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What is outsourcing? Definition and meaning

Outsourcing means farming out or contracting out services to a third party – not using the company’s own employees to do the work. The company turns over part or all of an activity to a supplier, usually one that specializes in the task. In the past, this occurred mainly in specific activities, but today pervades the management of many companies.

Outsourcing is also the practice of contracting out control of public services to for-profit corporations.

Companies that farm out work to a third party say it cuts costs and gives them flexibility. They also say it improves service quality and speed because it allows them to use specialist suppliers.

Outsourcing
This image contains just a tiny sample of US corporations that outsource work to third-party suppliers – many of them in other countries.

By transferring non-core activities to an outside provider, firms say they can focus on their core business.

Apple’s core business, for example, is to design its computers so that it has an edge over the competition. It outsources the manufacturing of its iPhones and iPods. The company says that it reduces costs considerably.

According to the Merriam-Webster dictionary, outsourcing means:

“To send away (some of a company’s work) to be done by people outside the company.”

The term ‘global sourcing‘ means seeking products and services beyond one’s border. It has the same meaning as outsourcing, i.e., when the supplier is foreign.

Outsourcing vs. offshoring

The two terms – outsourcing and offshoring – do not have the same meaning, even though we commonly use them interchangeably.

Offshoring also involves turning over certain activities to an outside supplier – but the supplier is abroad. Outsourcing might include either a domestic or foreign supplier.

Why outsource
Outsourcing is a strategy by which a company farms out major functions to specialist service providers. These providers eventually become valued business partners. In some cases, it involves transferring employees from the company to the third-party provider.

Using a foreign supplier with cheaper labor costs has become increasingly more common for companies in the advanced economies. The practice has also become a political hot potato because unlike giving work to domestic suppliers, local workers see it as the exportation of jobs.

Apart from allegedly causing unemployment, workers in the company’s home country say that offshoring keeps wages low. Their wages stay low because their employer tells them that if labor costs rise too much at home, they will outsource more and more work abroad.

The concept ‘outsourcing’ came from the American Glossary ‘outside resourcing’ and dates back to 1981.

The opposite of outsourcing is insourcing, which means bringing activities done by third-party firms back into the company.

Why do companies outsource?

The main reason companies outsource is to reduce costs, especially non-core or peripheral business expenses, production costs, labor costs, and high government regulations/mandates. Other high costs also include elevated rates of tax and greater energy costs.

In the United States, with its corporate taxes and mandated benefits for workers, the incentive to outsource is strong.

However, US companies do not appear to outsource executive or managerial tasks, which burden businesses with enormous costs.

Executive pay in the US in 2007 was over 400 times greater than average workers’ pay. In fact, this gap that had increased twenty-fold since 1965. Surprisingly, twenty-six of America’s largest corporations in 2011 paid less in federal taxes than they did to their CEOs.

The most commonly outsourced activities include:

– Information technology (IT)

– Content development

– Recruitment

– Legal services

– Web design, development & maintenance

– Logistics

– Customer services, customer support, technical support

– Manufacturing

Jérôme Barthélemy, Professor of Management at the ESSEC Business School, made the following comment in the Financial Times Lexicon:

“Outsourcing is generally considered a very powerful tool to cut costs and improve service quality because it enables companies to take advantage of specialized suppliers. It can also help firms focus on their core business by transferring non-core activities to suppliers.”

The pros and cons of outsourcing

The practice has some advantages and disadvantages. For most companies, the pros tend to outweigh the cons.

Advantages:

Expertise: the supplier is usually a specialist in its field. This not only increases the likelihood of a job well done but also saves the *client money and resources that it would need to train staff and purchase specialist equipment. (* A client, as opposed to a customer, is protected by another, has a relationship with another).

Swiftness: with expert employees and specialized equipment, the third-party supplier can complete tasks more rapidly.

Core Business: by farming out its non-core activities, the company can focus on its core business.

Sharing of Risk: risk-analysis is one of the key factors determining the outcome of a project or campaign. If you outsource certain activities, the supplier takes over some responsibilities. Since the 3rd-party vendor is a specialist, it is probably better equipped to plan the client’s risk-mitigating factors.

Reduced Costs: if you outsource you do not need to hire workers in-house, which reduces recruitment and operational costs, especially if the supplier is abroad in a country with considerably lower labor costs.

Disadvantages:

Confidential Data: the third-party service provider will have access to confidential information, including perhaps recruitment services, payroll, and HR. There is a risk that the supplier could expose confidential company data to a competitor.

Deadlines: the company could be at the mercy of the 3rd-party’s ability to get things done or goods/components produced on time. The more a company outsources, the greater the risk of deadlines not being met.

Boeing, the US aircraft maker, always used to design and build its airplanes in-house, that is, until the 787 Dreamliner came on the scene. Dreamliner’s outsourced manufacturing to more than fifty suppliers.

Boeing thought that by doing this, it could save lots of money and increase flexibility. Only the final assembly would be performed by Boeing.

By the middle of 2009, however, Boeing was two years behind schedule. The main reason – suppliers not meeting deadlines. Eventually, the US aircraft maker brought back major production lines in-house and took on engineers to monitor its suppliers more closely.

Hidden Costs: although in most cases outsourcing is cost-effective and saves money, sometimes there may be ‘additional’ costs, especially if the supplier is abroad.

Customer Focus: the supplier that the company outsourced is probably working for a number of clients. Its customers are those clients, rather than the clients’ customers. Therefore, the supplier may not have the complete focus on the customer that the client has.

If you are considering outsourcing some of your company’s activities to a third-party supplier, it is important that you weigh up all the advantages and disadvantages.

Outsourcing is extremely beneficial in most cases. However, if you do not choose the right services provider, you could have serious problems.

Video – Outsourcing: Is it Good or Bad?

This video first explains what outsourcing is in easy-to-understand language, and then looks at some of its advantages and disadvantages.