Cost of outsourcing


It has been well known that given free trade, letting everybody specialize in what they are good at makes everybody better off.

Yet, the puzzle is that few modern corporations can claim to be performing only that narrow set of activities at which they excel.

It took a noble prize winning insight by economists Ronald Coase to realize that companies typically undertake many more activities than they are expert at, simply because purchasing expertise through the markets is often more complicated than obtaining it from an internal supplier. Once we add these of dealing in the market – “transaction costs� – any advantages from outsourcing may be eliminated.

This simple contest between the gains from outsourcing to a specialist vendor from a low wage geography like India, and the transaction costs of dealing with an external organization that is culturally and physically remote, lies at the heart of sourcing decisions in client firms. Transaction costs basically arise from the difficulties of achieving cooperative relationships with a vendor firm, and of managing to work together as if distance did not matter. Only the naïve now estimate their cost savings from off shoring as being equal to the gains from wage arbitrage.

The key question is what can clients and vendors do to control these transaction costs? Here is how companies are managing “control without ownership� and “coordination without collocation�:

Select services that are easy to coordinate for off shoring. These tend to be relatively standardized and well– documented business processes.

Match sourcing model to process characteristics. Companies often take a portfolio approach, where they would “place� a process either in captive or third party modes, near shore or offshore based on specific process characteristics. Coordination concerns dictate near shoring, and control issues drive the decision to go captive.

Build capabilities at distributed organizing- managing work across corporate and geographic boundaries. This involves creating the expectation of future business, or managing with multiple suppliers

– as well as coordination tools that allow people sitting half way across the world to work together effectively. Coordination is best driven by creating shared knowledge that enables people to anticipate and interpret each others actions rather than liking people up through tele or video conferencing.

Redesign processes to make them as modular and standardized as possible, so that they are easy to control remotely.

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