From Outsourcing to "Offshoring"—Part 1

As a young man, I selected economics as my major and was introduced to the Theory of Comparative Advantage, first proposed by 19th century economist David Ricardo. In a slightly modernized context, Ricardo argued that countries with surplus labor should focus

on labor-intensive activity, and those with a rich endowment of natural resources should concentrate on efficient extraction of those resources. When each of the countries in a trading network focused on what it did best, then free trade among those countries would result in an improved economy for all. In its implementation, this theory has been the foundation upon which nations enter into "free" world trade.

This theory is being tested today as a wide swath of U.S. industry is moving from internal production to outsourcing (largely domestic) and increasingly to "offshoring" (shifting activities overseas). Not that offshore production is something new; companies in the United States and in other industrialized nations have integrated offshore production into global manufacturing and marketing networks for hundreds of years. What is new is the scale and scope of offshore activity today. Forrester Research, for example, predicts that at least 3.3 million white-collar jobs and $136 billion in wages will shift from the United States to lower-wage countries by 2015. If accurate, this prediction would represent a huge shift in both scale (number of jobs) and scope (white collar jobs). The Wall Street Journal recently reported that IBM was considering shifting 4,700 jobs overseas. Accenture has announced that it would double its workforce in India to 10,000 employees.

Many firms, fearing a backlash, don't talk about their offshoring plans when they involve moving jobs out of the United States. In fact, it's not that far-fetched to imagine an executive-education session on offshoring where the participants and speakers wear dark glasses, no one has nametags, and the press is not invited.

During an economic upswing that has yet to generate a significant number of new jobs, the fear of a backlash is a very real one. Indicative of this, the State of Indiana recently cancelled a $15-million contract with the Indian consulting firm Tata. The company's bid was $8 million below those of two U.S. competitors that had also bid on the contract. The cancellation came at a time when Indiana, like many states, was scrambling to cover a sizable budget deficit. As with this particular incident, the backlash to offshoring is likely to come from organized labor, state legislators, and politicians sensing a resonating issue during an election year. But it doesn't stop with these predictable opponents. Currently, there are more than 100 anti-offshore Web sites dedicated to stopping or slowing this practice.

Three Dynamics in Play

What's behind this increased, sometimes passionate interest in offshoring? Why has the scale and scope of offshore activity increased? We have identified three primary drivers that have steadily gained traction from the mid-1990s.

The first, of course, is the comparative cost of labor in the United States vs. China, India, the Philippines, Eastern Europe, and so forth. One wage rate comparison published by CIO magazine showed that the salary of a programmer in India was one-sixth that of an equivalent programmer in the United States. Similar wage rate ratios held for the Philippines, Malaysia, Russia, Poland, and Hungary. It's often difficult to put an exact number on wages overseas; however, most companies that have moved work abroad report a reduction in direct labor costs of anywhere from 30 to 50 percent. The scope of this shift is also significant. As offshoring moves from call centers to higher value-added services such as medical diagnosis, financial services, tax preparation, and software development, the impact on the services sector of industrialized nations only accelerates.

The second and related driver is the Internet, which facilitates a wide array of business process outsourcing activities. Procter & Gamble offers an excellent example. P&G reported a savings of $1 billion by outsourcing back-office work to Costa Rica, the Philippines, and Great Britain. Combining a low labor cost environment with the efficiencies of the Net also allows companies to expand beyond the traditional business process activities. One company that combined these elements reported that it could now chase down tardy customers who had purchased $100 worth of goods. In the past, without the low-cost labor and the Internet capabilities, the company could only follow up on tardy accounts over $1,000. Commenting on this expanded capability, P&G spokesman Damon Jones has said: "Your expense report doesn't have to be processed by someone down the hall. They can be in another country as long as you both have access to the same computer network."

This third driver, cost cutting, emerged in the late 1990s and was fueled by the economic downturn of 2000-2003. Many firms were desperate to maintain a tidy P&L in the face of diminishing sales. Reviewing the options open to them, they were attracted to the cost-cutting potential of offshoring direct labor. Although this is an effective short- to medium-range solution, experts expect wages overseas to rapidly increase, especially among the highly educated, English-speaking offshore workers. Wages in India, for example, are expected to rise 15 to 25 percent annually in the years ahead. In any case, low labor costs offshore remain a powerful incentive to U.S. goods and services industries.

Argument for Acceptance

In addition to the key drivers, there's a strong argument for offshoring as a way to improve the economies of those countries that benefit from the new job opportunities. The argument generally holds that offshoring helps build strong markets for the nation that exported the jobs. In this scenario, which draws directly from Ricardo's thinking, the nation that loses the jobs will eventually recover the economic loss by developing worldwide markets for its products and services. At the same time, those firms that have outsourced their lower- and mid-range jobs will be able to spend more time on their core competencies. And this, in turn, will lead to innovative goods and services that will be sold globally.

As the activities—and arguments—over offshoring intensify, supply chain professionals are no doubt asking, What does all this mean for me? We'll examine those truly profound implications in Part 2 of this column, appearing in the next issue (April 2004).

Bernard J. "Bud" La Londe is professor emeritus of logistics at The Ohio State University.