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Understanding Outsourcing.

James Seng writes about outsourcing in Malaysia. He makes good observations, but I think there is more to outsourcing than meets the eye. Most people think that outsourcing is about cutting costs. In fact it’s not, it’s more commonly about raising money than saving money.

Classic outsourcing is basically a form of off-balance-sheet financing. You are a CEO who needs to raise some cash. You sell off your IT division to venture capitalists (or EDS or HP, or whoever) and get a big chunk of cash in. You can then spend that money on some other area of your business, or buy a jet, or return cash to shareholders, or whatever. You rent back the services for a yearly fee in accordance with a prearranged contract. It is then up to the management of the newly formed outsourcing company, if they wish, to cut costs in the new company so as to maximise their return.

Because you have a long-term contract with the outsourcing company, you effectively have a long-term obligation to this company. However, this obligation doesn’t appear on the face of the company’s balance sheet and this is the benefit for the outsourcer. (Not having it appear there makes it easier for the company to keep shareholders, bondholders and lenders happy, and to raise more money if necessary.) A cynic could argue that the outsourcing contract is a loan in all but name.

Outsourcing is not the same as offshoring, where work is done abroad rather than in the home country. Outsourcing does not depend on driving down costs for it to be successful. In fact, there could be an increase in costs and the outsourcing would still be considered successful. Offshoring, on the other hand, is almost always about cost.

Outsourcing can involve offshoring, but it doesn’t necessarily need to. I think when you are talking about outsourcing above, what you actually mean is offshoring. It is absolutely true that offshoring a function that you don’t understand very well is unwise.

What rapidly expanding economies like the Chinese economy needs probably isn’t outsourcing in the above sense. What they need is probably more like an ASP. Pre-packaged or slightly tweaked software on-demand, with all the management and support rolled into the yearly fee.

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