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Is Outsourcing Profitable?

Prof. Paul A. Strassmann


George Mason University, March 6, 2006
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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
Outsourcing: Rising or Losing?

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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
What is Outsourcing?

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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
Definitions

Profits

Depreciation
Interest, Taxes

Cost of Outsourcing
Sales
Overhead
Operations
Direct

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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
Financial Profile of U.S. Firms (2004)

Standard & Poor's Data for U.S. Corporations with 3.8 Million Employees
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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
Outsourcing and Corporate Economics

• Overhead costs now manage not only internal


“direct” labor but also outsourcing work done
by suppliers.
• Computer applications, optimized for
“enterprise” integration have difficulty coping
with the suppliers’ incompatible systems.
• Unmanaged outsourcing complexity can void
labor saving gains.

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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
Critical Ratios

Outsourcing Ratio = Outsourcing / Direct Costs

Overhead Ratio = Overhead / Direct Costs

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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
Distribution of 2004 Outsourcing Ratios

Median Outsourcing Ratio for 769 U.S. Corporations = 75.6%


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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
Outsourcing Not Correlated with Profitability

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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
Distribution of 2004 Overhead Ratios

Median Overhead Ratio for 769 U.S. Corporations = 124%


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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
Overhead Not Correlated with Profitability

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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
Summary: Outsourcing and Overhead Ratios

• Outsourcing now equals 75.6% of corporate


direct costs and is rising.
• Overhead costs now exceed corporate direct
costs by 24% and keep rising as direct costs
outsourced.
• Neither outsourcing nor overhead correlates
with profitability. Corporate profitability
reflects effectiveness of management.

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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
Was Outsourcing
Profitable for GM?

A Case Study

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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
GM Employment and Outsourcing

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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
GM Outsourcing Increased Overhead Costs

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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
The Keys to Competitive Advantage

• Collaboration Costs
• Coordination Costs
• Intermediation Costs
• Transaction Costs
• Structural Costs
• Sales, General & Administrative Costs

= Overhead Costs

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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
Do Cuts in I.T. Indicate Success?

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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
A Comparison of I.T. With Business Indicators

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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
A Shareholder View

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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
A Comparison With Competitive Indicators

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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
While Outsourcing, Market Share Declines

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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
Summary of GM Case

• Outsourcing to lower costs did not stop market


share erosion.

• Value-chain did not improve while outsourcing;

• Despite a decline in employment and outsourcing


overhead costs are up;

• I.T. can not be successful if business is indicators


reveal information-related malfunctions.

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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
Is Outsourcing
Damaging?

A Case Study: GM vs. Caterpillar

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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
Employment: GM vs. Caterpillar

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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
Outsourcing: GM vs. Caterpillar

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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
Knowledge Value: GM vs. Caterpillar

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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
Compensation: GM vs. Caterpillar

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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
Summary of GM vs. Caterpillar Comparison

• Despite higher wages Caterpillar increased


employment.
• Despite high level of outsourcing Knowledge
Value of Caterpillar gains.

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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
Research Findings

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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
Highly Profitable Firms Outsource Less

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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
There Will Always be Outsourcing (2002)

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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
Outsourcing Ratios Differ by Industry

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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
Higher Pay Need not Result in Outsourcing

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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
Summary of Research Findings

• “Outsourcing” is essential for the growth of


any economy.
• Whether outsourcing is economically effective
depends on the organization of the the value-
chain.

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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
Outsourcing
in the Value-Chain

Case Study

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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
Estimated Cost of a Logitech Mouse

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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
Different Perspectives on Outsourcing

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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
Distribution of Costs of a Logitech Mouse

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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
Summary of Case Study

• The definition of “outsourcing” depends on


the position in the value-chain.
• The dominant cost in global commerce are
transaction costs, not labor costs;
• Assembly takes place from global sources
where technology and logistics dictates
sourcing.
• The greatest damage to the U.S. economy
can come from vertical integration that
reduces transaction costs.

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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
Transaction Costs in the Value Chain

Supply Chain Distribution Chain Consumer

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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
Manufacturing Supply Chain Costs
100%
100%

90%
All Other Costs
80%
Transaction Costs
70% 15.9%
Profit
60% 56%

50%

40% 8.1%
33%
30% Purchases
20% 5.8%
15%

10%
4.7%
0%
All Other Suppliers Secondary Suppliers Prime Suppliers Manufacturer
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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
Costs in a Manufacturing Supply Chain
100%
100%

90%
All Other Costs
80%
Transaction Costs
70% 15.9%
Profit
60% 56%

50%

40% 8.1%
33%
30%

20% 5.8%
15%

10%
4.7%
0%
All Other Suppliers Secondary Suppliers Prime Suppliers Manufacturer
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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
The Total Value Chain
158%
160%

140% 24%
127%

120%
23.5%
100%
100%

80%

Other Costs
60%

Transactions
40%

34% Profits
20%

0%
Manufacturers Wholesalers Retailers
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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
Potential Gains in the Automobile Industry

160%
158%
13%

140%
130%
Gain
120% 15%

81%
100% Profits
55% Information
80%
All Other
60%

40%
64% 60%
20%

0%
Old Value Chain New Value Chain 44
Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
A Value Chain View of Information Costs

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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
A Perspective of the CIO’s Job

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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
Impacts of Information Technologies

• Information drives an economic “arms race”.


• Obsolete assets will be discarded.
• Collaboration favors global consolidation.
• I.T. becomes an economic weapon.

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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
A Case of Value-Chain Superiority

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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
Outsourcing and
the U.S. Economy

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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
Is the US Economy Off-Shoring Itself?

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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
Summary

• Outsourcing is not subcontracting I.T. costs.


• Outsourcing is not “off-shoring.”
• Outsourcing is the distribution of labor and
knowledge through specialization.
• Gains from increases in Value-Added.
• Losses from divestment of Knowledge.

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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
Issue: Cut Costs or Lose Knowledge Assets?

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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY
Next GMU Lecture

When: April 17,2006


Topic:
What is the Worth of Employee Knowledge?

Prior lectures available on:

http://video.google.com/videosearch?q=strassmann

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Prof. Strassmann, GMU March 6, 2006 Lecture, REPRODUCED BY PERMISSION ONLY