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Beset by new competitive reality, firms typically start to focus on better asset management (reduction of working capital) as well as in reduction of investment requirements by selective outsourcing. However, vitality in the medium to longer term comes not from asset reduction but from resource leverage.

Competitive advantage is a function of two variables: the amount of customer-valued differentiation between what your company offers and that of its direct competitors, and the sustainability of that differentiation over time. The greater the difference and the longer you can sustain it, the more attractive your prospects for creating above-average returns for investors.

From an investor's point of view, any business process that creates additional differentiation, or that contributes to increasing the staying power of the differentiation currently achieved, is core. Investors want you to spend their capital to improve your stock price. By contrast, all the other business processes in your company are context--critical to run your business, but not related to creating or maintaining competitive differentiation. Investors don't want their capital to underwrite these efforts because they can't improve the stock price.

So how does context work ever get funded? Investors say to expense it, not to invest in it. That is, it's OK for them to see noncore spending on your profit and loss statement, they just don't want to see it on your balance sheet.

...Competitive differentiation on context is actually a liability. It requires financial and human capital to create and maintain, without increasing shareholder value.

In the long term, the best way to manage context processes is to turn them over to another company. This is the inherent logic of outsourcing--whether the processes are IT functions, manufacturing processes, payroll processing, or any other function.

If you list all the context processes in your company, you'll quickly note that many are crucial while others play a supporting role...Most managers conclude that the company simply can't risk outsourcing a critical process. That conclusion, however, inevitably leads to a slow but inexorable decline in stock price. More of the total assets get tied up in processes that can't produce a competitive advantage and therefore can't improve the company's prospects for increasing future earnings.

...In this new world, the mnemonic for ensuring that you focus on the right variables is QRSTUV, which stand for: Quality, Reliability, Scalability, Total cost of ownership, User control, and Visibility.

Today, for the most part, such control systems for business don't exist. Instead, both outsourcers and their customers throw human intervention into the mix, leading to a deterioration of the value proposition at both ends.

Historically, the critical interfaces for IT have existed with the functional departments. Key business processes such as finance, human resources, and marketing weren't standard between companies and, in many cases, weren't even standardized within an enterprise. In such an operational environment, business-process automation software was often custom-built to bridge the gap between the IT infrastructure and the rigid business-process architecture. It made sense to keep the IT function in-house so the interfaces between functional departments and their supporting systems could be tightly integrated.

This historical fact is perhaps the most compelling argument against using core competency to make outsourcing decisions. When it made sense to keep IT functions in-house, IT was no more a core competency of most companies than it is today. The reason outsourcing didn't offer a compelling value proposition is that it violated the principles of Value-Chain Analysis: The interfaces that linked critical business processes weren't standardized.

At least in the United States, most policymakers understand that in the long run, economic growth requires productivity growth: For per-capita living standards to increase, so must per-capita output. What is less well understood is that productivity growth requires the creation and satisfaction of new wants, not just the more efficient provision of existing wants.

Currently, discussions of productivity tend to focus on increases in efficiency and ignore the development of new markets, which is a dead end: Economies cannot sustain growth in productivity and living standards simply through efficiency. Sure, in the short run, increased efficiency does reduce costs, and as costs decline, people consume more of the good or service. But eventually, the law of diminishing utilities sets in: Sated consumers refuse to buy more even if prices continue to decline. After that, further increases in production efficiencies must come at the expense of the demand for labor.

In principle, societies could accommodate reductions in the demand for labor by increasing the time for everyone's leisure. Over the last century, economic growth has helped reduce working hours and increase vacations. But somehow, beyond a certain point, societies seem unable to accommodate reductions in labor demand by spreading the work around...It is the entrepreneurial activity of creating and satisfying new wants that keeps the system humming.

Outsourcing jobs to low-wage countries resembles efficiency improvement in its symbiotic relationship to the satisfaction of new wants. It improves living standards in the United States, provided the human capital released here can be used to make new goods and services. Otherwise, as with improvements in efficiency, outsourcing is all too likely to reduce the demand for domestic labor.

Viewed unemotionally, the offshore outsourcing of IT and call-center work to India is merely the most recent step in a 100-year-old trend in which large corporations farm out pieces of their value chains, through which raw material becomes finished products to be marketed, sold, and delivered.

The perspective on outsourcing must shift from a focus on cost arbitrage to one encompassing a global search for resources and methodologies for leveraging resources. That's the new basis for innovation. We've just started scratching the surface of the business benefits of managing global resources; companies that focus on building a core competence in managing remote delivery-that is, managing for innovation, influencing without ownership, and learning to work in intercultural teams across time zones-will have a clear advantage.

Note: Older EBF articles are not currently online. I'm not sure if this is temporary or permanent. If you click you will be taken to the Archive.org site to find an archived copy.

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Economists are blind to the loss of US industries and occupations, because they believe these results reflect the beneficial workings of free trade. Whatever is being lost, they think, is being replaced by something as good or better. They are unable to identify what the replacement industries and occupations are, but they are certain they are out there somewhere. It does not occur to them that the same incentive (cheap, skilled foreign labour) that causes the loss of one tradable good or service applies to all tradable goods and services. There is no reason why the ‘replacement industry' or knowledge job will not simply follow its predecessor offshore.

Economists misunderstand outsourcing because they have not got to grips with the challenge presented to comparative advantage by highly mobile factors of production and by production functions based on acquired knowledge. Their belief that free trade always makes trading countries better off demonstrates that economists are also unfamiliar with the latest development in trade theory.

Regarding outsourcing:

I wouldn't tell employees what's going on until you've come up with an idea or solution for what you're going to be able to do for them so they can land relatively safety. A person's first question is never Why is this happening? but What is going to happen to me?

Dominating a market is a function of being able to deliver more performance than your competitors on the basis of competition. And doing that depends upon being able to closely integrate those elements in the value chain that drive performance along the relevant dimensions. Whatever does not drive that performance can be safely outsourced.

It is not enough to get this analysis right just once, however, because the basis of competition changes over time...Making the shift to delivering improvements in a different dimension of performance can require reconfiguring your value chain, bringing back in- house processes that once were outsourced, along with their associated IT infrastructures, and vice versa. It is the need to respond to these changes that makes outsourcing decisions more complex, more subtle, and more challenging than they first appear...And so, when it comes to structuring outsourcing deals, agreements must recognize the inevitability-but unpredictability-of these shifts and incorporate a means of responding.

In the outsourcing realm, core competence thinking typically manifests itself as a prescription for firms to outsource IT-intensive processes because the IT elements that drive process capabilities rarely qualify as a firm's core competence. But outsourcing vendors make running IT infrastructures the focus of their business. For them, these activities are their core competence. This reasoning is encapsulated in marketing slogans such as "make your back office our front office."

Problems arise, however, when the processes these non-core IT functions support are, or become, a critical element of the value chain configuration needed to deliver improvements on that dimension of performance that is the basis of competition. In other words, just because something is not your core competence does not mean you should not do it yourself. The challenges of learning and mastering new capabilities are daunting and difficult, but the alternative is frequently competitive irrelevance.

Successful companies ask themselves, "What must I keep at home?" rather than "What can I send to LCCs?" The burden of proof shifts from the LCC advocate (often procurement) to the existing producer (manufacturing), which now needs to prove - and improve - its own competitiveness. Best-practice companies investigate and communicate the LCC options and costs, specify the target costs that will be considered competitive, and then give the organization a reasonable chance to meet or beat the target internally. Usually the organization will increase its efficiency and justify keeping a fairly large portion of the supply chain in-house.

Currently, in some industries, the difference in the cost of labor is such that they have no choice but to outsource to, say, China. But in other industries, the choice is not always so clear. My feeling is that in many cases not all costs in terms of increased risks are taken into account. One of the problems is that we don't have good metrics for operational risks. If a company engages a supplier in China to do something, there's no way to quantify that this company went from 0.71 to 0.73 on some sort of risk index or operational risk ratio. The appropriate metrics don't exist yet.

Some managers have a general awareness of risk. Clearly they know that taking a supplier in Indonesia is not like taking a supplier in Kansas City. It's easier to keep tabs on what's going on in Kansas City than in Indonesia. But there's no way to quantify the difference. So people make the decisions based on what they can quantify, and what they can quantify are labor costs, landed costs, or whatever the knowable cost might be. And since financial analysts also lack the tools to quantify the increased risk, this is not reflected in the stock price. My feeling is that much of the offshoring is done without proper comprehensive analysis of the consequences.

The outsourcing gurus have been…saying everybody ought always to do this. But it is really contingent on where you are on the spectrum from “not good enough” to “more than good enough,” relative to each tier of the market. It is when the product is not good enough that proprietary integration gives you a competitive edge. You cannot outsource and be competitively successful in this situation. But at the other end, where standard components assembled in standard ways can yield acceptable performance, you must outsource.

The short-term cost savings of outsourcing were very apparent, very attractive, and very seductive to companies [that] were desperately trying to improve their earnings per share quarter to quarter. But when you outsource something, you tend to make it more generic. You tend to lose control over it. You tend to pass a lot of the technology, particularly on the manufacturing or service delivery side, to your suppliers. That creates strategic vulnerabilities and also tends to commoditize your product. You’re sourcing from people who also supply your competitors.