Pros and Cons for Outsourcing

The Pros and Cons of Outsourcing services in the US By Berend Schoute (1713035), student of the VU university Amsterdam. INTRODUCTION Hillary Clinton, â€Å"I don't know what reality the Bush administration is living in, but it's certainly not the reality I represent, from one end of New York to the other. † This response came on the statement of the head of U. S. President George W. Bush's Council of Economic Advisers, Gregory Mankiw. He said: â€Å"outsourcing is just a new way of doing international trade,† which makes it â€Å"a good thing. † In the last decade most economists are a proponents of offshoring services outside of the US.They say that the benefits of outsourcing exceed the disadvantages. The main discussion is more likely a political one. It shows that a lot of citizens are pursuing protectionism to prevent any problems for American workers. THEORY Outsourcing occurs when a company fragmentizes a production process and sends this to another outsi de company. When companies are outsourcing to other countries/continents, it is also known as offshoring. A survey held by Lewin and Peeters (2006) showed that 90 of the 650 companies that are listed on the US Forbes Global 2000 are offshoring major business functions at that time.This outcome says that many major companies are interested in outsourcing jobs. Further outcomes mentioned that overall IT-functions (66% of the survey participants) are mostly shipped elsewhere, followed by Finance/accounting functions (60%). The most attractive destination for offshoring is India, where 60% of the functions of companies participated in the survey is to be offshored to. (Lewin and Peeters,2006) There are multiple arguments for offshoring jobs to another country. Some of these reasons can be examined by simply looking at the numbers, but most of them are abstract and difficult to catch.We speak of an omitted variable bias when a model that you create misses some important causal variables. The model can give you some positive results, but it isn’t reliable. This problem can occur in every survey, so the investigators need to be careful with the outcomes. The main argument for outsourcing is clearly labor cost reduction. The differences in wages are very large between the developing countries and the US. For example, an IT-specialist is paid $ 60 per hour on average in the US, where India pays this worker only $ 6 per hour.Although these cost benefits trough labor are substantial, extra costs incur when setting up the new offshore location. After taking all costs in account, there still is a cost reduction of 45 to 55 % (Mckinsey Global institute,2003). This cost reduction can cause a higher productivity because the domestic firm can focus on other important operations. Drezner (2003) said: ‘Thanks to outsourcing, U. S. firms save money and become more profitable, benefiting shareholders and increasing returns on investment. Foreign facilities boost deman d for U. S. roducts, such as computers and telecommunications equipment, necessary for their outsourced function. And U. S. labor can be reallocated to more competitive, better-paying jobs’. This statement is fully supported by most economists. The commodification process allows the spread of the benefits of IT-outsourcing even further, making the growth and the competitive advantage even greater (Drezner, 2003). A simple explanation of the advantage can be given by looking at the Heckscher-Ohlin model. This model simply suggests that countries that are capital abundant will export capital intensive products vice versa.For example it explains the fact that India focuses on labor intensive products because this abundance causes a competitive advantage caused by relatively low wages. In reality it’s off course more difficult, because the underlying assumptions are hardly realistic: 1. factors of production are perfectly mobile and 2. no difference in level of technology across countries. Drezner(2003) explained this by the following statement: ‘The logic underlying an open economy is that if the economy sheds jobs in uncompetitive sectors, employment in competitive sectors will grow.If hitech industries are no longer competitive, where will new jobs be created? ’ This previous theoretical introduction didn’t made the discussion between the pros and cons yet clear. It simply shoes some arguments of a proponent and a opponent. We still need hard evidence from both parties to give a good view on the truth. PROS VIEW Opponents of outsourcing are talking about the fact that American workers are losing their jobs cause of the labor movements. This is off course a fact, but what are the actual numbers ? The Mckinsey Global institute (2003) notes that in the upcoming 5 years , the growth was going to be around 30-40%.Forrester Research predicts that the total outsourced jobs will be around 3,3 million in 2015. According to projections, the hardest hit sectors will be financial services and information technology (IT). In one May 2003 survey of chief information officers, 68 percent of IT executives said that their offshore contracts would grow in the subsequent year (Mckinsey Global institute,2003). Therefore, at first sight the perception of the opponents is really sustainable. The total growth in the last two years (2002-2003) was really good, the productivity growth was even greater.The overall job growth have been really alarming. This indicates that the opponents are right in their perception. Controversially, if you unpack the numbers, you will find that 90% of all jobs in the US require geographic proximity. So these jobs were untouched anyway. The Forrester prediction of 3,3 million is spread over 15 years which means 220 thousand extra outsources jobs per year. Nowadays employment in the United States is about 130 million, and with approximately 22 million new jobs to be added till 2010, means that the ef fect of offshoring is less than 0,2% of American workers (Drezner,2003).Another argument of the proponents is that the net change in the outflow of workers against the inflow is negative. So the difference between insourcing workers because of foreign companies coming to the US and outsourcing is getting smaller. An important argument pro outsourcing is the fact that it increases the productivity of a company. The question we need to ask ourselves is can we confirm this increase with empirical evidence. Amiti & Wei (2006) investigated this question and have found some nice figures. In their survey hey tried to analyze whether there are any benefits of outsourcing in the productivity of a company. To prevent an omitted variable bias, they needed to find a valid instrument for service offshoring. In their regression model they used the number of internet hosts in the countries that supply the largest shares of services to the US. These outcomes reflect the changes in new technologies that would only affect US productivity through their effect on offshoring. Their empirical outcome was that there is a positive effect on productivity through outsourcing. CONSThe American citizens who are pursuing protectionism to prevent any problems for American workers. They say that they lose jobs because of outsourcing. This off course is true, but it’s important to look at the percentage that is reemployed. This number is provided by the Bureau of Labor Statistics, which tells us that 69% of the workers that lost their job due to offshoring, eventually is reemployed. In the previous, I only talked about low-skilled jobs outsourced to other countries. Nowadays a new trend is unfolding with the outsourcing of high value added jobs to ‘developing’ countries.For example radiologists who can be replaced by cheaper Indian radiologists that constantly are able to screen material that was send to them by US hospitals. The exact numbers aren’t clear because this trend recently came up. The debate about the high skilled outsourcing should focus on consolidating strength of the US in higher value added knowledge services where investment in human capital will be decisive. Until there is no empirical evidence of a negative effect of this kind of outsourcing, the US must focus on the quality of their higher value added knowledge services (Rudiger, K. 2007). There are also a couple of other disadvantages that come up when outsourcing services overseas. These disadvantages have been used by the opponents of outsourcing. A first struggle can be that a newcomer can find itself a unreliable supplier, which puts his work aside when finding a better paying partner or a supplier loses the workers who finds better paying jobs. In reality a supplier loses around 15 to 20 % of it’s workers each year (Weidenbaum, 2003). Other hidden costs or disruptions can be for example bad infrastructure, a lot of power blackouts and extra transportation cos ts.Weidenbaum also states ‘overseas managers often do not understand the American business environment: our customers, lingo, traditions, and high-quality control and expectations for prompt delivery of goods and performance of services’. These disadvantages can be prevented by good outsourcing preparation. CONCLUSION In the beginning of this essay I discussed the US protectionism to offshoring jobs. When looking at all the studies it came clear that offshoring brings substantially benefits to the economy of the US (and the world).In this essay we saw that firms can reduce costs up to 55 % of the particular department. Because of the cost reduction and productivity growth, the US can improve its output and competitive advantages against other countries. The disadvantages do not outweigh all the advantages of outsourcing discussed in this essay. When the politicians focus on the flexibility and quality of the economy they can create a win-win situation for the US. In the upcoming years next studies need to be about whether any skill group (high value added services in particular) is relatively more affected. REFERENCES Amiti & Wei. 2006). Service Offshoring and Productivity: Evidence from the United States. NBER Working Paper no. 11926. Drezner, D. (2004). The outsourcing bogeyman. Foreign Affairs. Mckinsey Global institute. (2003). Offshoring: Is It a Win-Win Game? † Weidenbaum. (2003). Outsourcing: Pros and cons. Business Horizons (2005) 48, 311—315 Lewin and Peeters (2006). â€Å"Offshoring work: Business hype or the onset of fundamental transformation? † Long Range Planning, 39(3): 221–239. Rudiger, K. (2007). Offshoring, a threat for the UK’s knowledge jobs? A working paper prepared for the Knowledge Economy Programme.