Innovation can diminish offshore outsourcing advantages

Alan Binder the Gordon S. Rentschler Memorial Professor of Economics and Public Affairs at Princeton University predicts that 25% of US jobs are “offshoreable.“ Offshoring is an attractive solution for business executives because:

• US executives have extreme pressure to increase quarterly profits and offshoring, and specifically offshore labor arbitrage (e.g. taking advantage of lower cost offshore workers) is a fast way to decrease costs with out committing significant capital.
• Corporations get more gratification from Wall Street for cost improvement without capital investment because Wall Street’s time horizon is short, and they don’t like waiting for benefits to catch up with depreciation.
• The constraints (e.g. infrastructure, communication, transport) that limited an absolute advantage of one labor market over another in the past have been largely eliminated, making it easier to launch an offshore program.
• Sarbanes Oxley has driven the commitment and control of capital to very senior levels in corporations and cost cutting programs like offshoring that involve little or less capital are an easier path to approval.

The value of offshoring is most often represented by a labor arbitrage benefit (e.g. lowered costs associated with workers), which is reaped as soon as the offshore operation can be established, but then diminishes over time as labor costs rise. The downside of offshoring is that often business processes become harder to improve and evolve once they are delivered offshore making continued innovation difficult and expensive to deliver. This slowdown in innovation can erode Customer Loyalty making product and service upgrades harder to sell, increasing service cancellations, and creating opportunities for new market entrants to outpace market incumbents.

Offshoring may appear less attractive to businesses after considering a transformative strategy.  Innovation and transformation diminish the advantage of lower cost offshore labor by yielding substantially more productive, transformed onshore processes that deliver the same or more output with less labor. However, the key to transformative strategy is broadening the focus of the analysis beyond a labor cost analysis, to a focus on revenues and net income. Focusing strategies completely on cost improvement, especially at the operating unit level, leads quickly to ideas like offshoring where the benefit is relatively fast, and uses less capital resources. Broadening the analysis to an impact on revenues leads to conclusions that include the impact to Customer Loyalty and Quality. A slight increase in revenues without a similar increase in cost can eliminate the advantage of offshore labor. When businesses consider the potential offshore impact to sales and revenue, the quick benefits of offshoring may seem less attractive. Transformative strategy by its nature engages leaders across the business in the same analysis and strategy resulting in a more comprehensive idea that blends the needs of all units into a single plan, and builds consensus and commitment.

As an economic strategy, transformative strategy can play a role in stemming the tide of continued job loss due to offshoring. While businesses can take on some of this burden to create jobs onshore instead of offshore with transformative strategy, the US Government can also share the burden by by enacting tax changes that stimulate capital formation to provide incentives for corporations to invest in transformational programs. Similar actions were taken by President Kennedy in 1962 and President Reagan in 1982, although this time around the goal of any tax changes should specifically target the early years of a transformation program before a return on investment has been reaped from increased productivity and performance. A tax credit targeted at the initial years of a transformation program could substantially diminish the advantage of offshoring, stimulating more capital investment in transformation and making offshoring less attractive.

Ed Fullman, Managing Partner
Adam Smith Consulting
www.adamsmithconsulting.com