Even firms that are vertically integrated leverage services and products from other organizations. It has
become more of a question for these firms as to how much should be leveraged from others. Suppliers
that accept outsourcing work are generally able to operate with a reduced level of overhead due to a
focused operating strategy and efficiencies gained from exploiting their areas of expertise. LaLonde [20]
states that reasons for outsourcing range from desire to reduce assets to desire to turn fixed costs into
variable costs. Companies come to the realization that there are some processes that another company is
simply better able to handle. These operating benefits are translated into lower product costs (even when
profit for the supplier is considered) as well as service level improvements. However, outsourcing has
its pitfalls. The company outsourcing the work could be in a difficult situation if the service provider is
unable to deliver on its obligation due to bankruptcy, lack of funds, labor problems, and the like. Other
challenges may include the outsourcing company losing control over its process, and current employees
in the company feeling threatened due to outsourcing of work and thus not functioning as well as
they should. These disadvantages are reasons why companies should carefully evaluate outsourcing.
Companies should adopt a planned approach towards outsourcing taking into account the interests of

employees and customers alike to come up with a balanced approach. Outsourcing work simply to beat
the competition or to follow competitors can lead to problems in the future. This paper lays out the
planned approach to making outsourcing decision.

Outsourcing has been a major movement across many industries in recent years and often viewed as a
way to find a supplier who can help in the reduction of labor costs. Beyond the reduction of labor costs,
there is not much general understanding in organizations about when and how outsourcing can be effective
and when and how it should not be done. In an effort to better understand this, the following research will
attempt to understand the major drivers for outsourcing, in addition to reduced labor costs. Also, the sorts
of industries and work types that are more successfully outsourced than others will be investigated, and
the types of technologies and structures that will enable effective outsourcing for an organization will be
explored. A framework is needed to show how the outsourcing decision process can be effectively carried
out in an organization to maximize stakeholder value. Stakeholders include employees, shareholders,
customers and suppliers. The study specifically looks at such issues that directly affect the stakeholders’
interest as intellectual property protection, quality, employee-management buy-in, and management of
risks involved in outsourcing.

2. Outsourcing: Definition and uses
First, a better understanding is needed of what outsourcing is and is not. Outsourcing can be described
as the practice followed by management of contracting out in-house functions that companies do not
do particularly well to outside firms that do [35, p. 50]. The strategy behind outsourcing is one where
the organization is to focus on its handful of core competencies, and then hire out the remaining
business functions to contractors [30, p. 46]. These core competencies are the collective learning in
the organization, especially deciding coordination of diverse production skills and integrating multiple
streams of technologies [31, p. 82]. A core competency provides potential access to a wide variety of
markets and makes a significant contribution to the perceived customer benefits of the end product, in
addition to being difficult for competitors to imitate [31, pp. 83–84]. If a function or task carried out
by a given organization does not meet these tests, it detracts from that organization’s ability to most
effectively compete, especially globally [31, p. 81].

Despite popular belief, outsourcing does not necessarily mean moving the business functions, like
manufacturing, overseas. Rather, outsourced production carries concrete collaboration burden. For
example, contractors providing electronics manufacturing services (EMS) market kept nearly 60%
of their business in the Americas and Europe in 2002, although that percentage has been shrinking
in recent years. An example of a company utilizing outsourcing of production to a couple of key
domestic contractors is Network Equipment Technologies (NET), a Freemont, California based seller
of high-tech networking equipment used as building blocks for high-performance, wide area networks.
With production outsourced, NET handles functional testing and systems integration in-house. Stratex
Networks, a San Jose, California based provider of digital radio systems, is another high-tech industry
original equipment manufacturer (OEM) involved in outsourced production. It manages order fulfillment,
demand planning and procurement functions, closely partnering with domestic contractors [24]. Many
companies prefer to work with domestic contractors so they can avoid dealing with the costs generated by
the communication and technology compatibility issues working with foreign suppliers. This option for
cutting production costs is called line transfer. It is similar to but different from contract manufacturing.
Line transfer manufacturing involves the transfer of a manufacturing line to a domestic company that
has the expertise to do it better, faster, and cheaper. Sometimes, just a technology is transferred from


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company to another; other times, the transfer includes equipment and even employees and buildings. The
companies that offer line transfer say that the advantages are compelling enough to make anyone thinking
about outsourcing abroad think twice. Precision Electronic Glass, who makes glass components for
medical diagnostic equipment, successfully transferred a manufacturing line from PerkinElmer Inc. [2].

To avoid dealing with complexities of overseas contractors, some companies will outsource to a
domestic firm, who in turn outsources some or all of the work to another offshore provider. Many
domestic manufacturers are turning to professional Printed Circuit Board (PCB) distributors. These are
companies that have come up in the past few years to partner with North American printed circuit board
shops in their effort to provide customers with offshore PCB solutions. These companies are not to be
confused with brokerage firms, which buy and sell products as over-the-counter commodities. The PCB
distributor firm is made up of seasoned PCB experts who have offices (distributorships) in the US and
offices offshore near the factory. They select, qualify and monitor the offshore vendors, and assume full
responsibility for quality, responsiveness and on-time delivery. They manage the offshore relationship,
providing a seamless partnership with the American printed circuit board houses. PCB distributors offer
an excellent solution to companies who want to offer customers the value of PCBs bought offshore, but
do not want to assume the risk and expenses that come with working directly with offshore suppliers [26].

Electronics manufacturing contractors such as Flextronics,SCI Systems and Solectron support complex
supply chain systems that can involve high risks for production. This issue causes many technology
companies such as Cisco, Dell, Hewlett-Packard, IBM, Motorola, and Nokia to decide not to make
products themselves. Instead they outsourced them to electronics manufacturing services companies
such as SCI. EMS companies purchase sometimes their customers’ old factories, where they will
assemble as many different products for different customers as possible, to keep the lines rolling all the
time and realize the maximum efficiency [33]. Again, large companies often lead the way in outsourcing.
Microsoft hired Flextronics to introduce and manufacture its Xbox gaming console in 2000, while in
2002, NEC hired Celestica to assemble, integrate, test and manage the supply chain of their optical
backbone and broadband access equipment [7, p. 3].

The outsourcing industry is large and growing. In 2001, the worldwide EMS market was $100
billion. In common with other top-tier EMS providers, Celestica operates a network of New Product
Introduction (NPI) centers, called gateways, in key geographies where a large portion of its customers
are clustered. In the U.K., the gateway is part of a larger production facility at Kidsgrove, near Stokeon-
Trent. Here, customers have access to the full range of NPI services, and the center also provides
a quality assurance failure analysis laboratory, component analysis facility, an R&D laboratory, and
comprehensive test and development services. The stand-alone facility is flexible enough to deal with
start-ups, and small, medium or large OEMs. Through the gateway, all customers have access to
Celestica’s global design, manufacturing and supply chain management expertise [39]. A 2003 survey
showed nearly half of companies in the US and Europe were considering outsourcing at least part of
their procurement operations within three years, which was higher than the 22 percent who said they
were already outsourcing it. Similarly, 83 percent of large manufacturers were using third party logistics
providers in 2003, up from 65 percent a year earlier [24].

Outsourcing is done in many industries and job functions. While high-tech industry is a leader in
manufacturing outsourcing because of standardized processes, high research and development costs, and
critical time-to-market requirements, the automobile industry is also a major manufacturing outsourcer.
Beyond manufacturing, a 1997 study showed outsourcing efforts to be focused on things like information
technology (30%), human resources (16%), and marketing & sales (14%) [30, p. 47]. Call centers,
medical diagnosis, financial services, tax preparation, and software development services are also prime
candidates for outsourcing and offshoring [21, p. 6]. Even product design and prototyping of complex
products like automobiles are being outsourced [13, p. 38].


S. Kumar and J.H. Eickhoff / Outsourcing: When and how should it be done?
3. Major benefits, risk considerations and success factors
Adopting an outsourcing approach can be major enabler to improve financial metrics of an organization.
A classic example is Dell, which does not own a manufacturing plant. In 2005, Dell supported $55.9
billion in annual revenues with $2.0 billion of fixed assets. It produced twenty-eight dollars in sales for
every dollar invested in plant and equipment. In 2005, IBM supported $91.1 billion in annual revenues
with $13.8 billion of fixed assets. In contrast to Dell, IBM generated about $6.50 for every dollar invested
in plant and equipment. An example covered later in this research will further explore this topic.

There are many benefits to outsourcing, but of course, the risks are numerous as well. Labor cost
reductions in other markets, especially in Asia when offshoring, can be significant [21, p. 6]. Major tariff
reductions in recent years have made these sorts of moves much less risky [10, pp. 84–85]. This can be
perceived by some as a net negative for the American economy because of the transfer of jobs out of the
country, and it may be seen by some as exploitation of poorer nations [9]. Less than 11% of Americans
today are employed in manufacturing, and over 3.3 million service jobs will also be moved to low-cost
countries by 2015 [10, p. 84]. On the other hand, contractors can provide significant time-to-market
capabilities, which might outweigh a higher wholesale cost. This only works if the contractor has the
process technologies and capacity in place to meet time-dependent product introduction windows [36].
Outsourcing can give organizations access to capacity, capability, skills and technologies that they do
not want to invest in themselves. This, in turn, enables them to free-up resources and capital for other
purposes and to focus on key differentiators, their core competencies [14, p. 12], while leveraging the
economies of scale of their outsource suppliers. By reducing risk and debt, the organization gains in
flexibility [11, p. 13]. The growth in the use of Internet, e-commerce and information technologies have
made these technologies more accessible to small manufacturers. In this new virtual manufacturing
environment, small manufacturers could have all the benefits of a large manufacturing enterprise without
the capital investment in equipment and personnel, or the risk involved in such ventures, enabling small
manufacturers to play in markets only large players could in the past [25, p. 151]. All of this is often
easier said than done.

Manufacturers often overrate the value of wage savings and underestimate the inventory obsolescence,
intellectual property and currency risks associated with outsourcing, and they discount the logistical risks
such as when the new supplier is further from current customers than the existing in-house facility [14,

p. 12]. Adding more steps to the supply chain can lead to a higher inventory position if not properly
managed. This inventory is then at risk to become obsolete, especially in a fast-paced product development
environment. Intellectual property (IP) risks can affect both the outsourcing firm and its vendor
negatively. Sharing the information necessary for successfully outsourcing a task might require revealing
trade secrets, special processing techniques or new product development plans. The vendor might decide
to run with the ideas of their outsourcing customer, stealing market share. Likewise, the outsourcing
firm might learn the processing methods of its vendor and either share them with another vendor or
even use them themselves. Both firms need to be sure to have complete and thorough IP agreements
in place before progressing far into their business relationship. Even with such agreements, each firm
must consider how much they trust the other before proceeding, as many such agreements could be
broken without the others’ knowledge or consent. Currency values fluctuate, especially in developing,
less-stable economies. Companies need to be sure that their contracts with outsourcing vendors take into
account the impacts of exchange rate changes over the long term.
Organizations that succeed at outsourcing generally need to have some critical capabilities. Chief
among these is the ability to recognize what is and what is not a core competency [31]. Failure to


S. Kumar and J.H. Eickhoff / Outsourcing: When and how should it be done?
recognize this means the organization is wasting time and capital on something it is not very good at
and does not give it a competitive advantage. This can be very hard to give up, especially when a
company has been doing a particular function in-house for a long time [30, p. 43]. Also highly important
is the ability to communicate all sorts of critical information with the potential supplier. This can be
facilitated greatly with electronic and Internet tools and systems like computer-aided design, virtual
design, on-line collaboration software, and simulation tools. This can drive big savings and efficiencies
when supplementing traditional communications like prototyping, face-to-face meetings, phone calls
and e-mails. This is especially true when common tools are used by all the players in a given supply
chain [13, pp. 33–34].

There are many reasons identified for when organizations fail at outsourcing. In general, it is cited
that there is a lack of understanding of what is needed to outsource successfully and that there is a
failure to make changes in the ’home’ business to cope with the change [14, p. 13]. As stated previously,
understanding one’s own core competencies can be difficult for many companies, but then finding a
high-quality supplier willing to provide the necessary product or service can also prove to be quite
daunting. Companies also can struggle documenting properly their needs to their prospective suppliers
because much of their production capabilities are tied up in the “tribal knowledge� of their employees.
Despite making the decision to outsource, many companies are stuck with the capital equipment and long
term labor contracts they had in place before the change, and that can be a major drain on accounting
metrics [30].

4. How can we decide on outsourcing?
There has been much research in trying to understand the reasons for an organization to choose or not
choose outsourcing and how to go about it. Now we will try to break that into a framework that can aid
in the decision process to maximize the likelihood of success for all stakeholders.

Offodile and Abdel-Malek have developed a model to aid organizations in the outsourcing decision
process in regards to manufacturing. The term the authors use is “telemanufacturing� which is an infrastructure
whereby a firm utilizes services afforded via communications networks and across information
superhighways to perform – in real time – operations and processes necessary for the design and production
of items [25, p. 148]. It takes into account a number of issues including core competencies, costs,
time-to-market, quality, availability of willing suppliers, and buy-in from employees.

This model can quite easily be applied generally to the outsourcing decision process for all types of
business functions, not just manufacturing, but a few key issues need to be addressed in this model to
do this fairly. First of all, the decision tree does not deal with outsourcing versus offshoring decisions.
This can be critical to the success of the entire decision because of the extra risks and benefits created
through offshoring. The model does not directly take into account intellectual property concerns, which
can be important even if the issue at hand is not a core competency but is rather related to one. Product
obsolescence, inventory and currency risks might be implied in the model in the cost analysis, but they
are not obviously stated. Technology and communication needs are also not included. Companies need
to be sure that all risks are considered to ensure an appropriate decision can be made that benefit long
term profitability.

Another problem with this model is that it suggests that outsourcing a core competency is acceptable.
This seems to fly in the face of all of the literature reviewed for this research. A core competency is
what the organization excels at and creates its differentiation in the marketplace. Why would a company
want to look outside when it can provide the most value within? The only cases that outsourcing a core


S. Kumar and J.H. Eickhoff / Outsourcing: When and how should it be done?
competency should be considered is when internal capacities can not be brought up fast enough to meet
market demands or capital is limited. This can be remedied through short-term contractors to provide
marginal production capacity. For the organization to truly provide value to customers, it must make
sure to keep its core competencies internal and improve their capability to deliver. This can be through
capacity or staffing increases, training, capital investment, and quality improvement programs.

Finally, the model does not provide a closed loop decision framework. Reevaluation of the outsourcing
decision from time to time is vital for successful operation of a business enterprise.

Figure 1 shows a modified framework that should remedy the problems described above with the
Offodile & Abdel-Malek model. We will go step by step through the model to explain and show the
decision process flow.

Starting in the upper left is the outsourcing decision. An organization has something that it needs to
decide to either make or buy, to do it internally or to hire out. First, it must be determined if this job,
task, or function is a core competency. If it is, there is still the possibility that this can be outsourced,
providing it gets through three tests. First, if the processes, equipment, capital, and employees are in
place to deliver to customer needs, then there is no need to outsource. If it truly is a core competency,
then the company should be able to provide value and should not give the business to someone else.
Secondly, if the quality is sufficient to meet customer demands, the function should not be outsourced.
Finally, one last exception to the core competency rule is that if the needs are short-term, that is, if
the marginal increase in capacity provided by the supplier meets the needs for the organization, then
outsourcing can still be considered. If all three of these tests are satisfied, then outsourcing is still a
possibility, and the decision process enters the next decision loop.

If the job is not a core competency, or if it is a core competency and passes through the tests described
above, then there are several more items that must be considered before deciding to outsource. First,
a vendor must have the necessary processes, equipment, manpower, and technological capabilities in
order to qualify. The outsourcing firm must have methods of fully communicating their requirements
to their vendors so that both parties can agree on the expected output. Intellectual property concerns
of both parties must be ironed out up front to help prevent disagreements from developing later on in
the relationship. The quality of the vendor’s output must also be sufficient and should not significantly
degrade cycle time and inventory metrics. If these areas are deficient, plans may be instituted to improve
these factors, but this may prove too costly for some. The organization might be better served by applying
those improvements internally and performing the function in-house rather than by solely bringing up a
supplier’s capabilities. Also, employee and management buy-in must be considered. If not, then there
will be a constant wall of resistance to making the outsourcing decision a successful one, and it can lead
to long-term difficulties. Employees, fearful of losing their jobs, might lose faith in management. This
can definitely be improved through education on what the benefits of outsourcing can be to the company
and by having effective compensation systems that reward employees and management on successful
cost reductions and customer satisfaction. Many employees might be forced to train their outsourced
counterparts. This can be quite frustrating as the employee is basically working him or herself out of a
job.

Once these risks have been considered, there are additional risks specifically regarding offshoring that
must be included in the decision process. These largely are out of an organization’s control but must
be considered before going forward with outsourcing to a foreign firm. The economic risks involving
the stability of the nation and its economy can be high. Currency risks are a major concern because
conversion back to the home currency might become a drag on earnings, and runaway inflation will
directly impact the supplier’s ability to operate. Many large multinational firms operating in South


S. Kumar and J.H. Eickhoff / Outsourcing: When and how should it be done?
Action Vendor Assessment Internal Assessment
Make or Buy?
The outsourcing
decision!
Is the job a core
competency?
Are in-house process,
equipment, capital, and employees in place
(capability and capacity)?
Y
Is the quality
available in-house to meet
customer needs?
N
Is the need
short-term?
N
Do not Outsource!
Y
Y
N
Are the supplier s process,
equipment and employees in place
(capability and capacity)?
Y
Can they be
developed cost effectively and to
enable TTM?
N
Can requirements be communicated
properly and are the information systems in place
to communicate with the vendor?
Y Y
Do not Outsource!
N
Can communication
systems be developed and
integrated cost effectively?
N
Y
Are there concerns about
intellectual property or of the supplier
becoming a competitor?
Can agreements and
work processes be structured to
protect IP?
Y
Y
N
N
Is the quality at
the vendor going to meet
customer needs?
Can the vendor s quality
be developed cost effectively and in a
timely fashion?
Y
N
N
N
Will the supplier
significantly effect cycle time
and inventory?
Y
Can the vendor s supply
chain be developed cost effectively and
in a timely fashion?
Y
N
Do not Outsource!
Is there
employee and
management
buy-in?
Y
Y
Education and
compensation
programs
N
Is the vendor
offshore?
Y
Re-evaluate
Y
Include economic,
currency, political
and secutiry risks
in analysis!
N
Perform cost
analysis: ABC,
breaeven, NPV,
DuPont model, EVA,
etc.
Include offshoring risk
(if applicable)!
Include integration
costs (vendor
development)!
Does it pass
the cost test?
Outsource the job Y
N
N
N
Fig. 1. Closed loop outsourcing decision model.


S. Kumar and J.H. Eickhoff / Outsourcing: When and how should it be done?
American countries such as Argentina and Brazil experienced such runaway inflation in recent years,
hurting their operating financials. Political risks can abound, both from changes in leadership effecting
how friendly the local government is with business but also with relations with the home country. If
tariffs or embargoes are put in place, or even worse, war breaks out, the ability for the supplier to deliver
to their commitments will be gravely distorted. There are security risks to deal with. Suppliers need
to demonstrate ability to provide the necessary security to protect themselves from potential attacks or
sabotage. If any of these risks can not be adequately neutralized or compensated, outsourcing is still an
option for the organization, but it should stick with domestic companies that provide more safety from
these risks.

Now that all the risks are considered, the last step before making the outsourcing decision is cost
analysis. There are many methods that can and should be used in this analysis so that nothing is
overlooked. Breakeven, net present value, activity based costing (ABC), economic value-add methods
are all good and can be used. The DuPont model, because of its bottom-line focus and because it
draws in inputs from across the organization, is an excellent tool as well. The DuPont model, which
includes return on net worth, is a technique that can be used to analyze the profitability of a company
by integrating elements of the Income Statement with those of the Balance Sheet. Developed in 1914
by the DuPont Company, the model remained the dominant form of financial analysis until the 1970’s.
There are many costs that must be included – labor, materials, inventory, transportation, etc. – but also
the risks that were considered earlier in the model must be noted. This can be done through Monte Carlo
simulations (to generate values for uncertain variables over and over to simulate a model) or some other
probabilistic model so that rational decisions can be made based on imperfect risk quantifications. Also,
the implementation costs need to be included, such as costs to bring up compatible information systems
or costs to decommission existing production lines.

Regular re-evaluation is an important part of outsourcing, and this is shown by the closed loops back
from the outsourcing and not-outsourcing cells in the flow chart in Fig. 1. As time passes, the business
environment changes so decisions made in the past might not apply as well in more current situations.
The performance of the supplier must be regularly measured against the goals and metrics set for it from
the outset of the outsourcing agreement. Those metrics should also be adjusted as the relationship grows
and as the market and business environment change. Not only should an organization continually look
back at the decision process to see if it still is the correct one given current inputs, they should consider
other vendors as well. When re-evaluating the outsourcing decision, switching costs to a new vendor or
back to performing the function internally must also be included. How often this re-evaluation should
occur will vary depending on the situation, but this should be done at least when renewing outsourcing
contracts and at most quarterly.

5. An industry example for the outsourcing decision process
A good way to show the effectiveness of this new model is by applying it to a real-world example. We
will go through various decision points shown in Fig. 1 to illustrate how a hard disc drive manufacturer
can use the proposed closed loop decision framework for a business critical decision to “make versus
buy� an optical fly height tester, which is an important tool used to test recording heads for hard disc
drives [28]. With the target for fly height (a distance between the magnetic record head and the disc
storing the bits of data) on the order of a few millionths of an inch for today’s leading edge hard disc
drives, continuous fly height monitoring in production is critical to ensuring optimal performance and


S. Kumar and J.H. Eickhoff / Outsourcing: When and how should it be done?
reliability of disc drives. Hard disc drive manufacturers could design and build their own fly height
testers but many make the decision to outsource tester design and manufacture.

A major core competency of hard drive manufacturing companies is their ability to miniaturize data.
They are constantly increasing the data capacity of their hard drives. Part of what makes this possible
is by reducing the fly height of their magnetic recording heads, bringing them closer to the disc and
making it easier to read and write data bits smaller and smaller. This enables them to deliver drives to
all data storage markets, from handheld devices to huge network servers. Customers are enjoying their
ability to store more data – documents, music, video, etc. – on their drives, and it is proving hard for
competitors to keep up. In fact, many have been losing money in the hard drive business. While fly
height capability is critical to this competency, tester design is not. There is limited need for these testers
as they are only applicable to the few companies that make hard drive recording heads. While it may be
difficult for competitors to make their own testers that is offset by the fact that hard drive manufacturers’
end customers do not perceive any value alone from the fly height of the recording heads. Rather, they
care largely about the data capacity of the drive and its speed. Fly height testing is clearly not a core
competency of many hard drive manufacturers, justifying choosing a “No� decision alternative out of
the decision box in the upper left of Fig. 1.

There are suppliers that specialize in designing and building test equipment for the hard drive industry.
One of the suppliers is KLA-Tencor [12]. They have recently announced a design for a very advanced
fly height tester. For a company with existing testers that are approaching end of life, upgrading testers
will involve a huge amount of capital and engineering resources. Assuming the tester supplier has the
capacity to build all of the testers a hard drive manufacturer might need worldwide affirms a “Yes�
decision alternative out of the decision box that checks supplier’s process capacity and capability. This
issue would be more complex if such testers still needed to be developed by the vendor. Qualification
and integration of the testers is critical to successful outsourcing. The communication between the hard
drive manufacturer and the supplier can be largely managed through weekly teleconference meetings.
The testers themselves also need to be able to directly communicate with the hard drive manufacturer’s
network, so the supplier must work with the hard drive manufacturer’s information systems groups to
format the testers’ outputs to properly feed into the hard drive manufacturer’s databases. Establishing
people-to-people communication and computer-based information exchange between the supplier and
the hard drive manufacturer enables a “Yes� decision alternative from the next decision box in Fig. 1.
Intellectual property is a big concern because many of the hard drive manufacturer’s advanced recording
head designs would need to be shared with the supplier to make sure their testers would work properly with
them. This can be handled through negotiations and an extensive non-disclosure agreement. Addressing
IP concerns through measures like this by the hard drive manufacturer with its supplier results in “Yes�
decision alternatives from the next two consecutive decision boxes in Fig. 1. The supplier should provide
ongoing support for its testers so if and when there are quality or performance problems, it can work with
the hard drive manufacturer on a resolution. This will be much better than just buying the tester off the
shelf with a �buyer-beware� approach. Assuring quality by the supplier that meets customer needs leads
to a “Yes� decision alternative from the next decision box that validates supplier quality. Development
cycle times would be much improved over existing hard drive manufacturer’s testers because the supplier
should have several units ready to deliver at any time, and the hard drive manufacturer would not have
to spend the time and R&D dollars to develop new fly height tester technologies themselves. Improved
cycle time provided by the supplier leads to a “Yes� decision alternative out of the decision box validating
possible cycle time improvement. Employee and management buy-in must be in place almost from the
start because the engineers and low-level managers will directly be involved in the vendor qualification


S. Kumar and J.H. Eickhoff / Outsourcing: When and how should it be done?
process in order to make the recommendation to work with the supplier. This results in a “Yes� decision
alternative from the decision box checking on whether employee-management buy-in exists. The hard
drive manufacturer’s management may not allocate the resources to further develop existing testers
which will be needed on newer recording head designs, so getting the outsourced testers will enable the
hard drive manufacturer’s engineers to work with a newer technology, even if it is designed and built
externally. Since the supplier could be based domestically, like KLA-Tencor, there are none of the risks
associated with offshoring and this results in a “No� decision alternative out of the next decision box
checking if the supplier is offshore. The hard drive manufacturers’ factories already are located in the
Far East so they are fairly highly exposed already, so even if the supplier were based offshore, it would
not add much risk.

Now that all the risks have been laid out, a cost model needs to be put together to evaluate the
outsourcing option. Table 1 illustrates this analysis comparing two hypothetical options and includes
the time value of money. This table has two major sections, one showing various costs over five years
associated with staying with the hard drive manufacturer’s testers and the other section shows various
costs over five years associated with the purchase of testers from a supplier. Net Present Cost for each
cost component for each option (make versus buy) is computed using the discount rate of 8% as shown
in the last column of the table. Finally, for each option, cost for each year and also net present cost are
shown in the table.

We assume the demand for testers the first year is higher than in subsequent years because laboratories
and factory lines throughout the company would be anxious to get their hands on new technology to test
the latest generation of designs. Subsequent years reflect how as new products are rolled out, they will
require support from the new testers. For hard drive company’s testers, there are fairly high initial costs
for engineering to develop new testers, as the existing testers are near end of life. This work will delay
the roll out of the new testers by at least two years, which may end up having a severe impact on the hard
drive manufacturer’s ability to properly measure their recording head fly heights in the interim. Since
the hard drive manufacturer would have to support its own tester design, there would need to be more
engineers supporting the testers than if it purchased them from the given supplier. In our example, the
supplier does have higher costs for the testers themselves and the product fixturing tools, but this option
still comes out with a net lower cost than it would be for the hard drive company to design and build
the testers internally. Based on the assumptions shown, the hard drive company should outsource their
fly height tester design and manufacture to the given supplier as shown by a “Yes� decision path since it
passes cost test leading to decision to outsource work to the supplier.

As suggested by the decision model, the hard drive company needs to close the loop and go back to
re-evaluate their decision based on more current, ever-changing data as shown by the feedback arrow
line going back to the first rectangular box designated as “make or buy?� on the top left of Fig. 1.
Other vendors may come along with proposals to replace the current supplier’s testers, but they need
to demonstrate their capabilities to be an improvement over the lead supplier. The lead supplier has to
keep their promise to service the hard drive company’s testers worldwide, which will help the hard drive
company in its quest to miniaturize data storage through the supplier’s ability to deliver high quality fly
height testers at a reasonable cost.

The dollar values, tester requirements, and timelines shown in this example are hypothetical and
may be subject to some error. A major limitation of the example is that it does not take into account
the potential revenue impact caused by delaying new tester introduction with the internal development
option. While the existing testers were nearing end of life, perhaps they can be extended for a while, but
the accuracy and capability of those machines on newer products could mean poorer factory controls or

faulty design decisions based on data errors or delays. This could ultimately lead to higher costs due
to scrap losses in the factory or reliability problems that could discourage customers, causing them to
switch to another hard drive producer.

It may be noted while the NPV cost savings may appear to be small compared to the annual revenues
of the hard drive manufacturer, this example showcases one of the many such projects underway in
companies and the cumulative savings from all such projects can be significantly large. This can be seen
well by using the DuPont model to compare the financial results of a company with and without such
cost saving projects. In the example shown in Fig. 2, financial results are analyzed for the company that
can likely generate $50 million (or 10% of sales) in expense reductions. Such cost savings go directly
to the “bottom line�, increasing Return on Assets (ROA) by over a full percentage point and improving
net profit by the same $50 million dollars. In industries like hard drive manufacturing where margins are
razor-thin, each percentage point improvement can make a big difference in the success of failure of a
given company or division.


S. Kumar and J.H. Eickhoff / Outsourcing: When and how should it be done?
6. Conclusions
The decision to outsource can be wrought with pressures and risks. Often managers are highly focused
on cutting costs without thinking of the impacts of other, harder-to-quantify risk factors. By using a
methodology like the decision model created in this paper, managers will take into account such �soft
cost� risks at the beginning of the decision making process rather than after all the “hard cost� savings
have been calculated. Managers need to consider first whether or not a given business function is core to
their ability to compete in the marketplace. If it is not, then it could be a prime candidate for outsourcing
providing a potential supplier passes all the tests listed. If it is a core competency, the leaders of the
organization must be sure that if they definitely cannot do it themselves that they should work so they
are capable internally as soon as possible. Giving out a core competency to a supplier is basically
giving away the root of one’s business. Armed with this information, managers must know to apply it
across their business when looking for cost reduction opportunities, understanding it is not limited to
manufacturing or to moving work to a foreign supplier.

The value of this study is that it has provided some insights to the drivers behind outsourcing beyond
just cost reductions. The types of industries and business functions that can benefit from outsourcing
have also been identified, along with technologies, processes and structures that help enable outsourcing.
A framework, leveraged from the work of other researchers, was created to demonstrate all of the risk
and issues that need to be considered when outsourcing. The proposed model showed how having a
closed loop decision process, one with regular evaluations against metrics and goals, is valuable. Finally,
the model was tested against an industry specific example to show how outsourcing can be effective
even when it is related to a core competency. This outsourcing was shown to be cost advantageous even
though it did not involve offshoring.