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Tuesday, January 30, 2007

So simple, and yet...

Economists do not decry outsourcing, indeed we tend to celebrate the fact that all trade is a form of outsourcing. As long as trade takes advantage of economies of scale and/or comparative advantage, economists consider outsourcing a success.

Evidently the outsourcing craze that gripped the corporate world suffers from a lack of understanding about how technology (the methodology used to combine factors of production to produce goods and services) can be proportional or variable. Some "functions," entail inputs with lots of excess capacity which, if sitting idle, represent a loss of efficiency. One solution is for a number of different firms to "share" one input so that the input has less excess capacity and therefore is more efficient. On the other hand, other jobs require inputs that have very little excess capacity and "sharing" such inputs would not be expected to yield tremendous cost savings or productivity gains.

That's the fancy economic-speak and it wasn't all that fancy to begin with. However, such a comparison of when outsourcing might prove profitable is something I address in my principles of economics class. I'll freely admit that most of what I say in a principles class is completely forgotten within two months of the end of the course, but CEOs are supposedly those individuals who did not forget their principles (and higher level) courses.

The confusion is put in easy-to-read words by Clive Longbottom in this thought piece:
By outsourcing the function, the outsourcing company could share these skills around, ensuring the engineer had a higher degree of utilisation. Each company would pay for, say, 25 per cent of the engineer's nominal time and the outsourcing company would share the engineer between, say, six companies - so everyone is nominally happy.

Now let's look at task outsourcing. A company that is task oriented will have internal resources that spend all day just doing repetitive tasks. Outsourcing, therefore, has no gains in utilisation - a dedicated resource is still required. Thus, the only possible way that savings can be made is if the resource costs less - even with all the overheads of the outsourcing company and the contract management as well.

The lesson is that outsourcing is not guaranteed to yield increased profits (although if it reduces transaction costs that might be a non-monetary benefit).

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