www.elsevier.com/locate/bushor

Outsourcing: Pros and consB

Murray Weidenbaum

Weidenbaum Center on the Economy, Government, and Public Policy, Washington University, St. Louis,One Brookings Drive, Campus Box 1027, St. Louis, MO 63130-4899, USA

0007-6813/$ - see front matter D 200doi:10.1016/j.bushor.2004.11.001

B This manuscript was accepted undeW. Organ.

E-mail address: moseley@wustl.ed

KEYWORDSOutsourcing;United States;Markets

Abstract Overseas outsourcing of jobs is far more complicated than isgenerally understood. Pressures to outsource range from better-serving overseasmarkets to increasing the competitiveness of American business. Outsourcing—domestic and international—responds to management’s desire to focus the firm’sin-house activities on its core competence. A negative side to outsourcing resultsfrom companies doing so simply because beverybody is doing it.Q They may besurprised by accompanying factors such as unexpected costs and complications,as well. Governmental policymakers need to realize that foreign companiesoutsource more business services to the United States than American firms sendoverseas.D 2004 Kelley School of Business, Indiana University. All rights reserved.

1. The complexities of outsourcing

Overseas outsourcing of jobs has quickly becomea controversial national issue. Some see out-sourcing as a way of maintaining or increasing acompany’s competitiveness. Many others viewoutsourcing in a far more negative light, focusingon jobs lost.

Clearly, outsourcing is not a subject that can beeffectively dealt with on a bumper sticker or via 30-second sound bites. Let us start with a littlebackground before we ponder on any firm con-clusions. Outsourcing involves far more compli-cated advantages and disadvantages thandebaters on either side of the argument are willingto admit.

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r the editorship of Dennis

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2. Why do companies outsource?

Many service companies started creating jobs over-seas to gain access to foreign markets. They had toaudit, consult, and repair where customers werelocated, rather than telling those same overseascustomers that they had to come here. Moreover,many foreign markets have been growing quickly,while some domestic areas have become relativelysaturated, or at least mature.

The age of economic isolationism has long sincepassed. Approximately 60% of the revenue ofAmerican information technology (IT) companiesoriginates overseas. That is not unique; in variousindustries, ranging from banking to consumerproducts to job placement services, leading firmsreport that their overseas revenues exceed theirdomestic sales.

Simultaneously, some domestic businesses hiredspecialized workers overseas to respond to U.S.

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diana University. All rights reserved.

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limits on immigration. When American employerscould not get those workers to come here, the needto send the work to them became real. While doingso, the companies learned how to use moderntechnology to shift the location of work econom-ically. They thus became accustomed to takingadvantage of lower costs, both domestic andforeign.

Telecommuting from employees’ homes alsohelped pave the way for some enterprises to extendthe process to new suppliers, at home and abroad.Moreover, the shift of some telemarketing andcustomer service jobs overseas followed an earlierpattern within the United States, when such workwas outsourced from urban to rural areas wherelabor costs were lower (Drezner, 2004).

Most fundamentally, many companies are focus-ing their efforts on their core competence. It is therare enterprise that produces an entire product byitself, or even half of the end value. Mostbusinesses subcontract out most of their activitiesto other companies, mainly domestic. Viewed fromthat perspective, overseas sourcing is a minor partof the trend to decentralize business operations.Nevertheless, many American corporations came toappreciate how frequently the higher productivityof U.S. workers offset the wage differentials andother costs of operating overseas. Thus, theyquickly encountered practical limits to offshoreoutsourcing. To put the matter bluntly, no companycan outsource the management, responsibility, oraccountability of its activities.

On the other hand, outsourcing can help acompany operate in an increasingly competitiveglobal marketplace. Many U.S. companies learnedthe benefits of drawing on workers stationed inother countries. Outsourcing can enable a businessto provide constant coverage, especially for con-sumers who need round-the-clock support (Siems &Rather, 2003). It is frequently impractical for a firmto adopt a unilateral policy against outsourcingwork, especially when its foreign and domesticcompetitors are doing so. There is also a growingdivision of labor. For example, system designers inthe United States working closely with retailersmay conceive an inventory management softwarethat helps use electronic product tags more effec-tively, but once the system has been mapped out,the actual software code could be written byprogrammers in India.

All sorts of adjustments are being made. In2003, Delta Airlines outsourced 1000 jobs toIndia, but the US$25 million in savings allowedthe company to add 1200 reservation and salespositions within the United States (Drezner,2004). Large software companies, Microsoft and

Oracle, have simultaneously increased outsourcingand their domestic payrolls.

It is important to gain some perspective byseeing the relative importance of domesticallyand internationally produced services. Much ofthe current controversy focuses on IT. In 2003,approximately US$120 billion was spent on IT in theUnited States. While approximately 1.4% wasmoved offshore, the 98.6% of the work that stayedhere was not deemed newsworthy.

In total, about 400,000 U.S. positions in IT havegone overseas. Meanwhile, total U.S. employmentrose from 129 million in 1993 to 138 million in 2003,mainly in the service sector. It turns out that, onbalance, the international movement of services isquite positive to the American economy.

This is so because American corporations are notthe only companies that engage in offshoring. In2003, for example, the United States imported(i.e., offshored) US$86.7 billion in private businessservices, which included a lot of relatively low-skilled call center and data entry work done inlower-cost developing countries. However, in thesame year, we exported (i.e., companies in othernations offshored to us) US$133.5 billion of privatebusiness services. That binsourcingQ generated asubstantial array of relatively high-skilled jobs inengineering, management consulting, banking, andlegal services. On average, binsourcedQ jobs pay16% above the national average. A net balance ofUS$46.8 billion flowed to the United States: a 63%increase over 1994, a decade earlier. Such goodnews rarely surfaces in the often emotional debateover the issue of offshoring.

3. The limits to and dangers ofoutsourcing

A word of warning, however, is necessary in theface of current business enthusiasm for overseasworkers. Companies who outsource just becausebeverybody is doing itQ may be surprised byunexpected costs and complications. About one-half of the outsourcing arrangements entered intoend up being terminated, for a variety of reasons.Some new overseas vendors encounter financialdifficulties, or are acquired by other firms withdifferent procedures and priorities (Lutchen,2004).

Businesses that arbitrarily set a fixed percent-age of work to be outsourced will likely regretit. Newcomers to overseas contracting may findthemselves dealing with unreliable suppliers whoput their work aside when they gain a moreimportant client, or their overseas vendor may

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suffer rapid turnover of skilled employees whofind jobs with more desirable firms. TypicalIndian operations in business processing (includ-ing call centers and offices handling payroll,accounting, and human resources functions)often lose 15—20% of their work forces eachyear. While software programming skills areplentiful, managerial experience is in very shortsupply.

Other costly complications may arise. Localhighways and transportation networks may beinadequate. Some overseas companies wind uptransporting their employees to and from work.Also, electricity may not be as assuredly availableas in the United States, where blackouts are veryinfrequent.

Some American companies are paying muchmore in real estate fees for their offshoringactivities than they would in the United States.This negative differential occurs for two reasons:one is the cost of upgrading poor infrastructureoverseas; the second is the fact that inexpensiveoverseas labor pools are usually found in very largecities, while facilities such as call centers backhome are located in lower-cost suburban and ruralareas.

Some U.S. companies limit their outsourcing toroutine engineering and maintenance tasks becausethey worry that their core technology might bestolen by vendors in Asia that do not respectintellectual property rights. U.S. firms may alsoencounter a variety of unanticipated difficulties,such as dealing with arcane legal systems andmeeting the requirements of different tax andregulatory agencies. Furthermore, they may morefrequently encounter corrupt officials in the publicsector.

Additionally, overseas managers often do notunderstand the American business environment:our customers, lingo, traditions, and high-qualitycontrol and expectations for prompt delivery ofgoods and performance of services. In 2003, Dellmoved its call center for corporate business supportfrom India back to the United States after clientscomplained about non-native English speakers withhard-to-follow accents, giving vague answers totechnical questions.

We can recall that many U.S. manufacturingfirms stubbed their toes in their initial encoun-ters with new vendors in Asia. They did not planon geopolitical risks, as in Indonesia, wherechaos followed the ousting of the longtimenational leader. The recent defeat of the Indianprime minister who promoted economic reformsmay also lead to another period of policyuncertainty.

4. What happens to the company’semployees?

The effect of outsourcing on U.S. employment is farmore complicated than it first appears. The visiblepart, or the tip of the iceberg, is widely known andrecognizable: some U.S. employees lose their jobsor get shifted to less desirable positions. Althoughthe iceberg may have had a very large tip in recentyears, serious analysis of the issue must encompassthe entirety of the iceberg.

The total employment effect of outsourcing ismuch larger than what appears at first glance. Farmore U.S. employees keep their jobs becauseoutsourcing helps companies stay competitive,resulting in many getting new or better jobs dueto enhanced financial strength of the firm. Forexample, as companies upgrade their softwaresystems, there may be less domestic demand forbasic programmers, but increased need for higher-paid systems integrators.

Corporate IT departments are changing their mixof in-house skills, and now place more emphasis onmanagerial experience, business process knowl-edge, and understanding the domestic customers.All of these capabilities can rarely be providedeffectively from an overseas location (McKinseyGlobal Institute, 2003).

Outsourcing and the savings it generates are thebeginning, not the end, of the adjustment process.Cost reductions from outsourcing can open up newmarket opportunities for U.S. companies, and thusgenerate additional jobs here at home. Companiesalso can afford to buy new equipment and expandtraining programs under this scenario. Hence, higherdomestic labor costs can be offset by higher workerproductivity (McKinsey Global Institute, 2003).

Over time, there is a positive feedback effectfrom outsourcing. As poor countries overseasdevelop their economies, new markets are createdfor U.S.-made products and services. China hasalready become a major importer of industrial andconsumer goods, as well as of agricultural productsand raw materials. In time, India is likely to do thesame.

Moreover, economic trends rarely move in astraight line for long periods of time. Salaries ofIT personnel in India are reported to be rising at15—20% a year. A more basic factor reducing thegap with U.S. compensation is the fact that demandfor trained IT personnel in India is beginning toexceed the supply. In addition, a lot of hidden costsarise, such as the need for U.S.-based managers tovisit the overseas sites from time to time to assurethat the work being performed meets the standardsof the American firm.

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Some historical perspective is also useful. In theearly 19th century, the United States was a poordeveloping country. European capital helpedfinance our canals, railroads, steel mills, and otherfactories. American workers began to producegoods that competed with European production.Because markets were relatively open, Europeansas well as Americans benefited in the process.Economic growth and job creation occurred onboth sides of the Atlantic. Currently, serviceproviders overseas require American-made com-puters, telecommunications equipment, and soft-ware. They also obtain legal, financial, andmarketing services from United States sources.Employees are increasingly becoming customersof American products, as well.

5. What is the net effect on the UnitedStates?

On reflection, most service jobs cannot be out-sourced. Personal contact is vital in virtually allbusiness activities. It takes domestic companies totailor new products and services to the needs oflocal customers (Drezner, 2004). Most of thepeople we work with regularly remain close by;we normally do not take long trips to see ourdoctor or dentist or lawyer or accountant. Muchless do we go to New Delhi or Manila for thosepurposes.

One of the great strengths of the Americaneconomy is that we have a very open labormarket—a characteristic that is basic to thisnation’s economic vitality. Approximately 1 millionworkers are laid off or quit each week, and an equalnumber are hired in their place. It is much harderto lay off workers in Europe or Japan; however,there is another side to the coin. Employers thereare very reluctant to take on new workers. Instriking contrast, American companies are muchmore likely to add personnel, and do so.

Over the years, far more new jobs have beencreated in the United States than have beenoutsourced; moreover, many foreign companieshave been setting up operations in the UnitedStates, and have hired American workers as staff(Mann, 2003). Our more realistic labor policies dowork, while their labor policy bstraightjacketsQ donot. By its nature, a strong and flexible labormarket has plenty of movement: out of some jobs,and into others. The bottom line is clear: theUnited States creates far more new jobs (net oflayoffs) than Europe and Japan combined. We havethe highest proportion (66%) of the populationemployed of all industrialized countries.

The record also shows that groundbreakingtechnology, rather than international competition,is the major cause of layoffs and new hires.Technological progress is the heart of the dynamicAmerican job-creating economy. Our positive tech-nology environment also encourages foreign manu-facturers, such as pharmaceutical companies, toset up laboratories here.

Adding a factual note to the emotional debateregarding the loss of manufacturing jobs, despitelower wages in some overseas regions, foreign firmshave chosen to produce automobiles made by high-wage American workers. Examples include Honda inOhio, Mercedes Benz in Alabama, BMW in SouthCarolina, and Toyota in California. Moreover, whiledirect manufacturing employment has been declin-ing, total U.S. production of manufactured goodshas risen by about 40% over the past decade. This isa tribute to rapidly advancing productivity, and thecombination of trends is an international phenom-enon. In recent years, China, Japan, and Brazileach lost more manufacturing jobs than did theUnited States (Center for Strategic and Interna-tional Studies, 2004).

A portion of the reported decline in manufac-turing employment is a statistical quirk, as is apart of the rise in service employment. Thatoffsetting change results when a manufacturingcompany contracts out some of its overheadactivities; after all, converting a business functionfrom an overhead burden center in an industrialcorporation to a profit center in a service firm is aprod to achieving greater efficiency and helpskeep American businesses more competitive. Asfor the corporate profits that may result fromoutsourcing, we tend to forget that the typicalshareholder is a pension fund or mutual fundrepresenting ordinary Americans.

6. What should we do?

Do those who advocate laws against Americanbusiness outsourcing really believe that foreigngovernments would not retaliate? It is likely thatthese same people have never given thought to thefact that, in a global marketplace, companies allover the world are outsourcing. The United Statesis both the world’s largest exporter, as well as theworld’s largest importer. In other words, we havethe largest stake in maintaining open markets, bothat home and abroad.

As in many other forms of regulation, proposedgovernment restraints on outsourcing would haveall sorts of unanticipated adverse consequences.Recently, the University of Maryland requested an

Outsourcing: Pros and cons 315

exemption from a proposed prohibition on out-sourcing by agencies and departments of thefederal government. It turns out that the universitymaintains a network of training centers at manyU.S. overseas installations. The alternative toincreasing the skills of Americans stationed over-seas via boutsourcingQ would be to hire foreignerswith the needed skills.

Hysterics aside, the Information TechnologyAssociation reports that setting up bdo-not-callQlists has already eliminated more call center jobsthan all of the outsourcing to India. Conversely, notevery job created overseas equates to an Americanjob being lost; for example, in the past, U.S.airlines traditionally did not pursue small billingdiscrepancies with travel agencies because it wasnot worth the cost incurred. Now, using cheaperIndian workers, the airlines can afford to correctsmall billing errors. For the airlines, it is a welcomesavings, while the practice has also created newjobs in India. Notably, there is no loss of jobs in theUnited States as a result.

Ironically, experts on offshoring report that all ofthe publicity, both unfavorable and favorable, hasbeen generating more awareness on the part ofU.S. companies of the potential benefits of over-seas outsourcing. Nevertheless, the nationaldebate on offshoring requires a constructiveresponse, especially in a presidential election year.Many of the people who lose their jobs are trulyhurting. If old-style protectionism is not a goodanswer, what should we do?

The positive approach is to enhance the produc-tivity and competitiveness of American workers.IBM recently announced the creation of a new

US$25 million retraining program for employeesconcerned about losing their jobs to outsourcing.

More fundamentally, the fact that the U.S. hasthe highest high school dropout rate of all indus-trialized nations is nothing that can be blamed onforeigners. Nor can we be proud of the fact that, atthe other end of the skill spectrum, the UnitedStates has fallen from third to 17th among nationsin terms of the share of 18- to 24-year-olds whoearn degrees in science and engineering. Also, letus not overlook all the regulatory and tax barriersto innovation and to more efficient domesticproduction of goods and services that have beenerected by the U.S. government.

An agenda of economic reforms is long overduein order to make the United States a moreattractive place to hire and keep productiveemployees. Such a debate on outsourcing wouldlead to real sustainable benefits for Americanworkers.

References

Center for Strategic and International Studies. (2004). Tradepolicy challenges in 2004. Washington, DC7 Author.

Drezner, D. (2004). The outsourcing bogeyman. Foreign Affairs,83(3), 22–34.

Lutchen, M. (2004, May). Outsourcing IT headaches is no answer.Chief Executive, 18–19.

Mann, C. (2003, December). Globalization of IT servicesand white collar jobs. International Economics PolicyBriefs, 1 –13.

McKinsey Global Institute. (2003). Offshoring: Is it a win—wingame? San Francisco7 Author.

Siems, T., & Rather, A. (2003, November/December). Do whatyou do best, outsource the rest? Federal Reserve Bank ofDallas Southwest Economy, 13–14.