Hiring a separate company to build a product or provide a service can make sense for some operations management projects because outsourcing may be cheaper, provide higher component quality, or reduce capital costs.
Outsourcing has continued to be a popular business tool since the turn of the 21st century. Here are some of the most compelling benefits of outsourcing:
Better quality: Sometimes another company is just better at building a product or delivering a service than your firm is. And do you really want your company to produce its own pens and paper? Most automotive firms outsource the production of tires. Ultimately, that’s a pens and paper kind of decision.
When the part or service to be outsourced, like tires, has a standard, easily defined interface with the overall product, the quality benefit rules. To buy a tire, even in the aftermarket, all you need to know are three measurements. If the tire matches those three measurements, you can put it on your car.
In contrast, very few automotive firms outsource transmissions because most transmissions are tailored to individual engines and automobiles.
Improved return on investment: A mainstay of outsourcing is its ability to reduce the investment in plant and equipment needed to produce a product, which must be booked as an asset. If you can retain the bulk of the profits for the product and not lose too much to supplier markups, then your return on investment should increase.
Lower costs: Some suppliers have economics in their favor. Generally speaking, outsourcing to low-cost labor means a company can reduce the labor cost that goes into the outsourced components. For example, labor costs in China are lower than in Western nations, so some firms hire Chinese companies to perform labor-intensive, low-skill activities, like cutting and sewing clothing.
This also has a reinforcing effect. If a number of companies outsource to a common low-cost supplier, then that supplier can obtain economies of scale from specialization. Sometimes, it just doesn’t make financial sense for a company to set up facilities and hire employees to produce an item that another company is already making efficiently.
A transfer of fixed cost to variable cost: If you produce a product or component yourself, you incur a number of investment costs that you need to recoup before you can make a profit. If a supplier provides the part, you may be able to purchase it on a per-unit basis before repackaging and selling it. This transforms the fixed cost you incur into a variable cost.
The upshot is that the number of product units you have to sell before you make a profit drops. Even if the product doesn’t sell well, you’re still likely to make a profit when you outsource.