Outsourcing as an economic experiment

One of my favorite economics articles of all time is by Nathan Rosenberg, “Economic Experiments.” Industrial and Corporate Change , volume 1 (1992). In that essay, Rosenberg pointed out that any dynamic economy had to let firms engage in experimentation to find out new ways to innovate and generate profits. Many of these experiments would fail, of course, but the successes would lead to massive economic gains. It was crucial that these experiments be permitted to fail, otherwise no useful information could be gleaned. I bring this up because looking at economic enterprises as a rolling series of experiments is a great analytical lens to think about offshore outsourcing. Specifically, a lot of firms outsourced offshore as an experiment to boost profits. And, not surprisingly, a lot of experiments fail: Gartner recently predicted that 80% of customer service outsourcing projects aimed to cut costs will fail. That cannot and should not stop other firms from trying — like MacDonald’s outsourcing its drive-thru windows to remote call centers (if you click on the story, note that they’re thinking of outsourcing to Norh Dakota and not Bangalore). The great thing about experimentation is that the people conducting the experiments learn more from failure as success. As firms gain more experience from offshoring, they are starting to recalibrate what is outsourced and what is kept in-house. Kelly Shermach makes this point in CRM Buyer:

By farming out only bits of business, U.S. organizations can more easily grasp the risks they take as well as the efficiencies they gain. “It’s easier to see you’re getting a better price, easier to get a benchmark when you’re selective for better process manageability,” said Robert McNeill of Forrester Research. Even when companies outsource some functions, they often keep control over far more than their core competencies. Unless outsourcing will deliver a cost savings with equal or better service quality, they keep it in-house…. And by farming out only bits of business , U.S. organizations can more easily grasp the risks they take as well as the efficiencies they gain. “It’s easier to see you’re getting a better price, easier to get a benchmark when you’re selective for better process manageability,” McNeill said.

U.S. firms are also starting shifting the location of offshoring activities. Some firms are relocating their offshoring activities to the Philippines because of increasing costs of Indian offshoring. Cultural familiarity is also causing firms to switch some of their activities to nearshoring — i.e., farming out operations to Canada (or, for western European firms, to eastern Europe). These trends worry some Indian analysts. Sonia Chopra frets in India Daily:

In recent days the escalating cost of employment in India, lack of qualified work force and deflation service prices have made outsourcing a tough business. The Western companies in India are running around to save even one cent. The escalating cost of living and shortage of qualified workforce is putting a solid pressure on wage increase. On top of that the companies have to keep 20% excess work force to accommodate turn over and other issues. The clients in the West are always threatening to stop business, not pay etc. based on quality and delivery of services on schedule. All these have made outsourcing a painful business. On top of those countries like Poland, Philippines, South Africa and so on are competing heavily lowering the prices and providing additional incentive to the clients…. Some Indian companies have tried to branch out into premium pricing environments – the vertical markets in IT. That is where India is failing. It was a easy honey moon for Indian companies to offer cheap services with less than par alary in the country and Indian rupees trading at a lower value than then the fair market values. But when these factors are taken out, Indian companies find they are nowhere.

It’s with this kind of experimetation in mind that one should read Pete Engardio and Bruce Einhorn’s excellent article in Business Week about the offshore outsourcing of R&D activities. The outsourcing of R&D is often considered the “line of death” for economic analysts. If that happens, the thinking goes, so does American technological leadership. Parts of the article sound ominous:

When Western corporations began selling their factories and farming out manufacturing in the ’80s and ’90s to boost efficiency and focus their energies, most insisted all the important research and development would remain in-house. But that pledge is now passé. Today, the likes of Dell, Motorola, and Philips are buying complete designs of some digital devices from Asian developers, tweaking them to their own specifications, and slapping on their own brand names. It’s not just cell phones. Asian contract manufacturers and independent design houses have become forces in nearly every tech device, from laptops and high-definition TVs to MP3 music players and digital cameras. “Customers used to participate in design two or three years back,” says Jack Hsieh, vice-president for finance at Taiwan’s Premier Imaging Technology Corp., a major supplier of digital cameras to leading U.S. and Japanese brands. “But starting last year, many just take our product. Because of price competition, they have to.” While the electronics sector is furthest down this road, the search for offshore help with innovation is spreading to nearly every corner of the economy….

However, a closer read reveals that what’s going on is experimentation:

[There is] a rethinking of the structure of the modern corporation. What, specifically, has to be done in-house anymore? At a minimum, most leading Western companies are turning toward a new model of innovation, one that employs global networks of partners. These can include U.S. chipmakers, Taiwanese engineers, Indian software developers, and Chinese factories. IBM is even offering the smarts of its famed research labs and a new global team of 1,200 engineers to help customers develop future products using next-generation technologies. When the whole chain works in sync, there can be a dramatic leap in the speed and efficiency of product development…. [D]ifferent companies are adopting widely varying approaches to this new paradigm. Dell, for example, does little of its own design for notebook PCs, digital TVs, or other products. Hewlett-Packard Co. says it contributes key technology and at least some design input to all its products but relies on outside partners to co-develop everything from servers to printers. Motorola buys complete designs for its cheapest phones but controls all of the development of high-end handsets like its hot-selling Razr. The key, execs say, is to guard some sustainable competitive advantage, whether it’s control over the latest technologies, the look and feel of new products, or the customer relationship. “You have to draw a line,” says Motorola CEO Edward J. Zander. At Motorola, “core intellectual property is above it, and commodity technology is below.” Wherever companies draw the line, there’s no question that the demarcation between mission-critical R&D and commodity work is sliding year by year. The implications for the global economy are immense. Countries such as India and China, where wages remain low and new engineering graduates are abundant, likely will continue to be the biggest gainers in tech employment and become increasingly important suppliers of intellectual property. Some analysts even see a new global division of labor emerging: The rich West will focus on the highest levels of product creation, and all the jobs of turning concepts into actual products or services can be shipped out. Consultant Daniel H. Pink, author of the new book A Whole New Mind, argues that the “left brain” intellectual tasks that “are routine, computer-like, and can be boiled down to a spec sheet are migrating to where it is cheaper, thanks to Asia’s rising economies and the miracle of cyberspace.” The U.S. will remain strong in “right brain” work that entails “artistry, creativity, and empathy with the customer that requires being physically close to the market.” ….Still, most companies insist they will continue to do most of the critical design work — and have no plans to take a meat ax to R&D. A Motorola spokesman says it plans to keep R&D spending at around 10% for the long term. Lucent says its R&D staff should remain at about 9,000, after several years of deep cuts. And while many Western companies are downsizing at home, they are boosting hiring at their own labs in India, China, and Eastern Europe. “Companies realize if they want a sustainable competitive advantage, they will not get it from outsourcing,” says President Frank M. Armbrecht of the Industrial Research Institute, which tracks corporate R&D spending. Companies also worry about the message they send investors. Outsourcing manufacturing, tech support, and back-office work makes clear financial sense. But ownership of design strikes close to the heart of a corporation’s intrinsic value. If a company depends on outsiders for design, investors might ask, how much intellectual property does it really own, and how much of the profit from a hit product flows back into its own coffers, rather than being paid out in licensing fees? That’s one reason Apple Computer lets the world know it develops its hit products in-house, to the point of etching “Designed by Apple in California” on the back of each iPod…. Companies are still figuring out exactly what to outsource.

Let the experimentation continue…. UPDATE: The EU, on the other hand, seems to disapprove of both outsourcing as experimentation and any report that signals that these experiments can be successful:

Outsourcing isn’t as bad for European jobs as some have feared, says an unpublished European Union study. On the contrary, the study suggests it can help create high-skilled jobs and boost Europe’s flagging economy. But the study was pulled from the agenda of European finance ministers meeting here yesterday to be rewritten, EU diplomats said. It was too inflammatory for countries such as Germany and France, which fear deindustrialization and falling investment from companies exporting jobs to lower-cost countries, they said. “The report says there’s nothing wrong with outsourcing, and that’s absolutely not politically sensitive,” an EU diplomat said. “That’s why it could not be discussed.” The 16-page report, commissioned by the EU’s economic affairs department and reviewed by Dow Jones Newswires, said “there is no evidence that a deindustrialization process is underway.” Developed economies consistently see increases in manufacturing output, the report found. Though some manufacturing jobs are lost, “One should not lose sight of the overall positive developments of net job creation throughout the EU,” the report concluded, “especially for the high skilled.”