Is Outsourcing Dying Or Thriving? (Part 3)

By guest author Tony Scott

In part I of my article, I pointed out the reasons why outsourcing to India based on pure labor rate arbitrage faces significant obstacles to continued growth – and possibly even to future survival. On the other hand, outsourcing is clearly thriving – in India and around the world. How can we reconcile this?

Two core economic concepts are driving the growth of outsourcing: specialization and comparative advantage. But these alone would not be enough to drive the global outsourcing business if two other key factors did not exist: the move to a digital and knowledge-based economy and the “flattening” of the world through low-cost data and voice communications.

The fundamental concept of specialization was first described by Adam Smith, and it is a core concept of modern industrial and post-industrial economies. To use the famous example, it would be highly unlikely that any one person could make a pencil. To make a pencil, multiple specialized skills are required, none of which are likely to exist in any one person or even one company. Even if they were, it would be much less efficient and cost-effective than utilizing specialists who handle various sub-sets of the pencil manufacturing, marketing, and selling processes.

This same concept applies to almost all human economic endeavors. The more an individual, company or region, or country creates competency around a specific aspect of specialization, the more attractive it will be to those seeking out that specialty because of their ever-increasing competency and economic efficiency.

The other core economic concept that is driving outsourcing is comparative advantage. Made famous by the economist David Ricardo in the early 1800s, comparative advantage describes a situation when one entity – country, region, company, collective, or individual – can produce something more efficiently at a lower relative cost than another person, group, or country. That means that even if we could produce a product or service in the United States at the same cost as in India or another country, it might not be in our economic advantage to do so, because we might be better off having our workers producing something of higher value as an alternative that could not be produced elsewhere.

How the two concepts of specialization and comparative advantage work hand-in-hand is well-illustrated in agriculture. Even if someone could grow their own produce in their backyard, it is usually not cost-effective or time-effective to do so. In this case, specialization means that farmers who raise a particular kind of produce or animal are typically much more knowledgeable and efficient than someone growing a tiny amount of many things.

In addition, there is a comparative advantage to be found in growing fruits, grains, and vegetables or raising animals in certain climates. As an example, while it might theoretically be possible (but very difficult) to raise oranges in greenhouses in Wisconsin it is clearly much easier to do so in Florida. On the other hand, the grass and climate in Wisconsin are much more conducive to large-scale high quality dairy farming than the less nutritious grass and hot climate in Florida. Thus, even with similar labor rates and land costs it makes more sense for farmers in Wisconsin to be in the dairy business, and for Florida farmers to be in the citrus business – a comparative advantage each has over the other.

The application of this concept was clearly seen at the dawn of the industrial revolution when factories were moved from the London area to other less expensive locales in Britain and its colonies to take advantage of labor rate differentials and access to waterpower, coal, or iron ore. This pattern has continued to this day, with for example the auto industry buying more and more parts and components from lower-cost manufacturing environments in Mexico and China.

But of course manufacturing typically requires significant investments in plant and equipment, with the capital component often matching or exceeding the labor component in a finished product. In addition, there are advantages for suppliers to be physically close to the final product assembly plant. Historically, when transport costs were much higher, it was also better for manufacturers to be close to their end customers. These factors mean that the decision to outsource or move production off-shore in a large-scale manufacturing environment is not trivial, and typically only undertaken by companies after serious consideration of the long-term consequences.

However, if one applies these same concepts to the digital, knowledge-based economy, it is easy to see why outsourcing has happened in these domains. If one country has a significant enough cost advantage over another to provide a service, there is a huge incentive to employ the means of providing that service in the low-cost environment. And if the work done to provide that service can be easily moved without physical barriers (as all digitally-based work can be), then there are almost no impediments for a company to take the lower-cost solution in a remote location.

India (and other countries) have both a comparative and absolute advantage over the United States in terms of the cost of delivering many services that are not constrained by geography. While it is currently impossible to deliver some things on an outsourced basis (plumbing services, for example), it is possible to deliver almost anything that does not require the touching and moving of a physical product on an outsourced basis.

Services that are based on intellectual capital and therefore able to be mostly or fully created and delivered in a digital environment are of course the least tied to any particular geography. That was of the big drivers of outsourcing initially. Those who remember the history of outsourcing know that the big boom in outsourcing to India was driven by the “Y2K” problem. There were millions of lines of code that needed to be checked and fixed to ensure that systems wouldn’t crash when the year 2000 began, and India had a large number of software engineers who could handle the mind-numbing task of manually checking and correcting code.

These were tasks most software engineers in the United States wouldn’t have wanted to touch during the boom days of the late 1990s – they were all too busy building dot-coms. Of course, we know how that worked out.  Today there are plenty of underemployed software engineers in the United States who would be glad to get that kind of steady work again – if only they were paid as well as they had been previously. But that isn’t going to happen. Why should a company pay two to five times as much for a service, particularly one that isn’t mission-critical?

Call centers based in India to handle outsourced business processes really came into their own after the Y2K outsourcing boom. Now any number of services are being provided on an outsourced basis, from the interpretation of X-rays and CAT scans, to financial analysis and patent application creation. Even the prosaic job of asking, “Do you want fries with that?” has in some cases been outsourced to call centers overseas, with people thousands of miles away taking orders from customers in their cars at fast food outlets in the United States.

The bottom line is that if it something can be converted to a digital format, that service can be provided from anywhere in the world where reasonably fast and reliable data and voice communications exist. That means just about anywhere in the world today.

All of the above means that outsourcing and off-shoring will continue to exist and grow. They may not grow as quickly in India in the future as alternative locales become relatively more attractive. But do not mistake any slowdown in labor-rate arbitrage outsourcing in India for a slowdown in the inexorable path towards specialization and outsourcing. The names and locations may change, but the overall game will definitely remain. Any person, any company, or any country that bets against that or foolishly tries to stop this tide will likely find out what it really means to be assigned to “the dustbin of history.”

This segment is part 3 in the series : Is Outsourcing Dying Or Thriving?
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