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Outsourcing: Definition, Pros, Cons & Examples

Written by Paul Boyce Posted in Microeconomics
Last Updated February 9, 2023

What is Outsourcing

What is outsourcing? Outsourcing is where a company hires an external firm to conduct certain aspects of its business. In other words, one business hires another to operate part of its operations. For example, Apple outsources the majority of its production to Foxconn which assembles many of its products such as the iPhone.

Outsourcing itself is an efficient cost-cutting measure that businesses use to help increase efficiency and profitability. In a way, it can be seen as the division of labor between businesses. The business that is outsourcing is left to focus on what it is most efficient at, whilst a third party conducts the rest. Looking at Apple, outsourcing has been a huge success. The company focuses on developing new software and designs, whilst it outsources most of its components to third parties.

Key Points

Outsourcing is where a specific part of the business is conducted by a third party.
Firms primarily outsource in order to lower costs and focus on its core competencies.
Outsourcing is generally advantageous, but can go wrong if a bad partnering company is chosen.

Outsourcing started to gain traction in the business community in the 1990s and took off alongside global trade. As trade barriers came down, it became easier and cheaper to outsource production to low cost businesses abroad. However, this has not come without its ramifications.

Many opponents cite the loss of domestic jobs, particularly in manufacturing, which have been outsourced to foreign entities. On top of that, services that have been outsourced can lead to a lower quality – largely because they are not in the company’s full control.

By contrast, outsourcing itself is seen as an efficient allocation of resources. Tasks are done by specialist companies that are more efficient in that role. For example, a mining company is unlikely to have the level of expertise to run and administer a pension scheme, so the firm understandably outsources this instead. For a mining company, wasting precious resources on an administrative job such as pensions just doesn’t make sense for it.

Outsourcing Examples

Administration

Many companies have outsourced administrative tasks such as invoicing, database administration, and third-party communications. These are relatively simple tasks, so often get outsourced to developing nations such as the Philippines and India.

Apple

Apple outsources the production of its iPhones to hundreds of separate firms – including Foxconn that manufactures the final phone. As part of the supply chain, Apple outsources multiple components from Samsung such as the flash drive and the mobile DRAM. This method of doing business works for Apple. Instead of focusing on the development of new components, it can outsource these whilst it focuses on its core competencies.

Call Centers

A significant number of call centers have been moved to developing nations such as India, Indonesia, and the Philippines. This may be for general queries, or technical calls regarding issues such as a broken-down laptop.

Following the initial boom in the 1990s and 2000s, the outsourcing of call centers abroad was met by customers who were unhappy with the quality of service they were receiving. The English language in some of the outsourcing countries was not to the same standard, which created a communication hurdle for customers. In turn, it led to many companies bringing back call centers and outsource them locally instead – although at a higher cost.

IT

There are a number of sophisticated software options that it would be wasteful for an individual company to design. For example, a restaurant may want an app that allows customers to order directly from their table. Most restaurant managers wouldn’t know where or how to start developing an app. Instead, it is far more efficient to outsource this to an independent firm that does this work day in, day out.

Many firms now use third parties to source their software needs that in turn can help increase the firm’s productivity. Not only do many companies outsource software, but also technical support. For instance, if you have an issue with your laptop, many of the places you call are outsourced. Microsoft is a famous example, whereby it outsources to companies such as Tata and Wipro.

Pensions

Pensions have become increasingly complex as regulations constantly change. The market itself has also developed from a relatively simple DB scheme which is solely payable by the company, towards a DC scheme which relies on employee and employer contributions. In turn, there is a mixture of schemes with different features and scheme rules.

The complexity of the market has led many big firms to outsource their pension administration to third parties. In turn, they deal with communication with the members and details surrounding transfers and investment options.

Outsourcing Advantages and Disadvantages

Advantages of Outsourcing

1. Constant Service

By outsourcing production, particularly abroad, the firm is able to operate on a 24-hour basis. For a firm that needs a contact center open to customers all day, this can be seen as a crucial advantage. Customers may need assistance during the night, so having someone on hand to help is important if it wants to maintain a high level of service.

2. Expertise

Outsourcing firms tend to deal with more than one business at a time. These firms run operations day in, day out, working on their specific part of the process. As with the division of labour, they are able to really focus on and enhance their capabilities. For example, security firms are much better equipped to train and source qualified personnel, as opposed to the local supermarket. This is because the security firm will already have processes and structures in place – such as training personel and manuals.

3. Focus on Core Competencies

As the firm doesn’t have to focus on 100 different components within the business – it is able to focus on factors that separate it from the competition. For example, Nike focuses on designing, developing, and marketing its product, but outsources the actual manufacturing process.

Similarly, firms require departments that have nothing to do with their core competencies. Think of finance or IT. For a clothing store, these are departments that aren’t necessarily part of its core competencies which is sourcing quality clothes. Instead, it outsources those areas where it has little expertise in – which would require significant levels of investment and time.

4. Increased Capabilities

By outsourcing, a firm not only benefits from its partners’ expertise, but also the wealth of resources it has available. For example, when Apple outsources its production to Foxconn, it has access to factories across Europe, America, and throughout Asia. That’s not only the factory but its process enhancement and the machinery it uses too.

A company like Apple can afford to buy these facilities itself, but for firms with limited capital, it can be a significant advantage as it allows them access to equipment they would otherwise be unable to afford.

5. Low Costs

When a business outsources its production, the other firm will have many other customers so significantly benefits from economies of scale in that field. For instance, UK based Lloyds Bank agreed on a seven-year deal with IBM to outsource their IT. Lloyds Bank itself does not function in the technology sector, so its scale is limited to its own business. By contrast, IBM serves the global community, with over $77 billion in sales.

At the same time, outsourcing to third parties in countries such as India and China can save significant amounts due to lower labour costs. The firm also benefits as it is able to set up in those markets relatively easily through outsourcing with a local supplier.

Disadvantages of Outsourcing

1. Loss of Control

When outsourcing, the firm essentially loses control over what is being produced and its quality. How can it ensure that the 1,000 units it receives are of the highest quality? At the same time, the firm is at the mercy of its outsourcing partner. If a key part of the business is outsourced, the firm has little negotiating power to move – largely due to the significant impact a move may have.

Larger firms like Nike and Apple may have greater power over their outsourcing partners, but smaller firms may find it more difficult. This is particularly true when the firm is trying to outsource new products from their partner. They may want the partner to develop a new product, but due to their size, are unable to.

2. Lower Quality

By extension of loss of control, there is the potential for a lower quality output. As the firm has no direct control over what goods or services are being produced, they may suffer from a sub-par standard. Whilst they may be able to negotiate with their outsourced partner, it may be difficult for them to adjust to the firm’s requirements.

3. Personnel Difficulties

Firms may outsource to partners outside the country, or even in different regions of the same country. What can result are language and cultural barriers. Some firms may have a relaxed and laid back culture – which may not be conducive to a firm that is very strict and demanding. This may be cultural, or structural to the business, but can create significant friction between firms that can impact on the final product.

4. Public Opinion

Outsourcing is generally viewed unfavourably by the public as it is perceived that jobs are being lost abroad. In fact, this was one of the main drivers that won Donald Trump the presidency in 2016. Subsequently, firms that engage in outsourcing, particularly abroad, have started to develop a bad reputation.

Part of the public opinion battle is the fact that firms are outsourcing abroad the take advantage of cheap labour. At the same time, firms have gone too far, noting the Nike sweatshop scandal in 2013, where child labour was used.

5. Security Risks

When outsourcing key aspects of the business abroad, there is a potential risk to intellectual property rights and other aspects of security. At the moment, China presents a real and credible threat to the firm’s intellectual property rights and wider security. In fact, research by CNBC found that Chinese firms stole from 1 in 3 US companies.

6. Slower Turnaround Times

When outsourcing, the partner firm will have many other clients to service. So although a fast turnaround time is crucial, it is also important for the other clients. This can lead to increased pressure on the partner firm to meet stricter deadlines which it is unable to do, due to other commitments. If it does not have sufficient capacity, it is likely to lead to slow turnaround times.

Outsourcing FAQs

What is outsourcing?

Outsourcing is where one firm hires another firm to conduct part of its business. For example, Apple outsources the production of its iPhone to firms such as Foxconn.

Is outsourcing good or bad?

Outsourcing can help companies reduce costs significantly and frees up resources to allow them to focus on their core operations. However, poor quality outsourcing partners could provide a bad service and damage the firms overall reputation.

Why do companies outsource?

The two main reasons for outsourcing is firstly to reduce costs, and secondly, to allow it to focus on its core operations.

What are examples of outsourcing?

Examples of outsourcing include: call centers, manufacturing, IT, pensions, and finance, among many more.

About Paul

Paul Boyce is an economics editor with over 10 years experience in the industry. Currently working as a consultant within the financial services sector, Paul is the CEO and chief editor of BoyceWire. He has written publications for FEE, the Mises Institute, and many others.

Outsourcing: Definition, Examples, Pros & Cons