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Most Outsourcing Is Still for Losers
Computerworld ^ | Paul Strassmann

Posted on 02/02/2004 9:39:14 AM PST by Mini-14

FEBRUARY 02, 2004 ( ) - The most frequent reason companies turn to outsourcing is the need to increase profits. Replacing premium-priced labor with workers earning less has led to lower costs for products and services. That in turn has led to an increase in the purchases—that is outsourcing—of materials, components, parts and services by the companies. The value of outsourced goods and services for U.S. companies now averages 65% of the value of their sales. This kind of calculation is in the spotlight because this phenomenon has become the central concern of what's called the "globalization" of commerce. Accordingly, firms with a higher ratio of outsourcing purchases to sales would tend to be more profitable since they would be substituting lower-cost goods and services from global sources for higher-priced U.S.-produced equivalents.

A theory that suggests that outsourcing improves profitability would contradict observations I made in Computerworld in 1995 [see "Outsourcing: A Game for Losers," QuickLink a3980]. At that time, I collected data on 13 of the largest IT outsourcing contracts. I showed that companies that were contracting out a major share of their IT spending could be characterized as losers. Their profits were declining while they were cutting significant numbers of employees.

To re-examine the economics of outsourcing, I collected 2002 payroll data on a diverse and random sample of 324 companies listed in Standard & Poor's financial reports. After adding taxes, profits and depreciation, I calculated each company's value-added. The difference between sales and the value-added yielded the worth of outsourced purchases because sales minus value-added equals the amount that has been outsourced to suppliers.

The results were surprising. One hundred and seven companies reported a negative return on shareholder equity, which would mark them as losers. But 217 reported a positive return on shareholder equity, which would earn them the winner's label. There were, however, statistically significant differences between the losers and the winners.

The losers' average outsourcing-to-sales ratio was 25% greater than the winners'. Eighty-six percent of the losers were outsourcing more than half of their costs. The returns on shareholder equity for the winners were clustered around low outsourcing ratios; the large losers showed high outsourcing ratios.

To verify these insights, I ran an analysis of 466 U.S. banks. For this homogeneous sample, the negative relationship between outsourcing and profitability was statistically even more significant. What do these finding tell us?

  1. My 1995 assertion that "outsourcing is a game for losers" still stood up in 2002, even though in this case I don't propose to connect the outsourcing of IT with negative profitability. The current findings offer a managerial perspective on the economics of outsourcing.
  2. My calculations indicate that only 26% of the low profitability results are attributable to outsourcing. Companies already failing for other reasons will tend to outsource increasing amounts of work, thus diminishing their value-added.
  3. My findings don't support the frequent predictions that U.S. firms will tend to outsource in order to increase profits and thus eventually leave us with a "hollow" economy.
What, then, is the significance of these findings for IT management?

First, the decision to outsource IT shouldn't be taken in isolation and without full exploration of the potential effects on the overall financial performance of a company. Sure, one can always show savings by passing IT tasks to someone who can do it cheaper. But IT accounts for only a small share of the total costs that a company incurs. The damage from mismanaged outsourcing will always exceed the potential benefits from anticipated IT cost reductions.

Second, any company bidding on an outsourcing contract should ascertain whether the potential client is a loser or a winner. There are many cases that demonstrate why delivering services to losers with already damaged systems is risky. Whenever IT work is outsourced, even under an ironclad contract, there is the likelihood that the losers' damaged operations systems can't be fixed by handing over custody for critical applications to a contractor. Both the winner of such an outsourcing contract and the company doing the outsourcing will end up worse off and in hard-to-reconcile finger-pointing.

Paul A. Strassmann (paul@strassmann.com) was involved in one of the largest IT outsourcing contracts ever made and witnessed how everyone ended up a loser.


TOPICS: Business/Economy; Foreign Affairs
KEYWORDS: employment; h1b; l1; offshore; outsource; outsourcing; trade; unemployment

1 posted on 02/02/2004 9:39:15 AM PST by Mini-14
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To: Mini-14
Successful companies are too busy getting and keeping customers to let pennypinching get in the way.
2 posted on 02/02/2004 9:46:06 AM PST by Winston Smith Jr.
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To: Mini-14
If Paul Strassman knew what the hell he was talking about he would be running a major computer company, not writing second rate editorials about them. The reason US companies outsource is to REMAIN competitive in a global economy. If they don't the US consumer would gladly buy lower priced foreign products and services. Don't blame the evil Silicon Valley executive, blame yourself if you are price conscious consumer!
3 posted on 02/02/2004 9:46:15 AM PST by Natural Law
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To: Natural Law
If Paul Strassman knew what the hell he was talking about he would be running a major computer company

This does not follow. (And if it did, I'd be entitled to ask whether YOU run a major computer company.)

4 posted on 02/02/2004 9:57:13 AM PST by Winston Smith Jr.
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To: Natural Law
while some of your arguments are well made, a web search says this guy did the kinds of work you mention and has "retired" to the acedemic world. His IT worked started in 1960 and ended in 93 as head of Defense Dept IT. He now a prof at West Point.
5 posted on 02/02/2004 9:58:08 AM PST by q_an_a
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To: Winston Smith Jr.
Companies already failing for other reasons will tend to outsource increasing amounts of work, thus diminishing their value-added.

You know, I think if you inserted the words "bankruptcy" or "plant closing" for the words "outsourcing", you would find all the author's assertions plausible too.

Outsourcing, bankruptcy, plant closings, are for losers. Winners avoid Outsourcing, bankruptcy, plant closings, while losers embrace Outsourcing, bankruptcy, plant closings.

I think there is some validity to the author's arguments, but the counter argument is that outsourcing is a companies last gasp to cut costs and is already a loser before outsourcing.

6 posted on 02/02/2004 10:02:55 AM PST by staytrue
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To: Natural Law
But he correctly states that if you screw up IT outsourcing, it will cost more, not less.

This may even be the case if it is done correctly, when you take all the hidden costs into consideration.

His point is that the stupider companies think they are saving money, but they are really spending more than if they had a properly organized operation in the US.
7 posted on 02/02/2004 10:05:08 AM PST by proxy_user
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To: Natural Law
The reason US companies outsource is to REMAIN competitive in a global economy.

That is certainly their intention. The problem is it generally doesn't produce those results.

The "holy grail" of outsourcing is to reduce expenses without negatively impacting productivity or quality. However in the vast majority of cases expenses fall, but productivity and quality fall along with it. Sometimes the attempt to fix this cost more than was saved by outsourcing in the first place.

This is a cyclical thing in IT. For a while all the attention is placed on innovation, service, and quality. Then on short-term profitability. That's the big difference between the late 90's and the past few years in the IT industry. The good companies don't lose focus on either one. But most companies aren't that good.

8 posted on 02/02/2004 10:10:20 AM PST by Snuffington
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To: q_an_a
I have seen his references too; they hardly qualify him as an expert on modern commercial high tech and IT technology or business models. He is an old, out of touch academian.
9 posted on 02/02/2004 10:32:48 AM PST by Natural Law
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To: Natural Law
W. Edward Demming and Peter Drucker did some of their most improtant work after they passed 70. The concept that money alone does not buy quality should be the backbone of the conservative's ideas. Since this is his arguement I am inclined to give him some slack.
10 posted on 02/02/2004 11:04:15 AM PST by q_an_a
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To: q_an_a
What corporations are interested is the bottom line. If they see outsourcing as a drain on corporate profits they will stop doing it. One of the benifits with so many IT people being out of work is that they are being forced to upgrade their skills to re-enter the job market. All of sudden those people who where not interested in java are learning java and getting certified. The people who did not learn about web technlogy are learning about J2EE and .Net frameworks, so and so on. In addition to doing book learning some people are developing applications/systems at home. They are getting ideas and starting up their own businesses. Others will become trainers.

Part of the structural change that we are going through in the US is go from writing everything to using components and sysetms integration. There is a huge over supply of software developers who have developed complete systems from the ground up. There is a shortage of folks with system integration skills and using componets, such as J2EE application servers and .NET application servers.

ALot of the work that has been shipped to India was the bottom up systems development. Systems that are in maintence mode. Systems that had huge cost over runs when they were developed. So the article is correct in that case.

The key for Americans is to learn the higher level skills. Learn about business modeling, use-cases, and UML. Learn about RUP - rational unified process. The architect skills are for the future and the future is now. Systems can be put together alot faster today than were done a few years ago.
11 posted on 02/02/2004 2:24:38 PM PST by hotdogjones (It is about making money.)
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