How 1937 Economic Theory, Which Won a Nobel Prize, Helps Offshore Buyers Today

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How 1937 Economic Theory, Which Won a Nobel Prize, Helps Offshore Buyers Today
By Paul Nowacki, Associate Principal, Everest Group

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medal winner If you're looking for an academic reason why offshoring is good for companies, you only have to go back to a landmark economic study done in 1937. Back then, when India was still a British colony and Franklin Roosevelt was just elected President, Ronald Coase wrote an essay called "The Nature of the Firm," which led to a Nobel Prize in Economics. Today, his landmark theory has significant suggestions for both buyers and suppliers that can maximize their offshore initiatives.

In case you didn't study Coase back in the day, here's a synopsis of his thinking: In his day, most microecononomists studied the cost of production. Coase looked at the world under a different microscope: he studied the cost of transactions.

Coase measured the friction in transactions. In other words, how difficult was it to buy the ability to post an item into accounts receivable (AR)? Regarding transaction friction Coase said "the most obvious cost of organizing production through the price mechanism is discovering what the relevant prices are" that is, friction is the cost of finding a provider, getting a quote, and negotiating the final deal to get the work done. Coase theorized companies hired an AR clerk because it was too costly and troublesome to go to the external accounting firm every time it needed to post an item. The more friction in a transaction, the more likely the firm did the business process in-house.

The friction in transactions caused companies to grow because they added staff to do BPO processes internally. Employees eliminate the friction costs of buying that service. Employees in traditionally structured firms have been co-located, which made it easy to transfer documents and information. The use of employees also eliminated the need to negotiate the price for services for each and every transaction.

Offshoring and Coase

Here is how Coase explained his theory: "At the margin, the costs of organizing within the firm will be equal either to the costs of organizing in another firm or to the costs involved in leaving the transaction to be organized by the price mechanism. Businessmen will be constantly experimenting, controlling more or less, and in this way, equilibrium will be maintained. This gives the position of equilibrium for static analysis. But it is clear that the dynamic factors are also of considerable importance, and an investigation of the effect changes have on the cost of organizing within the firm and on marketing costs generally will enable one to explain why firms get larger and smaller."

The labor arbitrage driving today's BPO offshoring industry is accessible to the masses because it takes much of the friction out of transaction costs. The Internet, low communications costs, digitization, automation, ERP systems, long-term outsourcing contracts, and the emergence of a single language (English) as the global standard for business now allows companies in high-cost countries to send their work halfway across the globe to a low-cost country; that is, companies in high-cost countries can now shed employees and get smaller.

And that is exactly what has happened. Companies in high-cost countries are cutting their labor forces in human resources, finance and accounting, IT, procurement, even some engineering positions.

Lower friction facilitates offshoring along two dimensions. One is language independence. English is now the language of global business. BPO service providers feel they can hire English language skills anywhere in the world that they operate. As firms increasingly use English as a standard, work becomes more language independent and therefore location independent.

The second dimension is digitization. Technology allows the translation of paper documents into digital characters. Today paper is the enemy! Currently the most popular solution is automated workflows of digital images that the BPO service providers' employees eventually key into the financial systems in the low-cost location.

Optical character recognition (OCR) offers the ultimate promise. It should overtake digital imaging for FAO work as OCR accuracy improves and costs fall.

Chart 1

Today the changing character of offshoring is affecting transaction friction. Just a few years ago companies could send work to India and reap immediate savings no matter how the work got there. Now several years of high wage inflation in India and tough price competition among offshoring competitors has forced BPO service providers to focus on operational excellence; today that is a requirement for success.

In other words, BPO service providers now have to reduce transaction friction to arrive at a competitive price for their services. This reduction creates value for both buyer and service provider.

What This Means for You

Make the work language independent: Buyers must pay attention to the BPO service providers' cost because cost plus margin equals price. Do you really need support in 27 languages for FAO transactions? You could get a better price if you asked your major suppliers to invoice you in English. If that is not possible, consider the benefits of replacing your local supplier with a regional or global one with English skills.

Another consideration: if you have to call local country suppliers for missing or disputed information and discuss the problem in, say, Serbo-Croatian, either retain this function in-house since your employees have the requisite language skills or be sure to choose a service provider who has in-country or in-region local language skills.

Make the work digital: Are you still receiving paper invoices? Why? Have you worked with your suppliers to establish digital links? Have you installed scanning hardware and software to automate workflows?

Make the outsourcing process collaborative: Offshore BPO providers can't help buyers optimize the solution if they are forced to respond to a request for proposal (RFP) that sets requirements that sub-optimize. Instead, have an insightful discussion between buyer and service provider about language requirements, workflows, and the elimination of paper.

BPO service providers that are going to succeed must invest in operational excellence such as digital imaging, workflow technology, OCR, business process reengineering, and Six Sigma.

Lessons from the Outsourcing Journal:

Ronald Coase's Noble Prize-winning work from 1937 explains why automation, language independence, and BPO offshoring are causing companies to downsize: they are removing the friction from buying services externally and taking advantage of offshore labor arbitrage.
English has become the lingua franca of global business. Buyers that are not using English in their transaction processing should consider working with their supply chain partners to migrate to English.
BPO service providers that are going to succeed will have to invest in the technology, process reengineering, and quality control to produce operational excellence.

Publish Date: July 2007

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