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 percent 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. 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 percent 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 percent 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 ([email protected]) was involved in one of the largest IT outsourcing contracts ever made and witnessed how everyone ended up a loser.