Offshoring

Offshore may refer to oil and natural gas production at sea; see oil platform.

Offshoring may be defined as the relocation of business processes from one country to another. This includes any business process such as production, manufacturing, or services.

Offshoring can be seen in the context of either production offshoring or services offshoring. After its accession to the WTO, China emerged as a prominent destination for production offshoring. After technical progress in telecommunications improved the possibilities of trade in services, India became a country leading in this domain though many parts of the world are now emerging as offshore destinations.

The economic logic is to reduce costs. If some people can use some of their skills more cheaply than others, then those people have the comparative advantage. The idea is that countries should freely trade the items that cost the least for them to produce.

Frequently used terms

Offshoring is defined as the movement of a business process done at a company in one country to the same or another company in another, different country. Almost always work is moved due to a lower cost of operations in the new location. Offshoring is sometimes contrasted with outsourcing or offshore outsourcing. Outsourcing is the movement of internal business processes to an external company. Companies subcontracting in the same country would be outsourcing, but not offshoring. A company moving an internal business unit from one country to another would be offshoring, but not outsourcing. A company subcontracting a business unit to a different company in another country would be both outsourcing and offshoring.

Related terms include nearshoring, which implies relocation of business processes to (typically) lower cost foreign locations, but in close geographical proximity (e.g. shifting United States-based business processes to Canada/Latin America); inshoring, which means picking services within a country; and bestshoring, picking the "best shore" based on various criteria. Business Process Outsourcing (BPO) refers to outsourcing arrangements when entire business functions (such as IT, Customer Service, etc) are outsourced.

A further term sometimes associated with offshoring is bodyshopping which is the practice of using offshored resources and personnel to do small disaggregated tasks within a business environment, without any broader intention to offshore an entire business function.

Production Offshoring

Production offshoring of established products involves relocation of physical manufacturing processes to a lower-cost destination. Examples of production offshoring include the manufacture of electronic components in Taiwan, production of apparel, toys, and consumer goods in China, etc.

Product design, research and the development process that leads to new products, are relatively difficult to offshore. This is because research and development to improve products and create new reference designs requires a skill set that is harder to obtain in regions with cheap labor. For this reason, in many cases only the manufacturing will be offshored by a company wishing to reduce costs.

However, there is a relationship between offshoring and patent system strength. This is because companies under a strong patent system are not afraid to offshore work due to the fact that their work will remain their property. Conversely, companies in countries with weak patent systems have an increased fear of intellectual property theft from foreign vendors or workers, and, therefore, have less offshoring.

Production offshoring got its big push when the NAFTA made it easier for manufacturers to shift production facilities from the US to Mexico. This trend later shifted to China, which offered cheap prices through very low wage rates, few workers' rights laws, a fixed currency pegged to the US dollar, cheap loans, land, and factories for new companies, few environmental regulations, and huge economies of scale based on cities with populations over a million workers dedicated to producing a single kind of product.

Services offshoring

The growth of services offshoring is linked to the availability of large amounts of reliable and affordable communication infrastructure following the telecom and internet expansion of the late 1990s. Coupled with the digitization of many services, it was possible to shift the actual production location of services to low cost countries in a manner theoretically transparent to end-users.

India first benefited from the offshoring trend as it had a large pool of English speaking and technically proficient manpower. India's offshoring industry took root in low-end IT functions in the early 1990s and has since moved to back-office processes such as call centers and transaction processing. In the late 1990s, India's abundant and cheap software engineering talent combined with massive demand from the Y2K problem helped to move India up the value chain to attract large-scale software development projects for US based customers. Currently, India's engineering talent has made India the offshoring destination of American high-tech firms, lead by HP, IBM, Intel, AMD, Microsoft, Oracle, and Cisco. Each of these companies has promised or is in the process of investing at least $1 billion in India, to supposedly retain market share in the face of competition and cost-cutting measures of rivals and industry in general, at the expense of investment in the United States.

As a result of the offshoring boom, India has seen double-digit wage growth for much of the 2000s. Consequently, Indian's operations and firms are concerned that they are becoming too expensive in comparison with competition from the other offshoring destinations listed below. They are now diversifying and attempting to branch out to other high-end work in addition to software and hardware engineering. These jobs include research and development, equity analysis, tax-return processing, radiological analysis, medical transcription, and more.

Other offshoring destinations include Brazil, Central American countries, the Philippines and Eastern European countries.

The Philippines has started emerging to be one of the top offshoring destinations because of its large pool of technical resources available. One of the most prominent retail chain (Safeway Inc.) in the US started offshoring its IT in the Philippines since 2003. It has grown six times its original staff size in three years time. The company is known in the Philippines as Safeway Philtech Inc.

CAFTA made nearshoring more attractive between the Central American countries of Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua, and the Dominican Republic and the US.

Transfer of intellectual property

Offshoring is often enabled by the transfer of valuable information to the offshore site. Such information and training enables the remote workers to produce results of comparable value previously produced by internal employees. When such transfer includes protected materials, as confidential documents and trade secrets, protected by non-disclosure agreements, then intellectual property has been transferred or exported. The documentation and valuation of such exports is quite difficult, but should be considered since it comprises items that may be regulated or taxable.

Debate

Offshoring has been a controversial issue spurring heated debates, some of which overlap those related to the topic of free trade. It is seen as benefiting both the origin and destination country through free trade, providing jobs to the destination country and lower cost of goods and services to the origin country. This makes both sides see increased GDP. And the total number of jobs increase in both countries since those workers in the origin country that lost their job can move to higher-value jobs in which their country has a comparative advantage.

On the other hand, job losses in developed countries have sparked opposition to offshoring in said developed counties. People argue that the quality of any new jobs in developed countries are less than the jobs lost and offer lower pay. Further still, they argue with some economists' assertions that more education is the key to producing higher-value jobs since a great deal of highly-educated workers such as software engineers, accountants, radiologists, and journalists in the developed world have been displaced by highly-educated and cheaper workers from India and China. Traditionally "safe" developed world jobs in R&D and the Science, Technology, Engineering, and Mathematics (STEM) fields are now perceived to be endangered in these countries as higher proportions of workers are trained for these fields in developing nations.

Some would argue this stems of a complete misunderstanding of comparative advantage and absolute advantage. Even if, hypothetically, a developing nation were to obtain absolute advantage in the production of all goods over a developed nation, it would still be in the best interest of the developing nation to continue purchasing goods, services, and labor from the developing country (despite higher costs). This is because an economy will always incur an opportunity cost when producing any good or service. If a country such as India or China were to stop trading with the United States, for example, they would experience rising prices and declining output. This is because opportunity costs would continue to prevail in a closed economy, firms would have to operate at below potential, and that country would experience a diseconomy of scale.

For decades, the labor force have been moving from manufacturing to services in developed countries. This has caused a falling employment in manufacturing and much fear among industrial workers, although the total employment has been rising in many countries. The effect of this has been shown to be much higher than that of offshoring or foreign investments, which has nevertheless been accused of being the cause of unemployment, since big offshoring projects are more visible than the slow change from an industrial society to a post-industrial society. Even so, economists have been unable to determine the reasons why job creation and wage growth was lax during the 2000-2005 period in developed countries. Some attribute that to offshoring.

Level-of-Service concerns

With the offshoring of call-center type applications, debate has also surfaced that this practice does serious damage to the quality of customer service and technical support that customers receive from companies who do it. Call centers have sprung up in India, Pakistan, Canada and the Caribbean. Many US companies, most notably Dell and AT&T Wireless, have caught much public ire in the US for their decisions to use Indian and Pakistani labor for customer service and technical support; mostly because of the apparent language barrier that it creates. While India, for example, has a high level of younger skilled workers who are capable of speaking English as one of their native languages, their English skills have caused debate in North America.

Criticisms of outsourcing from much of the American public have been a response to what they view as lackluster customer service and technical support being provided by overseas workers attempting to communicate with Americans in broken or incomprehensible English.

Worker exploitation

While offshoring companies sometimes treat workers better than other similar workers in the local environment, some in the developed world complain that workers in third world countries often do not have the same levels of legal protection as in developed countries. Some companies move to third world countries specifically to avoid first world laws and therefore save money. Low wages, inability to form a union, lack of child labor laws, lack of worker safety laws, lack of environmental protection laws, lack of worker retirement benefits or pension costs, and lack of federal or state unemployment taxes all reduce labor costs.

However, external pressure against sweatshops make some domestic companies offer a higher salary and better working conditions to their foreign employees than otherwise seen in their labor market. Therefore, these companies directly give third world countries higher standards, better jobs, and also increase the competitiveness on the foreign labor force, which forces companies to raise their bids on these workers.

Supply chain concerns

Some claim that companies lose control and visibility across their extended supply chain under outsourcing, creating increased risks. A 2005 quantitative survey of 121 electronics industry participants by Industry Directions Inc and the Electronics Supply Chain Association (ESCA) found that 69% of respondents said they had less control over at least 5 of their key supply chain processes since the outsourced model took hold, while 66% of providers felt their aggregate risk with customers was high or very high. 36% of providers responded that they felt an increased risk of uncertainty compared to their uncertainty risk prior to the rise to prominence of the outsourced model. 62% of respondents described as "problematic" at least two core trading partner management practices, which included performance management and simple agreement on results. 40% of all respondents encountered resistance to sharing risk in outsourced partnership agreements, according to the research.

Legal concerns

In April of 2005, Indian Citibank workers in Pune employed by Mphasis BFL Group were arrested on charges of defrauding four Citibank account holders living in New York, USA, for the amount of $350,000. Citibank had no prior knowledge of the theft until the customers noticed suspicious transactions in their accounts and notified the bank.

In September of 2005, Intel fired 250 workers in India after alleging they falsified their expenses claims. The firings followed an internal audit. The report implied fraudulent employee practices such as "faking bills to claim your allowances like conveyance [and] drivers’ salaries" were endemic not only with the Indian Intel employees, but in Indian business overall. NASSCOM, which is a forum of IT and ITeS companies, has attempted to address these fraud concerns in India by creating the National Skills Registry. That database contains personal and work-related information, enabling employers to verify a staff member's credentials and allowing police to track the background of workers.

Other concerns are the theft of intellectual property given the lax enforcement of intellectual property laws in overseas locations such as China. Domestic companies doing business overseas may have no legal recourse if problems arise. Such problems include domestic companies finding cosmetically near-flawless copies of their goods sold for less than the legitimate goods. These fake goods have even been returned to the legitimate manufacturer for a refund at the legitimate price. Even if IP laws were in place and enforced, tracking down the overseas fake producer is often extremely difficult. In other problems, a foreign government intercepts sensitive trade secrets for use by the foreign government, including use in the foreign military.

Corruption

While occurring everywhere, political corruption is an endemic problem in the third world. This problem may increase offshore business costs and difficulties through the price of illegal bribes, avoiding the negative consequences of competitors bribing the system, management cost of negotiations with officials, risk of breached contracts, and risk of detection of any illegal activity by outside organizations. Under US law, US companies face severe penalties if caught bribing foreign officials.

Transparency International tracks corruption in their Corruption Perceptions Index. Bangladesh, a popular offshoring destination, shares the position of the most corrupt country in the world. Other popular offshoring destinations such as Pakistan, Russia, the Philippines, India, China, and Mexico have decreasing amounts of corruption, in that order. Corruption is decidedly less pronounced in first world countries, partly because officials receive a decent wage and therefore there is less perceived need to engage in such activity.

Competitive concerns

The transfer of knowledge outside a country inevitably creates competitors to the original companies themselves. Chinese manufacturers are already selling their goods directly to their overseas customers, without going through their previous domestic intermediaries that originally contracted their services. In the 1990's and 2000's, American automakers increasingly turned to China to create parts for their vehicles. By 2006, China leveraged this know-how and announced that they will begin competition with American automakers in their home market by selling fully Chinese automobiles directly to Americans.

Further, when a company moves the production of goods and services to another country, the investment that companies would otherwise make in the domestic market is transferred to the foreign market. Corporate money spent on factories, training, and taxes, which would otherwise be spent in the market of the company is then spent in the foreign market. There is then a decrease in the property values, wages, and tax receipts in the home market of that company. The reduced tax receipts directly translate to reduced funding for domestic schools, increasing the long-term disadvantage of diminished educational opportunities in addition to fewer job prospects to workers' children.

As production increases in the foreign market, qualified and experienced domestic workers leave or are forced out of their jobs, often permanently leaving the industry. At some point, dramatically fewer domestic workers are left who are qualified to perform the work. This makes the domestic market dependent on the foreign market for those goods and services, thereby strategically weakening the "hollowed-out" domestic country. In effect, offshoring creates and strengthens the competitive industries of the foreign country while strategically weakening the domestic country.

Educational concerns

Offshoring proponents often say it is necessary to move jobs overseas due to a looming shortage of qualified workers in the domestic market and the booming number of qualified candidates in foreign markets, particularly in China and India. This ignores the many currently unemployed and qualified workers in the domestic market. Further, this perception is enforced by media reports that list incorrect numbers of qualified domestic workers, usually undercounting the number of workers.

A study by Duke University found that 222,335 engineers graduate annually from American universities, far more than the 70,000 often quoted in the media. Further, the Duke study highlights the conflicting numbers coming out of China, India, and the US. China and India, in their official numbers cited by the media, both count the graduates from three year training programs and diploma holders, equivalent to Associate's degrees in the US. The media then compares the China and India numbers to US numbers of four-year Baccalaureate programs. Duke University estimates the total number of engineers with Bachelor's degrees produced annually for the three countries to be 351,537 for China, 112,000 for India, and 137,436 for the US. These figures make the US the per capita leader in producing techology specialists.

Another study by McKinsey and Indian IT body Nasscom reports, "only 25 percent of [Indian] technical graduates and 10 to 15 percent of general college graduates are suitable for employment in the offshore IT and BPO industries respectively". Not only is India graduating engineers in the same numbers as Americans, the vast majority of Indian engineers are not ready to enter the workforce upon graduation.

Retraining concerns

One solution often offered for domestic workers displaced by offshoring is retraining to new jobs. However, some displaced workers are highly educated and possess a bachelor's and master's degree. Retraining to their current level in another field may not be an option due to the years of study and cost of education involved. There is also little incentive to go through this re-education given that the jobs in their new field could also be outsourced in the future. These workers may never recover if their jobs are sent overseas.

Effects of factor of production mobility

According to classical economics, the three factors of production are land, labor, and capital. Offshoring relies heavily on the mobility of two of these factors. That is, how offshoring effects economies depends on how easily capital and labor can be repurposed. Land, as a factor of production, is generally seen to have little or no mobility potential.

The effects of capital mobility on offshoring have been widely discussed. In microeconomics, a corporation must be able to spend working capital to afford the initial costs of offshoring. If the state heavily regulates how a corporation can spend its working capital, it will not be able to offshore its operations. For the same reason the macroeconomy must be free for offshoring to succeed. Generally, those who favor offshoring support capital mobility, and those who oppose offshoring call for greater regulation.

Labor mobility also plays a major role, and it is hotly debated. When computers and the internet made work electronically portable, the forces of free market resulted in a global mobility of work in the services industry. Most theories that argue offshoring eventually benefits domestic workers assume that those workers will be able to obtain new jobs, even if they have to obtain employment by downpricing themselves back into the labor market (by accepting lower salaries) or by retraining themselves in a new field. Foreign workers benefit from new jobs and higher wages when the work moves to them.

History

In the United States, moving jobs out of the country began in the 1970s and continued throughout the eighties. It was characterized primarily by the closing of factories, frequently with the corporations opening new factories in Mexico. Many of these new factories were called Maquiladoras. This offshoring and closing of factories has caused a structural change in the US from an industrial to a post-industrial service society.

In 1994 NAFTA went into effect. As concerns are widespread about uneven bargaining powers, and risks and benefits, negotiations are often difficult, such that the plan to create a Free Trade Area of the Americas has not yet been successful.

With the development of the internet, many new categories of work such as call centres, computer programming, reading medical data such as X-rays and MRI's, medical transcription, income tax preparation, and title searching are being offshored.

Literature

Ashok Deo Bardhan and Cynthia Kroll, "The New Wave of Outsourcing" (November 2, 2003). Fisher Center for Real Estate & Urban Economics. Fisher Center Research Reports: Report #1103.

http://repositories.cdlib.org/iber/fcreue/reports/1103

Georg Erber, Aida Sayed-Ahmed, Offshore Outsourcing - A Global Shift in the Present IT Industry , in: Intereconomics, Volume 40, Number 2, March 2005, S. 100 - 112, [1]
Bradford Jensen and Lori Kletzer, "Tradable Services: Understanding the Scope and Impact of Services Outsourcing", http://papers.ssrn.com/sol3/papers.cfm?abstract_id=803906
William Lazonick, Globalization of the ICT Labor Force, in: The Oxford Handbook on ICTs, eds. Claudio Ciborra, Robin Mansell, Danny Quah, Roger Solverstone, Oxford University Press, (forthcoming)
Catherine Mann, Accelerating the Globalization of America: The Role for Information Technology, Institute for International Economics, Washington D.C., June 2006, [2], ISBN paper 0-88132-390-X
McKinsey Global Institute; “Offshoring: Is It a Win-Win Game?”, August 2003

References

TechUnite - IT Workers Group

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