1

The Economics of Outsourcing

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

2

What is Outsourcing?

3

Definitions

Cost ofSales

DepreciationInterest, Taxes

Outsourcing

Direct Costs

Overhead

Profits

Outsourcing = Purchases + Contracts

Value-Added

Outsourcing

4

Financial Profile of U.S. Firms

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

5

Critical Ratios

Outsourcing Ratio = Outsourcing / Value-Added

Overhead Ratio = Overhead / Direct Costs

6

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.

7

Research Findings

8

International Firms Outsource a Large Share of Direct Costs

9

Some Banks Outsource Large Share of Value-Added

10

Calculating a Firm's Outsourcing Ratio

11

Outsourcing Ratios Differ by Industry

12

Higher Pay Need not Result in Outsourcing

13

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.

14

Distribution of Outsourcing Ratios

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

15

Outsourcing Not Correlated with Profitability

16

Distribution of Overhead Ratios

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

17

Overhead Not Correlated with Profitability

18

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.

19

Outsourcing in the Value-Chain

Case Study

20

Estimated Cost of a Logitech Mouse

21

Different Perspectives on Outsourcing

22

Distribution of Costs of a Logitech Mouse

23

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.

24

Outsourcing in the Value-Chain

Economic Analysis

25

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

27

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

29

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

30

A Value Chain View of Information Costs

31

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.

32

Is OutsourcingDamaging?

A Case Study: GM vs. Caterpillar

33

Employment: GM vs. Caterpillar

34

Outsourcing: GM vs. Caterpillar

35

Knowledge Value: GM vs. Caterpillar

36

Compensation: GM vs. Caterpillar

37

A Comparison With Competitive Indicators

38

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.

39

A Summary

40

A Case of Value-Chain Superiority

41

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

= Overhead Costs

The Keys to Cost Advantage

42

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

= Enterprise Profit Performance

The Keys to Value Advantage

43

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

SOURCE: A General Motors case study

44

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

SOURCE: A Bank of America case study

45

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.

46

Questions?

paul@strassmann.com