Outsourcing: Balancing the Risks and Rewards
By Tim Gray

ay Swaminathan figured that the 20 MBA students he took to India in May 2004 would have plenty of misconceptions about his native land. After all, India, as much as any country except perhaps China, has come to represent outsourcing — the trend of American companies sending jobs abroad to save money. Business Week devoted a recent cover story to comparing the uncertain prospects of a young American computer programmer with the glittering future awaiting his counterpart in India. While the young American rued his decision to attend graduate school in computer science, the Indian woman rhapsodized about creating the next Google. Swaminathan, a professor of operations, technology and innovation management at UNC Kenan-Flagler, wanted his students to visit Indian companies, interact with executives and employees, see the thronged streets of the billion-person country and then make up their own minds about the promise and perils of outsourcing.

“India is traditionally known to be an ancient land of elephants and snake charmers. Foreigners have been fascinated by its natural beauty, diversity and ancient history,” he says. “I wanted the students to get a firsthand experience of the other India — the technologically savvy, buzzing and developing potential global superpower.”

Swaminathan’s immersion trip, which grew out of his research funded by the National Science Foundation on warranty services in the electronics industry, is just one of the many ways that scholars and students at UNC Kenan-Flagler are wrestling with the economic and social dilemma that is outsourcing. At its most basic level, the term simply means hiring an outside contractor, sometimes abroad, to do a task that a company previously did itself. It can be as simple as bringing in a janitorial service or as high-tech as employing foreign radiologists to read American X-rays transmitted over the Internet.

But the word also has become a rallying cry, with the power to divide and inflame. It’s knotted up with free-market fervor and jingoistic fears. To some people, it heralds a more profitable and productive future, where American companies can easily send work to wherever wages are cheapest. To others, it signifies the permanent loss of American jobs and the atrophy of America’s economic muscle.

The debate resonates at UNC Kenan-Flagler because two of the U.S. industries walloped by the latest wave of outsourcing — textiles and furniture — have long been concentrated in the School’s home state of North Carolina. In the last recession, North Carolina lost more manufacturing jobs than any other state. Many of those jobs were at now-shuttered textile and furniture plants.

“Nationally, outsourcing may leave us better off, but in the short term, it can lead to wrenching problems,” says John D. Kasarda, a management professor and director of the Kenan Institute of Private Enterprise. “There can be very high short-term costs.”

Job losses haven’t been limited to North Carolina, nor to older industries. “About 300,000 jobs have been outsourced from the United States over the last three years,” says Kasarda. “Forrester Research estimates that about 3.4 million jobs will be outsourced abroad between now and 2015.”

Scary statistics aside, the real question is whether outsourcing is good or bad, both for companies that do it and for their employees. Talk with scholars and students at UNC Kenan-Flagler, and it’s clear that they believe that it’s inevitable and, on balance, positive. At the most basic level, the practice cuts costs for companies, which can lead to higher profits for shareholders and lower costs for consumers. It also can free up money for research and development and innovation. That, in turn, can lead in the long run to the creation of better jobs than the ones that move abroad. But in the short run, outsourcing can produce hardship, as some domestic firms and workers find themselves caught in the riptides of globalization. That’s why faculty at UNC Kenan-Flagler also are looking for ways to assist people in finding new opportunities and making the transition to new jobs, whether through education or entrepreneurship.

Outsourcing, Not Just a Recent Phenomenon

Separating facts from fears is the first step in understanding outsourcing.

Michael Luger, a management professor and director of the Kenan Institute’s Center for Competitive Economies, points out that outsourcing isn’t new, nor is the migration of labor-intensive industries to low-wage locales.

The U.S. textile industry, long identified with North Carolina, actually began in New England, he says. A national park in Lowell, Mass., even celebrates that town’s history as a textile-making center in the 19th century and preserves some of its old brick mills. In the early part of the 20th century, textile makers moved their plants South in search of cheaper workers. In the ’70s and ’80s, some textile jobs shifted to Latin America and then, in the ’90s, to China.

These days, blue-collar jobs aren’t the only ones moving abroad. “What’s gotten the public’s attention lately is the types of jobs being outsourced,” Luger says. “We used to say we don’t want those minimum-wage jobs anyway. Now we’re outsourcing high-level technical and financial-services jobs.”

Put another way, jobs may not be moving in greater numbers or at a faster rate than before; but this time, white-collar workers feel threatened, too. And unlike their blue-collar brethren, these folks know how to make their complaints heard in the media and at public meetings. A Web site called yourjobisgoingtoindia.com, for example, gives tech workers a forum for grousing about their plight. And CNN broadcaster Lou Dobbs lately has made railing against companies that send jobs abroad a signature of his program.

Differing Approaches to Outsourcing

Aleda Roth, a distinguished professor of operations, technology and innovation management, says that the sometimes-shrill public debate on outsourcing has confounded the search for answers. She says people too often fail to distinguish outsourcing and offshoring.

“Outsourcing is contracting out, giving something to another party, while offshoring means that a company is moving some or all of its operations overseas,” she explains. “Moreover, most outsourcing remains with domestic suppliers, and only about 10 percent of all outsourcing dollars are spent overseas.”

Sometimes, when going abroad, companies set up foreign operations as offshoring. For example, Lucent Technologies has established a lab in Bangalore, India. The outpost allows Lucent’s employees to work around the clock. When U.S. staffers leave in the evening, co-workers in India continue work on projects. As staffers in India finish their work day, those projects return to U.S. staffers in a continuous cycle. Thus, with offshoring, jobs may be reallocated using a company’s global workforce, but at least the expertise is retained by the firm.

At other times, companies outsource work abroad by hiring a foreign company to handle a task previously done by employees. “With overseas outsourcing, a firm may potentially lose its production know-how, which is traded off against the promise of lower labor costs,” Roth says.

Wipro Ltd. and InfoSys Technologies Ltd., both in Bangalore, have built billion-dollar businesses out of taking over everything from customer-service call centers to high-level computer programming. Swaminathan’s students visited both as well as a host of other companies in a tour that also took in the Indian cities of Mumbai, Dehli, Goa and Agra.

“Wipro has training courses to teach its people to speak in an American accent,” Swaminathan says. “Then they train on cultural issues — the names of football teams and basketball teams. And employees are given the choice to a pick an anglicized name. One person we talked to calls herself Julia because she likes Julia Roberts.”

Rebecca Swartz, a rising second-year MBA student, was struck by how similar Wipro was to well-run companies in the United States. “The workers get a lot of benefits like subsidized meals,” she says. “They have a concierge service to help them with errands, because a lot of them work at night and sleep during the day. They’re providing customer service to people in the United States and have to work when we’re awake.”

Wipro and Infosys couldn’t have built their hefty businesses unless companies elsewhere, especially in the United States, hadn’t bought their services. Which leads to an obvious, but crucial, question: Who exactly outsources?

The Surprising Reasons Companies Outsource

Roth and two UNC Kenan-Flagler co-authors — John Gray, a PhD student, and Brian Tomlin, a professor of operations, technology and innovation management — set out to answer the question of what companies outsource and why. They analyzed responses to an international survey, administered by UNC Kenan-Flagler and Deloitte & Touche, of senior manufacturing executives. Some of what they found surprised them.

“One of our primary hypotheses was that a company’s overall quality capability and priority would impact its plans to outsource,” Gray says. “That didn’t matter at all. What did matter was technical capability — the more technically advanced a company is relative to its competitors, the less likely it is to outsource manufacturing.”

In theory, a maker of microprocessors such as Intel, which might invest $2 billion in a single chip plant, would be less likely to outsource than a sock maker. A technology leader such as Intel invests a lot more in educating its employees and ensuring that its plants and systems are cutting-edge. That kind of company doesn’t outsource production because it can be more productive than a contractor. “Even more importantly, it wants to preserve its know-how as an engine of competitive advantage, Roth explains. Outsourcing gives outsiders an opportunity to poach its expertise.

Another result from Roth, Gray and Tomlin’s study was that companies that are good at developing new products are likely to outsource manufacturing. “What they’re doing is outsourcing production to focus on design,” Roth says. “These executives see design as the primary source of competitive advantage.”

Take Nike, which is constantly tweaking and changing its line of athletic shoes, apparel and gear. “They haven’t made shoes for a while,” Gray says. “Their competence is marketing and design.”

One study finding was no surprise: “The main reason that people are outsourcing manufacturing is for lower costs,” Gray says.

Risking More Than They Realize

Roth says companies that outsource for cost alone may be risking more than they realize. Cost savings from lower wages are easy to count. But short-term cost-cutting can lead to longer-term strategic problems that don’t show up as readily in a company’s financial statements.

Roth points to a big computer manufacturer that she studied along with Wendell Gilland, UNC Kenan-Flagler professor of operations, technology and innovation management, and a former student, Jeff Stratman, who is now an assistant professor at Georgia Tech. To save money, the company replaced many of its long-time manufacturing workers with temporary staffers. Each year, it would bring in a new group of temps, which kept wages low. Trouble was, the temps never stayed long enough to become good at their tasks. As the number of defective products shot up, the hidden costs of poor quality surfaced in lower productive capacity, disruptions and less organizational learning.

“The typical cost accounting way of looking at these things is inadequate,” she says. “It’s not capturing the dynamic tradeoffs between lower labor costs and the learning effects. Nor do traditional systems account for the opportunity costs of lost sales due to lower effective capacity.”

In other words, executives should beware of capability creep. They have to be sure that, in their zeal to save money, they don’t farm out tasks that may erode productive capabilities, and in turn, may undergird their ability to compete in the long run.

That’s what happened to the U.S. television industry, Gray says. A study by UNC Kenan-Flagler strategic management professor Rich Bettis showed that American firms once owned the industry. But they outsourced manufacturing to Japanese companies. As a result, by 1990, they were making only 12 percent of the TVs sold in the United States.

Arvind Malhotra, a professor of information and technology management, believes that smarter companies already understand that the savings from outsourcing are short term. These companies outsource to free up resources for research and development and innovation, he says. He and a colleague, Al Segars, who’s also a professor of information and technology management, recently began a study of outsourcing decisions at 300 multinationals.

An example of a firm that has used outsourcing in the way Malhotra and Segars envision is DuPont, the Wilmington, Del.-based chemical company.

“DuPont is good at invention and innovation — creating chemicals and fibers,” Segars says. “They layered atop that manufacturing and distribution. So they were fully integrated in the late ’80s. But they found that they weren’t making money on manufacturing fibers. They couldn’t do it as cheaply as others. So they started to outsource manufacturing. A company like DuPont is rediscovering its core capabilities.”

DuPont is investing money where it knows it can add value and command premium prices and handing off inessential activities that drain its coffers. But like Roth, Segars warns executives to be careful if they try to imitate DuPont’s success: They have to distinguish inessential tasks, which can be outsourced, from those that shouldn’t be. “When you start to outsource your thinking, you’ve gone too far,” he says.

James H. Johnson Jr., a management professor and director of the Kenan Institute’s Urban Investment Strategies Center, warns that companies already are sending their thinking abroad. General Electric, for example, has created an R&D center in Bangalore. (A key distinction: GE has offshored its R&D center without outsourcing it; the company owns the center.) This sort of activity may benefit GE shareholders, but it also could augur a more difficult future for the U.S. economy, Johnson points out.

“If the R&D dollars are going offshore, what makes us think the next biotech or nanotech wave is going to be in the United States?” he says.

This has implications for American universities, too, he explains. Traditionally, corporations have funded some university research. But if they can hire researchers abroad more cheaply, they’re going to be less willing to do that. And that, in turn, might undercut the ability of American schools to train the next generation of researchers and innovators.

“We have to teach the next generation of people to be more entrepreneurial and to think outside the box. And we have to create civic and social entrepreneurs as well as traditional entrepreneurs,” Johnson says.

Surviving in an Outsourced World

For U.S. companies in labor-intensive industries such as furniture and textiles, the question isn’t whether to outsource. It’s whether they can survive at all in an outsourced world. They’re faced with competition from, for example, Chinese factories that can pay their workers a fifth as much. For them, outsourcing isn’t the latest management vogue; it’s life or death.

Bob Connolly, a finance professor and a senior research fellow with the Center for the Study of the American South, came to see this vividly through conversations with officials at the N.C. Commerce Department about their efforts to aid the state’s struggling furniture makers. North Carolina accounts for a third of the nation’s $23 billion furniture market.

“What was clear was that the folks at Commerce didn’t have access to a lot of dispassionate research on what was going on,” he says.

Connolly figured he could help. He teaches an MBA class called Industry Economics in which student teams have to report on the determinants of profitability in a variety of industries. On the first day of class in the fall of 2002, he announced the assignment and told his students that the state had a special interest in the furniture industry and that their reports might help it formulate policy.

Several teams took up the challenge, and one group did a report that was good enough that a member of the U.S. Congress — Donald Manzullo, an Illinois Republican — cited it in a speech on the floor of the House.

A member of the group, Elizabeth Miller, who graduated in May, says she and her classmates learned that U.S. furniture makers are partly responsible for their industry’s plight.

“Outsourcing had been going on for some time to China, but it was low-quality, high-volume products. Then U.S. manufacturers taught Chinese contractors how to construct higher-quality furniture — how to do things like coating and staining — so we transferred that knowledge.” (In other words, they did exactly what Roth and Segars warn against: They exported their competitive advantage.)

Once the Chinese makers mastered these techniques, they were able to knock off higher-end designs. What’s more, Miller explains, they’ve done it with wood shipped from the United States. She says that Chinese companies haven’t learned to cure and dry lumber so that it’s appropriate for making furniture.

The MBAs also discovered that lower wages aren’t China’s only advantage. Overhead costs less there, too. Take health care, Miller says. In China, the government subsidizes it. For American firms, it’s a hefty and growing cost.

U.S. furniture factories and their employees undoubtedly have suffered because of outsourcing to China. But American consumers have benefited thanks to lower furniture prices, the group’s report points out. Which is why many economists say outsourcing, on balance, benefits everyone in the long run. Not only does it free up resources for innovation, but it pushes down prices.

If they’re going to compete with Chinese companies, U.S. furniture makers will have to find a way to cut their costs, the group concluded. One way could be by merging and taking advantage of economies of scale.

Another way to survive would be stressing design. In many consumer-products industries, consumers will pay more for familiar or fashionable brands and, if they can afford to, shun knockoffs. Call it the Sam Adams strategy.

Through marketing and advertising, the beer maker has persuaded consumers to pay more for its brews than for Budweiser. By stressing design, American furniture companies might be able to parlay a similar cachet into premium prices.

Even so, these strategies may only slow domestic furniture makers’ decline. Ultimately, they may have little choice but to move production abroad, just as textile manufacturers moved their plants to the South a century ago.

That’s why Miller believes that policy-makers’ response to outsourcing is just as important as businesses’. They have to look for ways to retrain furniture workers for, say, jobs in pharmaceutical manufacturing, which remains strong domestically.

Kasarda, of the Kenan Institute, recommends that, too. But he adds that encouraging the formation of new kinds of high-tech businesses is just as important, if not more so.

“We have to have an environment that encourages the transformation of ideas into enterprises that create jobs and value,” he says. “These jobs will grow at a faster rate than the jobs that we’re losing through outsourcing. We’re going to compete through innovation.”

The famed economist Joseph Schumpeter called the process by which the economy operates “creative destruction.” New companies, whether from China or Charlotte, enter the market with better products or processes. Their competitors must then respond with innovations of their own. If they don’t, they die.

As they die, new companies spring up to fill needs that might not have been foreseen a few years before. Think of eBay or Netflix. They were impossible to imagine until the invention of the Internet and, in Netflix’s case, DVDs.

Offshoring to India, China and a host of other developing countries is simply the marriage of this process with globalization. Scholars and students at UNC Kenan-Flagler are doing what they can to make sure the marriage is a happy one.