Production: offshoring and outsourcing
In the video, Facing the competition, several Italian clothing firms had considered changing the location of their production – either outsourcing the work to another firm, or moving their own production facilities abroad to save on labour cost. However, such a strategy has challenges: outsourcing reduces a firm’s control over parts of the production process and may produce quality issues. Offshoring involves investment in labour (training), and capital and land to set up a production facility. It may also take time to achieve the desired production standards. Some firms that decide either to offshore or outsource fail to consider their total cost of production and how costs may change over time when making their decision.
Activity 19
Read the article 'Herd instinct – Companies need to think more carefully about how they offshore and outsource' [Tip: hold Ctrl and click a link to open it in a new tab. (Hide tip)] from The Economist and list at least two factors that can make firms reverse a decision to offshore or outsource. Can you think of any other factors not mentioned in the article?
Answer
Here are three different issues in the article – you may have found others.
- Labour cost increase. The article highlights that when labour cost is not a large proportion of total cost, firms may not gain from offshoring. If the motivation for offshoring is access to cheaper labour input, then firms that have labour cost that is a low proportion of their product’s total cost have little to gain from moving production overseas. Also as increasing numbers of firms follow the same strategy, they end up producing in the same country or location, which pushes up local wages, eroding the expected cost saving.
- Quality of production falls. If a firm has high-quality standards, offshoring can make it difficult to maintain them or achieve similar quality levels of output because of a lack of experience and training in the workforce. This is also true with outsourcing, which has further difficulties for firms to maintain control of production processes taking place outside the firm. The video, Facing the competition, also highlighted that some firms had these concerns about the quality of producing goods from offshore or outsourced locations.
- Expected cost savings fail to materialise. The article also suggests some firms fail to allow for delays and unexpected problems that arise as a result of their offshoring or outsourcing decision. For example, consider the case of Boeing described in the article.
Some reasons not listed in the article include:
- Economies of scale cannot be realised. Economies of scale are not discussed in the article, but the video, Facing the competition, describes how small textile producers lacked the motivation to offshore production because they could not gain from economies of scale – their businesses were too small and could not realistically hope to increase output. Firms that only produce a small output will not realise the labour cost saving from offshoring, but will still face similar issues related to loss of control and quality.
- Increase in cost of transport. The production cost when firms offshore or outsource may involve significant transport costs that depend on factors outside the control of the firm.