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What is outsourcing? How does it work? [Business guide]

When running a business, you’d want to do it smoothly and seamlessly. However, it’s unlikely that you’ll be able to take care of all the aspects that come with it, and this is where outsourcing comes in. But what is that, and why should you consider it as a strategy for your business?

Perhaps before you contemplate on that model, you need to think of some of the following questions regarding your business priorities: is it more important to you to have a greater total amount of savings provided by the outsourcer or to have a quick turnaround time to cut costs? In addition, think about whether you want broad capabilities or expertise in a specific area. And finally, what type of price options are you after – low, fixed, or variable?

When you have a clearer picture of the answers to these questions, you’ll know whether outsourcing is right for you and what trade-offs you can or will make to help your business along. But before you do this, it’s critical to look at the meaning of this term so that you have a firmer grasp of this topic. 

What is outsourcing?

Recognised as a business strategy in 1989 and quickly gaining prominence as an integral part of economics throughout the 1990s, outsourcing is a business practice where services or job functions are allocated to a third party to perform tasks and handle certain operations of a business that were previously done in-house.

When making this strategic decision and hiring another company to perform your tasks, which were previously performed by your employees, you may reduce costs and increase efficiency. 

Another way to refer to business process outsourcing is contracting out. Contracting out, or BPO involves “the delegation of one or more business processes to an external provider, who then owns, manages, and administers the selected processes to an agreed standard.

BPO is also subdivided into back-office and front-office. The former refers to internal business functions, which include billing or purchasing. The latter, on the other hand, includes customer-related services such as marketing or tech support. 

Then there’s also something else known as knowledge process outsourcing – KPO, which involves processes that require advanced research and analytical, technical, and decision-making skills. You can find this in pharmaceutical industries where R&D and patent research takes place. 

Initially, the contract duration for such services was as long as 10 years. Although this was the norm back then, there’s been a shift to shorter contracts offering more flexibility. The reasons for this? Well, it all depends on what you’re outsourcing and why. 

Some of the most common reasons businesses outsource are because of the reduction in operating, labour, and overhead costs; a more honed-in focus on core competencies, improving a business’ competitive advantage; freeing up internal resources for other more valuable purposes; mitigating risks and building meaningful partnerships; as well as improving flexibility and efficiency.

How does outsourcing work?

Here's how the outsourcing business strategy works

Before we answer this question, it’s important to present some of the different types of outsourcing there are.

First, there’s onshore outsourcing, which takes place within one’s own country. Then there’s nearshore outsourcing, which happens in a neighbouring country or one that’s in the same time zone. Finally, there’s offshore outsourcing, which occurs in a more distant country. The first two are the options that were pursued in order to save on costs. 

In order to structure such engagement, you will need to first consider these variables:

  • Time and materials spent 
  • Unit or on-demand pricing
  • Fixed pricing
  • Variable pricing
  • Cost-plus
  • Performance-based pricing
  • Gain sharing
  • Shared risk/reward

What are the reasons for outsourcing?

There are many reasons for outsourcing and we cover some of the advantages in the section below. However, some of the main underlying factors are that it enables businesses to allocate resources in the most effective way while helping to maintain the nature of free-market economies on a global scale.

Advantages and disadvantages

Pros

By outsourcing business operations to a third-party, businesses receive many benefits. These include:

  • Constant service and logistics – the business will be able to operate on a 24-hour basis. This is ideal for companies that have large customer support centres with customers who may require assistance during the night.  
  • Expertise and specialisation – firms that are outsourced usually deal with more than one business at a time, which means they can hone in on their expertise.
  • A focus on strengths – this enables businesses to focus on how to differentiate themselves from the competition. This is ideal for small businesses with a limited budget and startups, which operate on a smaller scale. 
  • Improved capabilities – outsourcing provides access to equipment and expertise that some businesses otherwise could not afford. 
  • Reduced costs – there’s also the ability to save on costs such as lower labour costs in the country in which the strategy takes place. This is also applicable when businesses hire freelancers who don’t require office space or receive benefits. 
  • Staffing flexibility – businesses may find it more affordable to hire short-term outside contractors when they face a high demand as opposed to hiring new employees, which they may not afford when there are periods of lower demand.

Other notable mentions include:

  • Flexibility in meeting changing business and commercial conditions
  • Faster time to market
  • Lower investment in internal infrastructure
  • Access to innovation, IP, and thought leadership

Cons

Those are the pros and cons of outsourcing

On the downside, however, outsourcing has its disadvantages, too. These include:

  • Loss of control – this can affect the quality of the output that’s being produced. While this may not be the case for larger companies, which have more room and scope for negotiations, smaller businesses may struggle with this. 
  • Lower quality –the primary business has no direct control over what is being produced and may therefore suffer from subpar standards of production. 
  • Personnel troubles – these may include but are not limited to language and cultural barriers. In addition, the hierarchical structure of the outsourced business or if it’s a more laissez-faire model can also affect the output and communication if there are major differences between the business and the outsourced third party.  
  • Public opinion – public opinion views outsourcing as a means of leading to job losses at home while leading to job gains abroad, but at a lower, and often much cheaper rate that’s not competitive. 
  • Security – the model can also pose security challenges such as intellectual property rights. 
  • Slower turnarounds – this is because the outsourced partner may serve other clients as well, leading to other commitments, which means they can’t service their business partner as quickly as if it weren’t servicing other clients. 
  • Structural instability – it is not possible to determine for certain whether the company that provides the service will not go out of business. 
  • Hidden costs – an example of this is last-minute changes in the supply chain. Additional costs associated with outsourcing include the cost of benchmarking and analysis to see if this strategy is the right choice; the cost of investigating and selecting a vendor; the cost of transitioning work and knowledge; costs of layoffs; as well as ongoing staffing and management of the relationship.

Examples of outsourcing

The world of outsourcing is great – it can range from small firms doing minor tasks to large firms handling greater parts of the manufacturing process. Here are some examples.

  • Bookkeeping – a small company may choose to outsource its bookkeeping duties to an accounting firm to save on the costs of hiring a full-time accountant.
  • Recruitment process outsourcing, or RPO – this can include payroll and health insurance, and other human resources tasks. Alternatively, it may include identifying, attracting, and screening new applicants. 
  • Manufacturers – they may purchase internal components from other companies to save on production costs.
  • Legal process outsourcing, also called LPO – can relate to the storage and backup of files using a service provider that specialises in cloud computing, saving on the costs of owning the technology. 
  • Banking – can include managing customer service operations related to inquiries, complaints, etc. 
  • Engineering process outsourcing, or EPO – this is when specific engineering functions are assigned to an outside team. It may include automotive companies. 
  • Information technology outsourcing, ITO – this can include software development, application development, telecommunications, technical support, etc.
  • Knowledge process outsourcing, known as KPO – may include data entry, market research, intellectual property research, content creation, etc. 

Other notable mentions include but are not limited to content writing, marketing, supply chain management, research and design, computer programming, online payment acceptance, training, data entry, assembly, labour constraints, and more.

Insourcing vs outsourcing

In brief, insourcing refers to the process when “a company assigns work to a subsidiary that is within the same country,” differing from outsourcing and its variations mentioned above. This can entail establishing satellite locations for specific business entities.

This process focuses on delegating or reassigning procedures, functions, or jobs within one business in one location to another internal entity that specialises in that operation. The purpose of this is to streamline production, improve competency, and increase profits and revenue.

Conclusion

And there you have it! A brief but comprehensive guide on outsourcing and all the factors that are associated with it. If you’re considering this strategy for some or many of your business functions, it’s a good idea to weigh up the pros and cons first to see if and how they’ll affect your bottom line.

Compromising on quality is something no business should do, as this will affect their reputation and sales. Ultimately, when you outsource, you need to ensure your vendor agrees with you and will put in the time and effort to ensure that what they produce for you is of the highest quality standards in terms of the agreed-upon fees you predetermined so that your customers can continue to receive the best results, thereby using outsourcing to drive your business forward.

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