‘What is outsourcing in business?’
Running a business is a challenging task.
A lot has to be done, and sometimes, regardless of how organised and effective your workforce is, they will need help in getting everything done at some point.
This is why most businesses tend to contract some tasks and projects to third parties.
While you may be familiar with outsourcing, you may need to fully understand what it entails and how it works in business.
This article will answer the question “what is outsourcing in business” and every other thing you need to know about the practice.
So, continue reading.
Meaning of Outsourcing in Business – What is Outsourcing in Business
Outsourcing is when a business hires a third party to perform a task or service that the business otherwise used to perform using its workforce.
You can outsource any aspect of your business, from customer service to manufacturing and office management.
If a company sees that it does not have the in-house capacity to carry out a specific task, it can outsource that task to a third party.
Outsourcing became recognised as a business concept in the year 1989.
This is not to say businesses did not practice this concept before then, but it was in this year that it became recognised.
However, even though this practice is now widespread, there are a lot of arguments around it.
Some people support the practice, while others are against it.
Those who are for it argue that the practice is very beneficial to businesses and is a great way for them to properly allocate their resources to more efficient areas while letting other parties handle the other areas for a cost, which would still ensure proper use of funds.
On the other hand, those against the practice argue that it’s bad for domestic workers who lose their jobs because it is outsourced to another party.
Regardless of these arguments against the practice, one thing remains true.
Outsourcing is a practice that a lot of companies have and is still benefitting from.
Types of Outsourcing
Outsourcing is typically categorised based on the distance between the parties involved in the business.
Based on this categorisation, there are three main types of outsourcing: onshoring, offshoring, and nearshoring.
Let’s take a quick look at them individually to help you better understand their differences.
Onshoring – What is Outsourcing in Business
Onshoring is when a business outsources to a third party in the same country that the business is operating from.
So, if a business operating in the United States outsources to a third party still in the United States, this would count as onshoring.
Nearshoring – What is Outsourcing in Business
Nearshoring is when services or tasks are outsourced to a third party near the business that is outsourcing the task/services, typically between bordering countries.
An example of this is when a US-based company outsources to a third-party company in Canada.
Offshoring
Sometimes people confuse offshoring and outsourcing to mean the same thing.
But these terms are quite different.
While outsourcing is the act of contracting to a third-party, offshoring is a type of outsourcing.
So, what is offshoring?
Offshoring is when tasks or services are contracted to third-party providers located overseas.
For instance, if a company operating in the United States outsources a service to a third-party provider in Nigeria.
But this type of outsourcing is largely criticised.
This is because, when jobs are outsourced locally (onshoring), domestic workers will likely lose their jobs in the company they currently work for, but they can then transfer and work for the third-party provider.
But this isn’t possible with offshoring because workers can’t move to another country to retain their jobs.
This type of outsourcing often leads to layoffs.
Advantages Outsourcing – What is Outsourcing in Business
At this point, you are probably wondering why businesses choose to outsource.
Well, there are several advantages businesses stand to enjoy by outsourcing.
Here are some of the common reasons:
Reduce Costs
One of the major reasons businesses tend to outsource is that doing so makes it possible for them to reduce costs; this is especially true with offshore outsourcing.
When a business outsources, it can cut labour costs via offshoring.
Suppose labour costs in the country the business is operating in are high.
In that case, the business can reduce this cost by looking for an overseas country with reduced labour costs and then outsourcing a part of its production to a company in that country.
Let’s give another illustration of how businesses can reduce costs via outsourcing.
So, let’s say a company is struggling with space and needs a larger office space.
For the business to do this, they will either need to rent or buy a bigger building, which would require funds.
Therefore, instead of spending money on getting a bigger space, the business can outsource an entire department’s work to a third-party company.
For instance, they can outsource their customer service to a third-party provider.
People working in this department will then be laid off, and the business will have more space to accommodate the remaining workers.
Improved Capabilities
Firms that provide the services that businesses tend to outsource specialize in those areas.
For instance, let’s say you want to outsource a digital marketing project; you would be outsourcing that project to an agency that deals specifically in digital marketing.
Because of this specialisation, the agency you hired will be able to do the job more effectively.
An in-house digital marketing team may give the same results, but you may not be able to afford that.
Also, because third-party providers deal with providing these needed services, they tend to have the best equipment to get the job done.
So, outsourcing gives the business improved capacities that you otherwise would not have been able to afford.
It Helps the Business Focus on its Strengths
When a business outsources some aspects of its business, it has the chance to focus on its core areas and functions.
This way, it will be able to stand out from its competition.
As a small business owner, you will significantly enjoy this advantage of outsourcing if you try it out.
This is because you can utilise your limited budget and resources in the areas that need them the most.
Constant Service – What is Outsourcing in Business
Outsourcing can help you operate your business round-the-clock.
There is only so much your in-house customer support team can achieve.
But, if you decide to outsource this aspect of your business, you can operate 24 hours a day.
This advantage of outsourcing is especially helpful for businesses that operate round-the-clock.
Staffing Flexibility – What is Outsourcing in Business
Staffing is a very important aspect of a business.
This is because a business is only as strong as its workforce.
However, getting the best talents in your company may prove rather difficult.
But outsourcing takes out this challenge.
When you outsource, you get the best agency for the job.
Therefore, you won’t have to undergo a rigorous staffing process to get the best.
Also, the need to hire new workers may arise if demand increases.
But outsourcing makes it possible for you to hire contract workers when demand peaks.
This way, you can easily access the required human resources for your business to run smoothly.
Disadvantages of Outsourcing
Despite all the many advantages discussed above, outsourcing is just like every other thing in life and business and has some downsides too.
Below are some of the major disadvantages of outsourcing:
You Won’t Be in Control
As a business owner, you have full control of your business.
This would include all the production processes and everything in between.
But when you outsource, you lose this control over the area of your business that you have outsourced.
This loss of control will then result in several other disadvantages, inferior quality.
Because you do not have control over how the third-party provider decides to deliver the service, they may end up delivering poorly.
Ethics – What is Outsourcing in Business
Remember, most people see outsourcing as a social and economic bad, one that takes jobs from the people of one society and transfers them to others abroad.
This is especially true of offshore outsourcing.
While your company’s ethics may not have any qualms with this, you may face opposition from the public, especially if you run a very big company.
Personnel Issues – What is Outsourcing in Business
With offshore outsourcing, you may encounter cultural or language barriers that put a strain on the outsourcing relationship.
Apart from this, the structure or business model of the third-party provider may allow certain issues regarding personnel management and hierarchy.
This may, in turn, affect productivity and efficacy.
Security
You may encounter some security issues if you do not properly draft out the contract for the outsourcing deal.
The third party may decide to claim intellectual property rights or some other thing that could jeopardise your company.
Hidden Costs
You may think you have everything figured out regarding outsourcing costs.
However, this may not be the case, as you may end up having to pay some additional fees later on.
Some additional fees that you might encounter with outsourcing include benchmarking costs and analysis costs: this is the money you would have to spend to see whether the strategy you are looking to adopt is feasible.
Other costs include evaluating and choosing a 3rd-party provider cost and layoffs costs.
How Outsourcing Works – What is Outsourcing in Business
Now that you know what outsourcing is and the types of outsourcing there are, you will be ideal if you know how to implement this in your company.
Thankfully, the process involved in outsourcing isn’t rocket science.
One thing you should know about outsourcing is that it is a form of business partnership.
Most people like to think of it as a buying project where they buy a service for an agreed cost.
But thinking of it this way may likely affect the smooth running of things.
For your outsourcing efforts to work, you must maintain a great and cordial relationship with the other party.
And knowing that it is a partnership rather than a buying project will help you accomplish that.
Another thing you need to know about outsourcing is the different pricing and models involved.
The structure of an outsourcing deal can be in different forms; these include time and materials, unit, cost-plus, fixed pricing, variable pricing, performance-based pricing, and so on.
When you want to outsource a task/service, you need to know and then decide on the pricing/model you want to adopt.
Therefore, let’s take a closer look at the pricing, as mentioned earlier, and models to help you better understand them.
Outsourcing Pricing and Models
Time and Materials
With the time and materials method of outsourcing, you will pay the third party according to the time and materials they used in getting the job done.
This model of outsourcing is best for maintenance projects or development application that is meant to run long-term.
On-demand or unit Pricing – What is Outsourcing in Business
With on-demand or unit pricing, a rate is set for an agreed set/level of service.
For example, let’s say your company needs a content writer for the company’s website.
If you then pay the content writer an agreed amount per article, you are using on-demand or unit pricing.
The best time to adopt this model is when calculating units is possible.
Its major advantage is that it aids productivity.
Cost-Plus – What is Outsourcing in Business
With cost-plus, you would pay the vendor the actual production/service cost and a predetermined profit percentage.
Let’s give a brief illustration to help you understand this better.
Let’s use a car manufacturing company for our illustration.
Supposing the company’s profit margin keeps reducing because of the increased price of raw materials.
The company then chooses to outsource an aspect of its production to a third-party company.
Let’s say it outsources its window manufacturing process to a third-party company.
If the cost-plus method is used for the partnership, the car company and the third-party company would have to agree on a profit percentage.
Then, when the project is completed, the car company will pay the third party the exact amount it took to manufacture the windows and the agreed profit percentage.
While this pricing plan sounds very advantageous, it might not be quite so.
This is because the third party may not have enough incentives to spur effective and efficient service delivery.
Secondly, it is quite inflexible and may likely prevent technologies or objectives changes.
Fixed Pricing
If you choose this model, then it means you and the third party have to agree on a specific cost for the deal from the beginning.
Fixed pricing offers a level of stability that other models do not have.
But this advantage can become a disadvantage in the long run.
This is because, whatever happens, the price would stay the same.
So, you will still have to pay the agreed price even if the price market changes.
The vendor will also be disadvantaged if the market pricing increases.
Therefore, both parties involved may not find this model sustainable.
The best time to adopt this model is when the deal has clear requirements, scope, and objectives.
Performance-Based Pricing – What is Outsourcing in Business
With this pricing method, you will give the vendor monetary incentives based on how well they perform.
The great thing about this pricing method is that it works conversely.
This means that if the third-party provider does not deliver the task satisfactorily, they would have to pay you a penalty fee.
This pricing method isn’t sustainable on its own.
You have to use it alongside another model, like fixed pricing or the time and materials model.
The best time to adopt this method is if you have a sure way of evaluating the vendor’s performance.
This is important because if there is no way to measure performance, you may reward the vendor for something they should have done anyway.
Reward/Shared Risk– What is Outsourcing in Business
This outsourcing model is ideal for new businesses or businesses looking to produce new products.
With this method, the business and the provider will partner financially to develop a new product or service.
The business owner and provider will then share the profit based on a predetermined percentage.
And if the product/service does not perform as expected, the provider will also share in the loss.
This model is great for businesses because it reduces the financial risk the business has to carry.
Another advantage it offers is that it makes the provider more invested in the project.
Their shared responsibility in the business will motivate them to work effectively and focus on the growth of the business.
Any of the above-discussed pricing/models of outsourcing will work well as far as you use them in the right situations.
So, before you choose a particular pricing/model, ensure you properly consider the factors of the outsourcing deal.
Conclusion
Outsourcing as a business practice became recognised in 1989.
And since then, it has become a standard business practice.
This practice involves hiring a third party to carry out a task that your company originally performed by itself.
However, while there are so many benefits of this practice, it also has its pitfall.
Therefore, before you decide on outsourcing any aspect of your business, consider both the pros and cons to ensure you make the best decision for your business.
