty of motivations as to why a corporation outsources: getting labor when there’s no ordinary workforce available; getting specialist skills or manufacturing structures / facilities without investing capital in them; overcoming labor union obstacles or other strictly human resource problems.

But what I’d like to analyze a bit in this theoretical scenario is: without outsourcing, what would happen? Is outsourcing really that bad; or has it become synonymous with negative issues without merit? Rephrasing: What are the lost opportunity costs of not outsourcing?

Backgrounders: 36 word primer

“In microeconomic theory, the opportunity cost of a choice is the value of the best alternative forgone, in a situation in which a choice needs to be made between several mutually exclusive alternatives given limited resources.”

The two key ideas behind outsourcing are…

a) a company mitigates shortages in their own skills, expertise, or time (basically: resources)

b) a company aims for lower unit costs and a greater impulse (amount of done work per time) with outsourcing

Outsourcing generally means that instead of doing a certain work “with one’s own staff”, a company contracts the work to an external workforce; a more or less familiar partner. Outsourcing may be one-time, for instance when there’s clearly an insurmountable task to be done and time is nigh.

On some fields a less cyclic and in fact a semi-permanent outsourced portion of labor has become norm.

An example: fixed labor corporation vs. outsourcing corporation

Let’s assume there are two companies competing in the same market. They’re producing plastic widgets. The products themselves don’t have variance in terms of features or quality, and thus all profit-affecting factors are internal (coming out of the costs of the production process). The demand for the widgets changes seasonally, though not in a very predictable manner.

Looking at the graphical depiction of production, Agileplast can follow the demand curve more accurately. Tradiplast has to choose a certain level of labor force, which tries to minimize two factors at the same time: overcapacity and undercapacity. But for Tradiplast, which factor is more important to get correct – overcapacity or undercapacity? This depends purely on the

Agility – the ability to increase and lower production power – thus starts to play a major role in the competition. It’s assumed that an agile company could reap better benefits (greater sales) out of the same demand fluctuation. If a company however is not agile, it cannot adjust the production power and thus loses sales – either via underperforming on peak demand or having excess workforce in times of lower demand. There are different strategies for both cases: being agile, and on the other hand being a less agile company and trying to find a suitable “middle line” of work force to manage demand fluctuations.

What are the real financial implications of outsourcing? In the very center there’s the fact that all companies probably want to seize (capture) sales from opportunities (perhaps short production runs) that would have otherwise been impossible to achieve. In classical production microeconomics, a product’s costs come from three things: labor, material and energy. Labor costs are broken down to essentially wages and social costs. If for some part of the fiscal year the labor is idle, it means that the aggregate product costs over the produced items tends to rise; since the company has to allocate – and get compensated for – costs somewhere. This also brings up the counter-argument: “Isn’t a company that resorts to outsourcing actually just lazy or incompetent in planning?”

[In Part II, let’s drill down to more modeling]

Links and further related reading

[1] “Meeting Demand” 

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