Economies of scale are the holy grail of outsourcing. Certainly, scale is the most easily understood leverage point in outsourcing.
The optimal use of infrastructure and the experience and expertise around a process are what generates the power of economies of scale. Outsourcing is often the only way many buyers can take advantage of this business benefit.
Even though the importance of economies of scale is the most talked about aspect of outsourcing, it can be overplayed. It’s not necessary to have economies of scale to have a productive outsourcing relationship. I’ve seen many companies overstate the importance of the economies of scale that serve as the foundation for their relationship. This is because the idea of economies of scale is easy for buyers to understand and impossible for them to duplicate. Vendors push the idea of scale because it overcomes a buyer’s resistance since they could never generate the magnitude of cost savings internally.
Where economies of scale do exist, they are very powerful and extremely beneficial. Some areas of outsourcing form a natural fit. The OS 390 mainframe (MVS to us old timers) data centers are one example. Net hosting is another. Network management is a third example. Payroll and some of the Enterprise Resource Planning (ERP) areas also produce profitable economies of scale.
Application service providers (ASPs) also are able to generate significant savings through economies of scale. ASPs leverage a single application platform over their entire customer base.
Scale and BPO
Economies of scale play a large role in the business process outsourcing (BPO) arena. Shared services centers and call centers allow BPO providers to pass along significant savings to all their users. BPO providers also generate cost savings through their combined purchasing power.
Often, scale plays multiple roles in a specific outsourcing relationship. For example, a single buyer can enjoy savings by outsourcing claims processing and using the vendor’s imaging center, data center and call center.
Strangers in a Strange Land
Being able to utilize a substitute leverage point like cheaper labor is another advantage produced by economies of scale. This occurs when a supplier is able to find a labor source in another country that can do a comparable job at a lower cost. For example, American outsourcing vendors have been able to employ talent in India and the Philippines that is not as costly as their American counterparts.
Creating a workforce out of your home country has many hidden costs which can dilute the value of these cheaper resources if you try to do it yourself. A company with a foreign staff has to develop internal infrastructure, telecommunications infrastructure and uninterrupted energy resources in the new land. Then it has to learn how to recruit and train local talent. Finally, the executives of the mother ship have to learn how to operate in a foreign political environment in a foreign tongue.
This can become an expensive process. But once an outsourcing vendor has spent these sunk costs to develop the infrastructure and has overcome the difficulties of operating in a foreign land, any incremental costs are now much lower. Suddenly, economies of scale appear. Now the outsourcing proposition becomes much more valuable.
Economies of scale come in many flavors. Another potent form is offering a fractional use of a resource. All these fractions equal a whole, which equates to the full utilization of a resource for the vendor. Full utilization of a vendor’s resource is a crucial ingredient for economies of scale.
Outsourcing vendors, for example, specialize in providing office space around the world for companies with less than 500 employees. These firms acquire blocks of space at a great price per square foot and then staff them. They are the perfect solution for a company that needs a remote office with just 10 people. This outsourcing relationship provides value for both buyer and supplier.
Swear Off Customization
Buyers, however, have to be careful that their actions do not dilute the power and savings generated by economies of scale. Buyers who demand a high degree of customization destroy much of the value that economies of scale provide. They pay three ways. They:
- Lose the savings scale provides.
- Pay special fees for customization.
- Give up top quality. Vendors are set up to deliver quality within the scope of their outsourcing agreements. Once they step outside those lines, I?ve found quality drops dramatically.
Companies who want to take advantage of economies of scale must let the supplier make all the process decisions. If they do, they harness a powerful cost savings generator.
Scale combines with the other benefits of outsourcing — process expertise, learning curve advantages and top talent — to do the job better, faster and cheaper for the buyer. I describe the advantages of scale in great depth in my book, Turning Lead Into Gold. The Demystification of Outsourcing.
Lessons from the Outsourcing Primer:
- Scale is one of the most important aspects of outsourcing and the easiest to understand.
- Buyers can benefit from economies of scale if they let the vendor make all the process decisions. If they demand customization, they erode the advantages of scale.
- Vendors can afford to set up foreign offices, which can produce great savings on the labor side.