Capturing the Real Value from Offshoring

Viewpoint: April 2, 2004

There’s a storm brewing over offshoring, but the irony is that neither side in the emerging debate fully understands the challenges – and the opportunities – ahead.  One side – the opponents – focuses on the workers being displaced from their jobs as companies shift work to offshore locations and see nothing but challenge.  The other side – the companies that are actually shifting key areas of activity offshore – focus on the near-term cost savings and see only benefit, if only they can keep a low enough profile to avoid adverse publicity. Both sides miss the key significance of the offshoring trend.

Offshoring is not just about cost reduction through wage rate arbitrage. Instead, it is a powerful way to improve performance by accessing distinctive resources and accelerating capability building.  Bottom line: offshoring will force all of us to become more specialized and to make some difficult choices to exit certain activities along the way. In fact, by viewing offshoring too narrowly as simply a way to access cheap labor, companies risk unleashing a vicious cycle that will lead to value destruction.

I have just written a working paper that develops this message in some detail.  My perspectives on offshoring have been developing over quite some time.  Many of you are familiar with my writing on Li & Fung, the leading offshoring service provider in the apparel industry. My first experience with offshoring actually goes back to 1982 when I played a key role in helping Atari (remember them?) shift its manufacturing of home computers to Hong Kong.

But this particular working paper came about through my collaboration with a private equity firm based here in Silicon Valley.  Crimson keeps a low profile, but it is a remarkable firm.  It is the leading private equity firm focused on advising and investing in the efforts of U.S. companies to build out their offshore capabilities. Crimson and its portfolio companies work with some of the most sophisticated global players in developing offshoring operations.  These companies are building impressive capabilities that deliver world-class performance.

In studying their experience, it has become clear to me that offshoring creates an opportunity to build a new kind of high performance organization.  We generally are familiar with the characteristics of a high performance organization in the U.S., Europe or Japan.  Many of these characteristics are present in offshoring operations as well, but offshoring creates an opportunity to tailor these approaches to more effectively tap into the full potential offered by distinctive resources offshore.

What are these distinctive resources that can be accessed offshore?  In some cases, they involve world-class skills.  For example, Chinese engineers are now recognized as some of the leading designers of semiconductors for wireless devices. In many cases, Indian software programmers perform at a higher level of productivity and expertise than software programmers in the IT shops of large enterprises in the United States. But it’s not just about unique technical skills. It also includes distinctive cultural attributes, like the reliance on social networks that helps Chinese companies to collaborate closely across enterprise boundaries.

To realize the full potential of these distinctive resources, companies need to adapt their approach to building high performance organizations, often going against conventional wisdom.  For example, in offshoring locations, it makes sense to significantly reduce the ratio of front-line managers to staff while in the U.S. we have been focused on ripping out entire layers of management and expanding the ratio of managers to staff.  Why the difference? The alternative approach makes sense in offshore locations given both the significantly lower wage rates for managers and the opportunity created to deploy more management time to coach staff and to work with staff to identify performance improvement opportunities.

What are other differences in approach? In many offshore locations, it makes sense to hire people who would be viewed as overqualified for comparable positions in the U.S.  Once again, lower wage rates are part of the reason to do this, but the real opportunity is to accelerate performance improvement by drawing on highly trained and motivated people and creating opportunities for rapid advancement.  In offshore locations it often makes sense to open up new operations sites that would be regarded as sub-scale in the U.S. rather then expand existing ones because these operations tend to be less capital-intensive and because the greater competition across sites can also accelerate performance improvement. The working paper discusses these and other differences in more detail.

It is challenging to master these techniques for building high performance organizations offshore.  In many cases, it will make sense to go with specialized offshore service providers, rather than trying to create your own offshore operation.  Even here, techniques must be mastered in terms of working effectively with offshore third parties.  It is hard enough for us to outsource activities to third parties domestically – the distance, time zone differences and cultural differences all conspire to make this even more challenging when dealing with offshore service providers.

But the real value comes once these techniques have been mastered.  Once companies have mastered these techniques in one area of offshore operations, they can rapidly improve performance by systematically expanding offshore operations into adjacent areas. This is where the power of offshoring comes into full view.  Rather than viewing offshoring simply as a defensive move to cut costs, the real winners will be companies that understand that offshoring can be used as a competitive weapon to expand market position.  Look at some of the more aggressive computer companies like Dell, Gateway and Hewlett Packard. They’re using offshoring service providers as a way to accelerate entry into the consumer electronics market.

This is another way that companies think too narrowly about offshoring.  Since they focus so heavily on cost savings from lower wages, they tend to view this purely as an operational issue.  By understanding how to access world-class capabilities through offshoring, companies are more likely to recognize that offshoring is not just an operational initiative.  It has profound strategic consequences.

As in the case of the computer companies, offshoring can be used to restructure entire industries, not simply to improve the performance of individual companies.  But this cuts both ways.  Industries can be restructured to your advantage or to your disadvantage. If you choose to let go of activities, you had better be sure that these activities cannot be used to erode your own position or profitability over time. Offshoring creates significant strategic issues that few companies have begun to recognize, much less resolve.

This is particularly challenging because the strategic choices must be made in a highly dynamic environment.  Capabilities offshore are rapidly deepening, reinforced by robust local business ecosystems that seem to be emerging overnight in key areas like Bangalore, Taiwan and coastal Mainland China.  Choices that seem sensible today may be deeply regretted 18 months from now.  Given this situation, choices must be continually reassessed and fallback positions clearly identified.

Given all this, what should companies do?  Let me suggest a few early steps.

– Get on the ground. If your senior management team hasn’t personally been to India and China recently, it probably makes sense to arrange a visit and see firsthand the kinds of capabilities and infrastructure that are now available in these areas.
– Identify high impact opportunities. Conduct a diagnostic of your operations to identify systematically the highest impact opportunities to improve performance through offshoring initiatives. Don’t just focus on performance in your existing business. Think creatively about entering new businesses by accessing offshoring capabilities and combining them with assets and relationships you already have (think of the example of computer companies entering the consumer electronics business).  If you already have activities offshore, audit their performance to date and focus on lessons learned.
– Debate the strategic choices. Use this diagnostic as a catalyst for a broader strategic discussion within your senior management team regarding the choices involved in offshoring.  This may be the time to re-visit the most fundamental question of all: what business are we really in?  It may be useful to focus on the three business choices I outlined in the “Unbundling the Corporation” article in Harvard Business Review. Beware of simplistic core and context distinctions – many core activities are being moved offshore and outsourced while context may in some cases become core. Remember also that offshore doesn’t necessarily mean outsource – there are options to build your own operations offshore or to engage in “build, operate, transfer” arrangements that ensure long-term control of strategic operations.
– Staff the right team. Determine if you have the operational skills necessary to successfully move target operations offshore and to manage them effectively over time.  If you have limited experience in this area, it may make sense to either recruit the skills or to work with advisors that have relevant experience. Whether or not you are outsourcing the operations, make sure appropriate teams are configured both in the offshore locations and your home operations to get maximum performance impact.
– Make sure the foundations are solid. Clean up the operations targeted for offshoring.  Offshoring is not a panacea.  If performance metrics are not clearly defined, business rules poorly articulated, underlying data fragmentary and inconsistent or interfaces with other activities unclear, then offshoring will only complicate your life.
– Set aggressive targets. Benchmark the performance of the operations targeted for offshoring and work with the offshoring team to define aggressive targets for performance improvement.
– Implement redeployment plans for staff.  Successful offshoring initiatives require a smooth transition from existing locations to offshore locations.  This in large part depends on retaining and motivating existing staff to transfer knowledge.  This will generally be more effective if the existing staff can be effectively redeployed in other activities once the offshoring transition has been completed. You’ve invested a lot in these people so, if at all possible, find alternative roles for them in your company. If this cannot be accomplished, then at least help them in their transition to other employment and provide them with enough cushion so that they stay focused on ensuring a smooth transition as long as required.

This last point brings us back to where we started.  A lot of the opposition to offshoring is driven by concern over the job losses that occur as activities move offshore.  Supporters of offshoring focus on the macro-economic view that the savings generated by offshoring will get re-invested and create new jobs. That’s generally true.  But it misses a key question.  Who will create these new jobs?  Will the same companies that shifted the jobs offshore to begin with create these new jobs? Or will they be created by a different set of companies?

If you are the senior executive of a company, don’t celebrate because you have cut your employment expense through offshoring.  Unless you were able to do this in some proprietary way that can’t be easily copied by competitors, the savings you generate will soon get competed away and captured by your customers. The only way to continue to create value in this environment is to reinvest those savings to fund major new growth opportunities. If you do this well, you will thrive and create new jobs along the way.  If you ignore this challenge, someone else will create new jobs and you will be managing a shrinking business.

If you are an employee in a company and concerned about the threat that your job may be moved offshore, don’t blindly resist the offshoring option.  If this is a viable option for the kind of work you do, your company will be weakened by efforts to prevent it from accessing the capabilities available offshore.  Your job security will erode as your company faces growing challenges from companies that have been more aggressive in accessing offshore capabilities. Your challenge is to invest in your own skills to make them irreplaceable.  Just as every company must ensure that it has a distinctive specialization, every employee will need to develop a skill set that cannot be easily reproduced offshore.  This is a moving target, so you must continually reinvest in deepening your expertise.

We are all consumers.  In that dimension of our life, we will all reap the benefits of offshoring in the form of higher quality products and services delivered at lower prices.  But we are also producers.  Offshoring will challenge us to get better and better at what we do. That will mean more specialization, more effective coordination with other specialized resources and more rapid learning to maintain our edge.

 


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