Is Outsourcing Good?

I’ll graduate from the University of Central Oklahoma with an MBA next month (http://www.busn.uco.edu/mba/).  One of the classes I took was a hybrid marketing / economics class – Prices, Profits and the Market Economy.  We spent our time outside of class reading, writing and thinking, and then showed up to class to hash out our ideas. 

One of our professors (http://mickeyhepner.blogspot.com) asked the following question to get us ready for an in-class discussion:

“Since 2000 the U.S. has lost 5 million manufacturing jobs (nearly 30% of the total manufacturing jobs in the U.S. in 2000). This is mainly due to increased use of outsourcing. Is this a good development? "

Following is my attempt to answer this question…

I argue that this is a very good development. We've already agreed that the only reason a company would outsource work is because it is more profitable. The more money a company returns to the bottom line, the more it can invest in plant, property and equipment to expand operations, thereby creating more jobs.

To explain my point further, let’s take the shirt I just bought from Land's End. It was made in Bangladesh. I thought about how this shirt would have arrived at my door under two scenarios: manufactured in Bangladesh and right here in the US of A.

The major inputs for "shirt" are: machinery, materials and labor. We can assume that the industry for commercial garment machinery is mature. In fact, if anyone happens to be in Cologne, Germany in late April, you can visit “Textile Machinery Live” (http://www.textilemachinerylive.com/?gclid=CO_KycWwkpkCFSQMDQodYC90bA). Looks like a riot. Since this industry is mature, we can assume that the cost for commercial garment machinery isn’t an insurmountable competitive advantage from one firm to another. Of course, larger firms will purchase machinery at lower costs and have access to the most productive models, but overall, I would argue that machinery isn’t a competitive advantage. In any case, D’Avenis would argue that such an advantage is unsustainable because it is easily duplicated.

So let’s look at materials. My shirt is made of cotton, which is bought and sold on the New York Mercantile Exchange’s Food and Fiber market (http://www.nymex.com/index.aspx). Incidentally, cotton futures, like most other commodities in the current global downturn, are dropping like a rock. Most of the textiles that go into shirts are commodities, although not all are traded like cotton. Therefore, I think you have another unsustainable competitive advantage if you’re just buying cotton right.

That brings us to our last input: labor. The Bangladeshi minimum wage in US dollars is $.05. (Check out this useful interactive site I found: http://news.yahoo.com/page/minimum_wage. It lists minimum wage rates worldwide.)  If I’m making shirts, and I know I can’t gain an advantage on machinery or materials, I’m making them in Bangladesh.

Before we cry too many tears for the Bangladeshi textile worker, take note of another statistic on this site: 45% of the population in Bangladesh is unemployed. I assume that many of these folks would rather earn a few dollars a week than resort to subsistence agriculture – otherwise there wouldn’t be a textile industry in Bangladesh.

Let’s say the cost of materials and PPE allocation for this shirt is $10 and it takes an hour to make. My COGS is $10.05 in Bangladesh or $15.15 in the US.  With a keystone markup, the shirt costs me (the consumer) $20 if made in Bangladesh or $30 if made in the US.  We’re talking the exact same shirt.  So the US textile mill shuts and the clothing company maybe goes out of business.  What happens to those factory jobs?   The minimum wage workers have to get new jobs, and probably not in another mill.  The workers need to be retrained or repurposed.  This is bad in the short run because these workers have no income to spend on the goods and services produced by other workers.

But we also need to look at the clothing companies that didn’t close down when they shut their mills.  Let’s assume they shifted production to Bangladesh, helping improve the 45% unemployment there.  Let’s then assume that they started selling clothes over the internet direct to consumers, like me.  I can then take my extra $10 and buy breakfast for my kids at Panera Bread, which provides local service-sector jobs that can’t be outsourced. Panera Bread certainly needed more workers this morning…I wonder if they would be in the market for former textile mill workers?

What else was involved in the e-commerce shirt transaction?  Well, internet sales require computer hardware and software.  This demand creates high-paying jobs.  These highly-paid techies can buy their breakfast at Panera Bread too, but I bet they can afford to go every day.  Looks like more mill workers will be needed...but what else happens with this company?  Let’s say that selling clothes over the internet is a great business venture and the company expands, creating demand for more logistics jobs.  The company needs more order pullers at minimum wage and more forklift drivers at twice that rate.  There will also be increased demand for truck drivers and third-party logistics services.  More places for displaced mill workers to go.

So, to sum up my rather long-winded argument, outsourcing manufacturing jobs is good.  It shifts the work to where it can be done most efficiently.  This lowers the price of goods for consumers who have more money to spend in other sectors of the economy.  It also improves the local economies that gain new manufacturing jobs.

Dr. Hepner then wanted to know if this only applied to manufacturing jobs.  My response:

How would this story change if we outsourced white collar workers instead of blue collar workers?  Well, the net result would still be a benefit for the economies of both countries.  We must remember that the firm wouldn’t outsource the work in the first place if it wasn’t profitable to do so.  In addition, there wouldn’t be a market for the work in other countries if wage rates for the jobs weren’t acceptable.

To put this in the context of “shirt”, let’s think about the IT department in the clothing company that implement this e-commerce initiative.  Suppose they start out with a labor-intensive tech support staff that answers trouble tickets, resets passwords and troubleshoots the network for the firm’s growing staff of customer service representatives.  The next thing you know, the world is flat and an Indian call center can do the same work via WebEx for a tenth of the cost.  The IT department slashes its staff of technicians and outsources basic troubleshooting to India.

The laid-off techs could seek employment doing the same job for other companies, although the smarter ones would probably get more training in the interim.  There would still be a need for some technicians to do the physical repairs and part-swaps, and the firm would likely keep a core set of IT administrators that know the system images, network topography and customized applications.  These techs would become more important to the organization and likely command a higher wage.  This would come from the largesse spawned from outsourced IT services.  The firm could spend the remainder of these funds on new technologies to further improve customer service and operational efficiency.  This would, in turn, create new jobs in other sectors of the economy.

Looking back, outsourcing still looks like a good deal to me.