Outsourcing: Purpose, How It Works, Advantages, and Disadvantages
Outsourcing is a business model that has gained increased popularity in recent years. It involves the business practice in which a company contracts a third party to provide services or produce goods that were traditionally handled internally by the company's employees and workforce.
This article will take a deep dive into what outsourcing is, how it works, its advantages, disadvantages, challenges, and more.
Outsourcing is a business practice in which a company contracts out certain tasks, processes, or functions to external service providers or third-party organizations rather than handling them in-house. These tasks can include a wide range of functions, such as: customer support, information technology, manufacturing, data entry, and more. The primary reasons for outsourcing are to reduce costs, improve efficiency, access specialized skills, and focus on core business activities while leaving non-core functions to external experts or entities.
The history of outsourcing can be traced back to the 18th-century Industrial Revolution when US companies began outsourcing certain operations to reduce costs while maintaining quality. Modern outsourcing as we know it emerged in the late 1980s and early 1990s, with businesses offering a range of services. It evolved through three key stages which are: traditional, strategic, and transformational.
The initial stage of outsourcing, which occurred from the early 1980s to the late 1980s, was characterized by traditional outsourcing practices. During this period, businesses primarily outsourced non-core activities to external suppliers with the primary goal of reducing costs. Automatic Data Processing (ADP) played a significant role during this era, specializing in payroll, taxes, and accounting services. This outsourcing approach allowed entities, including the US government and private companies, to redirect their focus away from intricate financial calculations.
Throughout the years, outsourcing objectives fluctuated based on market needs, reflecting shifts from cost-saving measures to strategic advantages and, more recently, a focus on innovation and enhanced operational benefits. However, the traditional model of offshoring or onshoring comes with risks tied to the financial stability of outsourcing providers, as seen during the pandemic, when contract cancellations and closures affected the industry.
Outsourcing goes by different names, but some common terms are subcontracting, externalizing, or contracting out. The term offshoring is also sometimes used interchangeably with outsourcing, although they are not the same. Outsourcing is an umbrella term that refers to one company hiring another company to perform some work. Offshoring is a specific type of outsourcing, in which the company that gets hired to do the work is located in a different country than the hiring company.
It depends. Outsourcing refers to the practice of contracting out certain business functions or processes to external third-party service providers. These service providers can be located either domestically (onshore) or internationally (offshore). In outsourcing, a company delegates specific tasks or activities to a specialized vendor. This is often done to reduce costs, access expertise, or focus on its core competencies. Offshore outsourcing involves partnering with companies in different countries, while onshore outsourcing entails working with service providers within the same country as the hiring company. However, onshoring does not necessarily mean that a company has to outsource the work. It can also include internal operations within a company inside national borders. Onshoring is a strategy in which a company keeps its business operations or processes within its own country. In onshoring, a company chooses to handle its activities internally or may collaborate with local service providers.
The purpose of outsourcing is multifaceted and can vary depending on the specific goals and needs of a company. One of the primary purposes of outsourcing is to reduce operational costs. Companies often seek to lower expenses by outsourcing non-core functions to specialized service providers which can perform these tasks more efficiently and at a lower cost. Companies can also focus their efforts on core business activities by outsourcing some work. Organizations can direct their resources and efforts toward areas in which they excel and add the most value by delegating non-core tasks to external experts.
Additionally, outsourcing provides access to specialized skills and expertise that a company may not possess in-house. Service providers are often industry experts who can deliver high-quality services or products. Moreover, outsourcing offers scalability and flexibility. Companies can adjust the scope of outsourced services based on fluctuating demand, helping them adapt to changing market conditions.
In terms of risk mitigation, companies can transfer certain risks to outsourcing partners. For instance, outsourcing IT services may involve risk-sharing for data security and technology infrastructure, reducing the company's exposure to potential risks. Finally, outsourcing facilitates global expansion by leveraging the capabilities of international service providers. This is particularly valuable for companies looking to enter new markets and tap into a global talent pool.
The process of outsourcing typically involves four main aspects, which are the following:
- Program Initiation: Focuses on documenting these ideas and intentions to create the foundation for a draft contract. It sets the stage by defining the program's objectives and outlining what the final program should achieve.
- Service Implementation: Initial ideas and intentions are transformed into a formal, planned outsourcing program. Specific activities during this phase include: defining the transition project, transferring staff to the service provider (if necessary), establishing a Service Level Agreement (SLA), defining service reporting mechanisms, and implementing and handing over the service to the outsourcing partner.
- Final Agreement: This is produced upon completing the negotiation cycle. It serves as the formal, legally binding document that outlines the terms, conditions, and expectations for the outsourcing relationship.
- Program Closure: This involves filing away the wealth of information generated throughout the program. This information, stored to varying degrees of formality by team members, is archived for future reference.
Outsourcing in manufacturing involves hiring another company to manufacture a product on your behalf. It is a fairly common practice and is usually done to reduce labor costs. Outsourcing manufacturing usually involves the following:
- Set out basic requirements.
- Identify potential manufacturers. Look for ways to vet manufacturers and select the best one based on abilities, reputation, and price.
- Request product samples or options and work with the manufacturing company to refine the design.
- Once production starts, perform quality assurance to ensure the products are up to standard.
Outsourcing refers to hiring an external company to do a piece of work, whereas in-house operations refers to a company doing the piece of work internally. In-house operations result in a lot more control of the process, and flexibility in terms of changing procedures if any reason to do so arises. Unfortunately, there is also the risk of costs running over for a project, and the extra costs associated with managing and supplying labor for a project. Any projects taken on internally also lock in a section of the workforce, meaning they cannot focus on other areas that the company might deem important.
Conversely, with outsourcing, a company can benefit from competition on the global stage, generally leading to reduced costs, access to experts in the field, and freeing up internal employees to focus on work that could be more rewarding for the company. This does come at the cost of less control over the work being outsourced, along with extra risks, such as the outsourced company not delivering on time or up to standard.
Outsourcing has many advantages, some of which are listed below:
- Can lead to reduced and more controlled costs, as you can shop around for the best price, and usually negotiate a fixed price.
- A company is not limited to the internal knowledge pool but has access to the global pool of experts in any given field.
- Allows a company to focus its efforts on higher-yield areas.
- A company can get more done, without increasing the size of its staff.
Outsourcing has the following disadvantages:
- Have less control over the service being performed on your behalf.
- May harm internal morale, with staff potentially stagnating, or being upset at not doing the work themselves.
- There are risks involved with outsourcing, such as the risk of inferior products, the risk of a subcontractor not delivering on time, or the risks of an outsourced company going out of business or breaching a contract.
Outsourcing can be subdivided into different types, which can be classified based on two factors: location and type of work being outsourced. The different types of outsourcing based on location can be divided into three categories: offshoring, nearshoring, and onshoring. The different types of outsourcing based on the type of work (service, product, etc.) being outsourced include:
- BPO (Business Process Outsourcing): Involves outsourcing various business processes, such as: HR, IT, accounting/payroll, and customer service, to external providers.
- LPO (Legal Process Outsourcing): Focuses on legal services, outsourcing tasks like: legal research, contract management, and document review to external law firms or lawyers, beneficial for companies without in-house legal expertise.
- KPO (Knowledge Process Outsourcing): Handles knowledge-based processes, like: data analysis, R&D, and market research.
- ITO (Information Technology Outsourcing): Encompasses IT services such as: web development, application management, and software or game development, helping companies stay current with evolving technology by outsourcing tasks to IT experts.
- Facilities Management Outsourcing: Outsourcing services like: security, maintenance, janitorial work, and landscaping to third-party agencies for efficient facilities management.
- Creative Process Outsourcing: Involves outsourcing creative tasks such as: photography, content creation, graphic design, video production, and voice recording to specialists.
- Manufacturing Outsourcing: Hiring external firms to produce parts or entire products. This can range from cosplayers collaborating on costume elements to tech companies contracting manufacturers for smartphone components.
Several well-known businesses began their journeys by outsourcing development in their early stages. Listed below are some examples:
- GitHub: A platform for software development collaboration, initially brought in Scott Chacon as a consultant on an outsourced basis, leveraging his rare understanding of Gits to contribute significantly to the platform's backend.
- Fab.com: Fab.com's founder, Jason Goldberg, utilized a software development firm in India to build his e-commerce business, eventually acquiring the firm as his company's needs evolved.
- Groove: Alex Turnbull, founder of Groove, outsourced the technical aspects of his software-as-a-service company to retain full ownership while saving costs on full-time workers.
- Slack: Enlisted the help of a design firm, MetaLab, to refine its product during its early stages. MetaLab's redesign of the website, app, and logo contributed significantly to Slack's success.
- Upwork: Built its foundation through a team largely composed of contractors, emphasizing the flexibility and advantages of freelancers in their business model.
Yes, Business Process Outsourcing (BPO) is an example of outsourcing. BPO specifically involves outsourcing particular business processes or functions, such as: HR, IT, accounting/payroll, customer service, and other tasks, to external service providers. In this context, outsourcing refers to the practice of delegating these specific functions to third-party entities, whether they are individual freelancers or employees of a BPO call center, to enhance efficiency, cost-effectiveness, and expertise in handling those processes.
Outsourcing has a range of effects on economics and labor. One popular reason for outsourcing is to outsource to a company in a country with reduced labor costs. The economies of these countries, as well as the laborers themselves, benefit greatly from the influx of foreign money. Conversely, the labor force and economy of the outsourcing countries can start to suffer as more and more companies outsource their work, leading to higher unemployment.
Yes, in general, outsourcing can be good for a specific company. Outsourcing can lead to significant cost and time savings, freeing a company up to focus its efforts more effectively. If an expert company is contracted to perform a specific service, the hiring company can also end up with a superior result than if they performed it themselves.
Outsourcing's future looks promising, with predictions of substantial growth. Globally, outsourcing spending is expected to reach $731 billion in 2023. IT outsourcing spending could increase by 22%, reaching $519 billion, and business process outsourcing spending is forecasted to rise by 19%, reaching $212 billion by 2023. Further into the future, the business process outsourcing industry is projected to reach $525 billion by 2030.
Several trends are poised to drive the evolution of outsourcing, including: cybersecurity, talent competition, cloud-based technology, remote work continuity, mergers, AI, automation, and global expansion.
Some common challenges in outsourcing include:
- Project Control: Working with external companies means limited control over the project and the team executing it.
- Outsourcing Experience: A lack of experience in outsourcing can make the process overwhelming, particularly when conveying your vision and requirements to a new partner.
- Differences in Organizational Culture: When outsourcing, disparities in corporate and regional cultures can lead to misunderstandings and conflicts between the two teams. These differences can affect communication, interpretation, and productivity.
- Communication Challenges: Language and communication barriers can be significant when working with offshore outsourcing partners, leading to misunderstandings and miscommunication.
- Challenges in Data Security and Intellectual Property: Data security and intellectual property protection are major concerns when sharing sensitive information with third-party outsourcing partners.
- Challenge in Transferring Knowledge: Transferring knowledge between your organization and the outsourcing partner can be challenging, especially when project outcomes need to be managed after the partnership ends.
Outsourcing is an umbrella term used to describe when one company hires another company to do work that could have been done internally. Offshoring is a type of outsourcing in which the hiring company is located in a different country than the company being hired.
To learn more, see our article on Outsourcing and Offshoring.
This article presented outsourcing, explained it, and discussed how it works and its various advantages. To learn more about outsourcing, contact a Xometry representative.
Xometry provides a wide range of manufacturing capabilities and other value-added services for all of your prototyping and production needs. Visit our website to learn more or to request a free, no-obligation quote.
The content appearing on this webpage is for informational purposes only. Xometry makes no representation or warranty of any kind, be it expressed or implied, as to the accuracy, completeness, or validity of the information. Any performance parameters, geometric tolerances, specific design features, quality and types of materials, or processes should not be inferred to represent what will be delivered by third-party suppliers or manufacturers through Xometry’s network. Buyers seeking quotes for parts are responsible for defining the specific requirements for those parts. Please refer to our terms and conditions for more information.