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."

posted by Dan on 03.16.05 at 07:52 AM




Comments:

> The great thing about experimentation is that
> the people conducting the experiments learn
> more from failure as success.

Let's see:
1) take reasonably successful company
2) add new CEO
3) outsouce functions
4) profits rise temporarily
5) CEO collects $30 million bonus
6) CEO moves on to next job
(positions open at H-P and Boeing)
7) Long term consequences of
outsourcing hit home
8) Company tanks
9) Company files BK
10) Any employees left lose their
livelihood

Who exactly "learns" from that cycle? I don't know how it is in academia these days, but in the world of big business anyone who gets a CXX title is home-free for the rest of their lives: they are NEVER punished for mistakes. Even Carly is getting $20 million and possibly a position at the World Bank!

Cranky

posted by: Cranky Observer on 03.16.05 at 07:52 AM [permalink]

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That McDonald's story is hilarious. One thing I have noticed that they do now is have a prerecorded "welcome message" at the drive thru. It says something like "Welcome to McDonald's. Have you tried the whatever were are pushing this week?" in a completely different voice than the person who actually talks to you. Now, if they throw in another person, it would just be ridiculous how many people one could supposedly talk to just to order a freaking Big Mac.

posted by: Don Mynack on 03.16.05 at 07:52 AM [permalink]

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The first part of Dan's story makes sense to me. Some corporations went in for outsourcing as a kind of fad a few years ago, when among other things the dollar was stronger against many currencies than it is now, and are now pulling back.

I still shake my head, though, at the complacency behind statements such as Pink's, about outsourcing "left-brain" work while retaining in the United States "right-brain" work that requires creativity. There is nothing that I know of guaranteeing that Americans are by nature bound in perpetuity to be better able to do creative work than Indians, Chinese or Poles, first of all. Pink's remarks are followed immediately by a paragraph that supports a quote downplaying the importance of outsourcing by noting that some Western companies are cutting back at home while increasing hiring in their labs abroad. That sure sounds like a right-brainish trend to me.

Of more immediate importance, the number of Americans doing that creative work is likely to be small relative to the population of this country. This is not a trivial consideration, at least outside of corporate boardrooms. If instead of a division of labor between West and East we see emerging a division of labor between "the highest levels of product creation" (done partly in the East) and the job of turning concepts to products and services (done mostly in the East), that will have fairly serious consequences for a number of people in the West.

posted by: Zathras on 03.16.05 at 07:52 AM [permalink]

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> I still shake my head, though, at the complacency
> behind statements such as Pink's, about
> outsourcing "left-brain" work while retaining in
> the United States "right-brain" work that requires
> creativity. There is nothing that I know of
> guaranteeing that Americans are by nature bound in
> perpetuity to be better able to do creative work
> than Indians, Chinese or Poles, first of all.

Kelly Johnson, one of the greatest airplane designers of all time and the creator of thousands of jobs, had an ironclad Rule of 10: his engineers (that is to say, his "creative" people) could not be located more than 10 steps away from the manufacturing floor. Reason being that only the constant, minute-to-minute interaction of engineering and manufacturing could understand and solve problems rapidly and creatively.

I did my MBA during the 90s, when "core competency" was rampant. I brought up this kind of example again and again, to be shot down each time: no need for anyone to get their hands dirty.

Now it is outsourcing. Just as in the 80s, except this time to foreign countries and on a much vaster scale. Yeah, this is going to be a learning experience allright.

Cranky

posted by: Cranky Observer on 03.16.05 at 07:52 AM [permalink]

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The families in Ohio and Michigan filing bankruptcy and losing their homes through foreclosure think this is a marvelous experiment.

By the way, bankrupt families are not very good consumers, even of cheap Chinese imports. They don't pay much in taxes either. Gee, many of them have to send their kids to junior college because the 4 year version is too expensive (check the trends in Ohio, for example).

I still like the idea of insourcing cheap college professors, it would save taxpayers and parents a bundle, and the insourced profs would do more teaching and less useless publishing (check the Accounting Review, from my field of endeavor, if you want to understand "useless.").

If we are going to experiment, let's really get into it.

Tom

save_the_rustbelt@yahoo.com

posted by: Tom on 03.16.05 at 07:52 AM [permalink]

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My company is starting to experiment with outsourcing to... Dallas and Salt Lake City. You don't save nearly as much in labor costs, but you hardly lose anything in terms of culture/communication. We're still sending stuff to India, but the distribution of work is starting to become much more sophisticated than the simple, "We'll dump everything in Bangalore" idea which scares so many people.

posted by: Independent George on 03.16.05 at 07:52 AM [permalink]

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In many ways the EU experiment over the last 10+ years is outsourcing - the breaking down of barriers to employment, goods and services. The Irish alone must make-up 25% of any EU company's secretarial pool, in any EU country :) More seriously, EU companies have been optimizing labor and product differentials among member countries for a good decade. Add to that the *sizeable* import tariffs on non-EU product (and services, direct or through stringent hiring restrictions) and you have an economy with little gain from the more global strategy of US & Asian companies looking to eek the last percent advantage from the newest "underadvantaged" labor connected to the world market.

posted by: Jon on 03.16.05 at 07:52 AM [permalink]

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In partial support of Cranky's argument about the design-manufacturing interface: Canon recently announced that it's pulling manufacturing of high-end digital cameras out of China and back to Japan. The stated reason was that in the fast-moving world of high-end cameras, where newer high-densitiy CCDs require new manufactuing techniques, they needed designers and manufacturing folk to look over each other's shoulders. This tracks with the Kelly Johnson anecdote--when you're pushing the state of the art at the systems level, you need lots of organizational integration and short distances really helps.

On the other hand, for products that are not moving forward so quickly, where system performance is not being stretched so much, system integration is less demanding. In those cases, different functions can get away with bigger distances and less communication. The market experiments are largely about distinguishing these cases by trial and error.

posted by: steve on 03.16.05 at 07:52 AM [permalink]

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Terrific post, Dan. Lots of things to read and think about.

Thank you.

SMG

posted by: SteveMG on 03.16.05 at 07:52 AM [permalink]

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You know, experimenting on human beings without their consent is illegal in most civilized countries. Obviously, the U.S. is an exception.

posted by: Firebug on 03.16.05 at 07:52 AM [permalink]

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I can't wait till we start outsourcing professors. Then we won't have to listen to the Brad DeLongs et al telling us how great outsourcing is.

posted by: Susan on 03.16.05 at 07:52 AM [permalink]

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I wish I had time to write a longer post, but in 25 years in various businesses I have yet to see this careful weighting of experience and experiments that essays of this type discuss. Even in the company where 80% of senior managers were engineers, that only meant that we carefully studied the problem before the final decision was made on emotion and personal preference; most organizations just skip the study part and go right to the brilliant intuition of the Great Leader. One of my neighbors works for a very large aerospace components company; in two years he has been through 7 supervisors, 5 plant managers, and 2 division heads, and is now one of the most senior management employees in the division. I don't see how any "learning" can take place in that environment, which is the norm.

This view of the "firm" doesn't match up with any experience I have had in the US or Western Europe. Mabye somewhere there is that mythical rational business, but I haven't found it yet.

Cranky

posted by: Cranky Observer on 03.16.05 at 07:52 AM [permalink]

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Great post for the most part.

But I think Cranky Observer is more on target.
If you have ever seen how senior management makes decisions you know it is just as he describes.

It is like all these theories taught in school about calculating the present value, etc.. But the problem is that no corporate vice president worth his salt ever made an investment proposal that promised less then a 30% return. They just plug whatever numbers they need into their assumption about what the volume and price will be when the new facility comes on line to generate a rate of return that massively exceeds the hurdle rate.

This is why capital spending always has a very strong positive correlation with rates. I remember as a stock analyst around 1980 hearing firm after firm saying that double digit rates were not impacting their capital spending plans
because of this.

posted by: spencer on 03.16.05 at 07:52 AM [permalink]

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> On the other hand, for products that are not
> moving forward so quickly, where system
> performance is not being stretched so much, system
> integration is less demanding. In those cases,
> different functions can get away with bigger
> distances and less communication.

Steve,
I understand your point. I would suggest that you read the HBS Thorn/EMI CAT scanner case [the only HBS case I would recommend of the entire library ;-) ]. Bottom line: after outsourcing their "routine" manufacturing (in 1972!), when it came time to develop the next generation of systems (a) their creative dude failed to deliver a breakthrough [not surprising as there never was another breakthrough in CAT] (b) their engineering staff no longer had the detailed daily knowledge to do incremental improvements. They went from 95% market share to 0% share in 5 years on what had been essentially a gold mine of a product line.

Cranky

PS There is another lesson hidden deep in that case but I won't spoil the fun by pointing it out!

posted by: Cranky Observer on 03.16.05 at 07:52 AM [permalink]

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I am an American living in Ukraine with a team of offshore software developers. My business partners, both displaced tech consultants, live in Phoenix. We have been in the offshore outsourcing business (software development) for a couple of years. During this time we have learned the following:

1) Managing offshore outsourcing is extremely difficult. Most of our clients we currently work with have been burned by previous offshore suppliers. The reasons that offshore outsourcing projects fail are numerous and have been discussed in my blog (http://blog.shadowbox.com/index.php?p=19).

2) Too many companies believe that outsourcing is an easy panacea for cost savings - it is not.

3) There are business processes which can not be outsourced. And there are business processes that should not be outsourced – R&D.

4) Offshoring is in fact an economic experiment. It wont take companies long to understand that there maybe better alternatives to offshore outsourcing nearshoring, homeshoring and offshore/onshore models.

5) We are anticipating the bubble to burst this year. Offshore outsourcing is a viable method for SOME companies to cut costs and focus more attention to their competitive advantages, but the wholesaling of jobs offshore without having the experience or a viable strategy in place will often be more costly then if they kept the jobs in house.

Just my two cents.

Patrick Dodd

posted by: Patrick Dodd on 03.16.05 at 07:52 AM [permalink]

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Cranky: "Kelly Johnson, one of the greatest airplane designers of all time and the creator of thousands of jobs, had an ironclad Rule of 10: his engineers (that is to say, his "creative" people) could not be located more than 10 steps away from the manufacturing floor. Reason being that only the constant, minute-to-minute interaction of engineering and manufacturing could understand and solve problems rapidly and creatively."

No kidding. I'm a software engineer in my 40's and cannot believe the pressure there is in my business driving top people away from doing what they know works and toward the opposite.

Software Engineering is usually best done in small teams close to the consumer - whomever and whatever that is. I've been on more projects failing because they were over-elaborate and overstaffed. I've delivered on-time and under-budget by cutting the core team in half - from 8 to 4 in one case. A lot of it is getting as close to the situation as possible and focussing on what can be done rather than the opposite.

How is one going to do that in India or China? I can't live in those places or influence how the offshoring company works enough because I can't get close enough to the engineers.

If my company nearshores work to South Dakota I can go live in Rapid City for a few months, so that can work.

As things speed up again I think we're finding that even the best-run outsourcing team can't operate effectively over continental distances - the time lags are too long. A decision which can be taken in 30 minutes on a co-located project can take 24 hours or more with part of the team in the US and the bulk in India. Time to market suffers.

for this reason most of the major success stories have been when the entire operation is done in India - soup to nuts.

posted by: Don on 03.16.05 at 07:52 AM [permalink]

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