In some manufacturing situations, firms avoid a portion of fixed costs by buying goods or services from an outside source. In business, we refer to this as outsourcing, or sometimes offshoring, as when an auto manufacturing outsources parts to a company in Japan or Mexico. Often, the decision to outsource is a financial one. Some companies can manufacture components more quickly and/or cheaper than the main producer. In economics, we call this competitive advantage. For instance, Mexico produces auto parts and even completed autos for many companies because it has a skilled labor force, low labor costs, and open trade agreements that allow products to be shipped across borders without high tariffs.

The financial decision to outsource (or offshore) a product or service is fairly straightforward: which is better for the bottom line–keeping it in-house, or outsourcing?

Let’s look at an example:

YORE Co. has a human resources department for 100 employees and recently invested $25,000 to add payroll functionality to the accounting system because the current payroll accountant could no longer keep up with the demands of the job. However, that accountant was unhappy about the change to the computerized system and has tendered her resignation, effective in two weeks. She currently earns a salary of $65,000 plus medical​ insurance, employer payroll​ taxes, and contributions to the pension plan that run about 25% of gross wages. Required annual updates to remain in compliance with all state and federal laws run about $100 per month. The company also spends $2,500  per year in professional development for this position to ensure the employee stays​ up-to-date with payroll changes. A company called PDA has sent a solid proposal offering to process the​ company’s payroll for $1,000 per week. This fee also includes preparing all necessary payroll tax​ returns, reports, and​ W-2s.

Using differential analysis, and ignoring the sunk cost of $25,000 for the computer upgrade, we find that outsourcing is more cost-effective:

In manufacturing, management must often decide whether to make or purchase a part or material used in manufacturing another product. Management must compare the price paid for a part with the additional costs incurred to manufacture the part. When most of the manufacturing costs are fixed and would exist in any case, it is likely to be more economical to make the part rather than buy it.

Sometimes the cost to manufacture may be only slightly less than the cost of purchasing the part or material. Then management should place considerable weight on other factors such as the competency of existing personnel to undertake manufacturing the part or material, the availability of working capital, and the cost of any loans that may be necessary.

In outsourcing decisions, management also should consider opportunity costs and other non-quantitative aspects of the decision. For instance, in the payroll outsourcing scenario, outsourcing may result in more compliance work for the HR department and more difficulty for the employees to get answers to questions.

Some pros of outsourcing include:

• Better revenue realization and enhanced returns on investment due to lower costs
• Increased specialization
• Tapping into a different knowledge base for better innovation
• Freed-up management time, enabling companies to focus on core competencies while not being concerned about outsourced activities and parts
• Increased speed and quality of finished products

Some cons of outsourcing include:

• Possible loss of control over a company’s business processes
• Supply chain issues, such as
  • Problems related to quality and turnaround time
  • Sluggish response times coupled with slow issue resolutions
  • Complete inability to get the product
  • Price hikes
• Union, customer, and other stakeholder issues

Now that you have learned about the costs and benefits of outsourcing, check your understanding.