the economics of outsourcing - strassmann · interest, taxes outsourcing direct costs overhead...

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The Economics of Outsourcing

Prof. Paul A. StrassmannGeorge Mason University, October 5, 2007

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What is Outsourcing?

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Definitions

Cost ofSales

DepreciationInterest, Taxes

Outsourcing

Direct Costs

Overhead

Profits

Outsourcing = Purchases + Contracts

Value-Added

Outsourcing

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Financial Profile of U.S. Firms

Standard & Poor's Data for U.S. Corporations with 3.8 Million Employees

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Critical Ratios

Outsourcing Ratio = Outsourcing / Value-Added

Overhead Ratio = Overhead / Direct Costs

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Outsourcing and Corporate Economics

• Overhead costs 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 laborsaving gains.

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Research Findings

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International Firms Outsource a Large Share of Direct Costs

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Some Banks Outsource Large Share of Value-Added

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Calculating a Firm's Outsourcing Ratio

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Outsourcing Ratios Differ by Industry

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Higher Pay Need not Result in Outsourcing

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Summary of Research Findings

• “Outsourcing” is essential for the growth of anyeconomy.

• Whether outsourcing is economically effectivedepends on the organization of the the value-chain.

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Distribution of Outsourcing Ratios

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

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Outsourcing Not Correlated with Profitability

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Distribution of Overhead Ratios

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

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Overhead Not Correlated with Profitability

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Summary: Outsourcing and Overhead Ratios

• Outsourcing now equals 75.6% of corporate directcosts and is rising.

• Overhead costs now exceed corporate direct costsby 24% and keep rising as direct costs outsourced.

• Neither outsourcing nor overhead correlates withprofitability. Corporate profitability reflectseffectiveness of management.

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Outsourcing in the Value-Chain

Case Study

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Estimated Cost of a Logitech Mouse

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Different Perspectives on Outsourcing

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Distribution of Costs of a Logitech Mouse

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Summary of Case Study

• The definition of “outsourcing” depends on theposition in the value-chain.

• The dominant cost in global commerce aretransaction costs, not labor costs;

• Assembly takes place from global sources wheretechnology and logistics dictates sourcing.

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Outsourcing in the Value-Chain

Economic Analysis

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Supply Chain Distribution Chain Consumer

Transaction Costs in the Value Chain

26All Other Suppliers Secondary Suppliers Prime Suppliers Manufacturer

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

4.7%

15% 5.8%

33%8.1%

56%

15.9%

100%

ProfitTransaction Costs

All Other Costs

Purchases

Manufacturing Supply Chain Costs

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Costs in a Manufacturing Supply Chain

All Other Suppliers Secondary Suppliers Prime Suppliers Manufacturer0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

4.7%

15% 5.8%

33%8.1%

56%

15.9%

100%

ProfitTransaction Costs

All Other Costs

28Manufacturers Wholesalers Retailers0%

20%

40%

60%

80%

100%

120%

140%

160%

34%

100% 23.5%

127% 24%

158%

ProfitsTransactions

Other Costs

The Total Value Chain

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Potential Gains in the Automobile Industry

Old Value Chain New Value Chain0%

20%

40%

60%

80%

100%

120%

140%

160%

64%

81%

13%

60%

55%

15%

All Other InformationProfits

130%

158%

Gain

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A Value Chain View of Information Costs

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Summary of Economic Analysis

• The global supply chain has accumulated enormoustransaction costs, far exceeding direct costs;

• There are enormous opportunities for cost reductionand improvement of customer service;

• The challenge is in organization of the value-chain.

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Is OutsourcingDamaging?

A Case Study: GM vs. Caterpillar

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Employment: GM vs. Caterpillar

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Outsourcing: GM vs. Caterpillar

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Knowledge Value: GM vs. Caterpillar

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Compensation: GM vs. Caterpillar

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A Comparison With Competitive Indicators

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Summary of GM vs. Caterpillar Comparison

• Despite higher wages Caterpillar increasedemployment;

• Despite high level of outsourcing Knowledge Value ofCaterpillar gains through good management of thevalue-chain.

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A Summary

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A Case of Value-Chain Superiority

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

= Overhead Costs

The Keys to Cost Advantage

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• Economic Value-Added• Information Value-Added• Knowledge Capital

= Enterprise Profit Performance

The Keys to Value Advantage

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A CIO’s Perspective - A Cost Based Point of View

SOURCE: A General Motors case study

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A CIO’s Perspective - A Value Based Point of View

SOURCE: A Bank of America case study

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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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Questions?

paul@strassmann.com