July 2008

Outsourcing: What is it good for?

By Hans Baumann

When discussing the pros and cons of outsourcing, one should first distinguish between domestic outsourcing and outsourcing to foreign countries.

Do not confuse a critical examination of this issue with animosity towards free trade.

Domestic outsourcing, if done right, creates beneficial micro-economic benefits for individual companies and therefore, by extension, for the national economy.

Cross-border outsourcing especially of labor, in contrast, can have profound negative macro-economic effects on our national economy.

The guiding criteria in determining the positive or negative aspects of outsourcing should be the question. Does it contribute to our national wealth? Such positive benefits will ultimately increase the average U.S. standard of living.

Internal outsourcing tends to increase operating efficiency, hence increases profits of individual firms, and thereby creates national wealth. Foreign outsourcing, on the other hand, tends to fall in the negative category by increasing the national debt, decreases State and Federal tax receipts, reduces the skilled labor pool, gives away technical know-how, and drains domestic capital.

There are, as always, gray areas where the two may combine. Here is an example. A domestic manufacturer outsources his castings from a domestic foundry. However, this foundry imports their raw iron from Brazil. This practice may be acceptable if the overall effect is economically beneficial, that is if the generated extra profit exceeds the drain on the U.S. dollar.

A recent article stated the positive benefits of domestic outsourcing practiced by the 7-Eleven company. The article claimed merchandise sales per employee increased from $98,000 of the industry average to $239,000 per employee. Even when we concede other employees involved in the above sales figures worked at outside suppliers, there still is a substantial increase in generated profit.

Beginning to see a reversal

Let's discuss foreign outsourcing in greater detail. The most problematic form of foreign outsourcing is farming out industrial production to foreign countries. While still fashionable, it entails considerable financial risks.

Since managerial decisions rest primarily on direct wage considerations, they typically ignore the resultant increase in overhead, of shipping expenses, additional inventory, and other factors. Additional factors that can deteriorate future profitability are climbing foreign wages and unfavorable exchange rates.

Outsourcing of services, while not desirable has much less of a detrimental effect on our national economy. First, U.S. wages lost are typically low. There hardly is any capital outflow to foreign countries. Only minimal training is required for foreign workers, and the whole outsourcing process is easily reversible.

Outsourcing of manufacturing, on the other hand, has a number of serious consequences. First, the U.S. loses highly skilled and high paying jobs including those of engineers.

There is a massive out flowing of capital in order to build foreign manufacturing facilities, tooling, and patterns. Our government experiences a sizable loss of tax revenue due to the deteriorating wage base; and finally, we lose a portion of our exports, the basis of wealth creation.
The flipside of the coin is we have to import the goods we can no longer produce domestically, adding to the current trade deficit hovering around $700 billion per year.

Outsourcing and our foreign debt are intertwined closely; you cannot solve one without the other. A large foreign debt lowers the value of the U.S. dollar causing, in part, the high prices for oil and gasoline.

On the positive side, we are beginning to see a reversal of the foreign outsourcing trend. May this be the beginning of our manufacturing resurgence which, in turn, will go far to restore out economic health.


Hans Baumann, P.E. (hdbaumann@comcast.net) is an ISA Life Fellow. He has an industrial engineering education and a Ph.D. in mechanical engineering. Baumann's new book is Hitler's Fate: The Final Story, Athena Press, 2008.