In a buyer-seller transaction, outsourcing is broadly defined as the provision of certain production activities to a third party which is not involved in the transaction. It involves a certain amount of responsibility being given to an outside producer who would then supply the intermediate or finished good back to the outsourcer for sale in the latter’s brand name. Thus the entire credibility of the product still lies with the original producer or seller while the actual work (or a portion of it), is carried out by the other party. There are many disadvantages of outsourcing due to some inherent and some executional flaws in the arrangement. Some of these disadvantages of outsourcing can be dealt with by clarifying the contractual terms and legal conditions while some others cannot be avoided due to their innate nature.
Here we examine some of the disadvantages of outsourcing both at a microeconomic level (company’s point of view) and macroeconomic level (country’s point of view). They can be broken down into two categories: financial/economic drawbacks and other administrative drawbacks.
Financial Disadvantages and Limitations
Hidden Costs – Though not easily calculable, there are a number of hidden costs associated with an outsourcing operation such as legal fees in drawing up a contract, excess transportation costs, administrative coordination cost etc. These factors are only introduced in the production line when a new third party comes into the picture. Any additional costs that are not included in the initial negotiations such as contract renewal, legal cases, loss of competitive edge, have to be dealt with at additional legal charges. Further, negotiations as to the share of profits booked by each party have to be considered which would involve lawyers and other fees as well as additional time.
Financial Health of the vendor – The quality of the product will depend on the financial health of the company to which the outsourcing contract is given (vendor). Thus, one of the additional disadvantages of outsourcing is that the company which outsources the production process has to keep checks on the financial state of the other company which involves that much more use of time, money and resources. The quality of product delivered by the outsourced company will directly affect the credibility of the former company and hence underlines the fact that an additional financial as well as credibility risk will have to be taken on by the company which outsources its production. Also, there will be extra money spent on ensuring that the quality of the product delivered by the outsourced company matches up to the standards set by the outsourcing company.
When companies in a country such as the United States outsources certain IT development projects to companies in countries like India, they need to take extra measures to ensure that their customers are satisfied with the product delivered. Such a process would require additional resources.
Unemployment Threat – As explained in the above example, when firms in the US outsource all or part of their operations to Indian IT firms, they inadvertently take away employment opportunities from American citizens. These vacated jobs are then created in India by the firms which obtain the outsourcing contract. Along with the financial losses to the US in terms of the income lost per capita, there is also the unrest and discontent among the population which puts both the outsourcing companies as well as the national economy under pressure. A significant example of such a situation has been observed in the United States itself where a major agenda of the ruling party is to maintain domestic jobs in the face of increasing outsourcing by American firms to countries like India and China.
This is one of the most important disadvantages of outsourcing currently and is a burning issue which has gone to the extent of affecting international relations between the above mentioned countries.
Other Issues with outsourcing
There are some other issues associated with outsourcing which fall into the realm of administrative, goodwill, and security issues. These are equally important as the financial disadvantages of outsourcing and will be discussed in detail in the following points. The management as well as public image of the company are an imperative part of the company’s reputation, which are directly affected if the company decides to outsource its activities, since the other company’s performance now becomes linked to the former’s.
Managerial Control – If a company decides to outsource its activities, then control over management of its product is transferred to the other company’s discretion since they are the ones directly involved in the production and provision of goods or services. This entails a higher risk for the company which outsources since it has to entrust certain operations to the other company which dilutes its control over the product or service provided. Since the other company may not have the same drive and pressure to deliver a high standard product as the original company, it may affect the quality of the product delivered. Also, flexibility in changing certain aspects of the product or service may be lost due to the shift in managerial control.
Security Threat – Some companies which hand over operations to other companies may require disclosure of certain trade secrets in order to maintain the same standards as the previous arrangement. This disclosure of information and company records could prove harmful to the original company in the long run if or when they choose to terminate the contract. Any confidential information involving product design, production processes or secret formulae should be protected through a penalty clause in the contract.
Quality Concerns – As mentioned before, the quality of the product or service delivered by the other firm may not be up to the standards of the company which gives the outsourcing contract. Extra measures and checks need to be maintained by the company to ensure that product standards are maintained since these are the most important aspect of a company’s reputation and saleability.
Goodwill and Reputation – The reputation of a company may be adversely affected when the news about its outsourcing operations becomes public. One of the major disadvantages of outsourcing is that it raises doubts in the minds of the populace regarding the abilities of the firm indulging in such an arrangement. They may interpret an outsourcing arrangement as the inability of the company to sustain production and distribution itself. Also, the goodwill among the employees of such companies will be positive or negative depending on which side of the bargain they are on. In other words, if the outsourcing arrangement provides increased employment opportunities to the local workforce, it generates positive goodwill for the company. However, the exact opposite sentiment is expressed by the population which loses employment opportunities due to outsourcing.
Here, we have examined some of the major disadvantages of outsourcing. In today’s age of globalisation, outsourcing is a technique which is widely implemented and links global economies closer together. There are differing sentiments on how good or bad the effects of outsourcing are. However, it is safe to say that the disadvantages of outsourcing though relevant, are not significant enough to completely eradicate such arrangements. Hence, outsourcing and its offshoots will continue to thrive in the coming years.