Uncommon Sense: Adam Smith on Outsourcing
Outsourcing is one of the marvels of the "new economy," and it is interesting to speculate what the father of the "old economy" would think of it. The principles underlying Adam Smith's work, The Wealth of Nations, were based on gains from the trade that exists in dynamic, free markets. Companies and countries that overcame the barriers to trade would reap the rewards. Those that did not overcome the barriers would forever be beholden to those that did.
To paraphrase Smith, the main barriers to trade then-and now-involve information, negotiation, transportation and enforcement. Information about what another country or company has, and what we have that they might want, is fundamental but not always readily available. The cost of exchanging products or services, the form of exchange and the potential for profit from an exchange are subjects of negotiation. Transportation is part of the cost, and also affects the potential for profit if delivery is time-sensitive. Enforcement addresses how contracts are honored, altered and dissolved.
So what happens when we outsource? We invest in a worldwide search for vendors to make something for us. When we find a potential vendor, we negotiate terms and sign a contract. But while all this is going on, original parts are still being consumed and overhead is still in place. Costs have not gone away!
Once the contract is in effect, parts are made in batch quantities, shipped in bulk, and may go through extended customs procedures if they come from overseas. There is more handling, more chance for damage and more need for higher enforcement costs. The people who negotiated with, and selected, the outsourcing vendors are still on the payroll. But now we pay other companies to make these items for us and we generate their profits from buying our old parts.
At what point do we have to ask ourselves, "If they are making a profit from selling us our old parts, and we have not reduced our overhead, who is making money now?"
Manufacturers need to look at costs in a different light. The cost of making parts or subassemblies is almost totally variable. Therefore, if parts that are not on a constrained operation or function are outsourced, and overhead costs are not removed, then the real costs must go up.
The only way out of this conundrum is to outsource the costs with the parts. Many of those who preached the "new economy" fell when the bubble burst because they failed utterly to address this tough question: Can offices and plants be shut, and can engineers, cost accountants, clerks, supervisors and managers be let go because parts and/or subassemblies have been outsourced?
Some manufacturers say they need to outsource because the core competence of other companies is making parts, while theirs is not. But at the same time, they want to maintain their margins. That's when I remind them that in The Wealth of Nations Adam Smith postulated that to gain wealth, companies and countries had to internalize and control external forces. When we outsource, we increase the influence that external forces can exert upon our internal cost structures. We allow others to constrain and dictate our ability to meet dynamic market demands.
Maybe our turn has come and gone. Maybe North America is truly no longer a manufacturer. Our nation's wealth is migrating to others. To continue growing we must define again our comparative advantage before we outsource our intellectual capital as well as our relatively declining manufacturing capital.
What's your opinion? Whether you agree or disagree, Martin Donegani will welcome your com- ments. You can contact him via the Bourton Group's Web site. Just point your browser to www.bourton group.com and click on Contact Us.