Off shoring effect
Offshoring and outsourcing have been studied by many economists (see for example Antras et al (2005), Grossman and Rossi-Hansberg (2006) and Deardorff (2005), among others). In (economic) geography however, there hasn’t been done much research about offshoring and outsourcing yet. Although in the field of firm demography, which can be thought of as a segment of economic geography, many studies have been published about the birth, death and migration of firms, this is mainly focused on the firms within a country. An important reason for this is of course that firm migrations abroad account only for a small part of all the firm relocations. Furthermore, firm demography is mostly concerned with the relocation of complete firms, not the relocation of certain activities, as is the case with offshoring. However, the number of firms moving activities abroad is increasing. It also shows that the yearly percentage of firms that relocated activities has increased over the studied period. All changes in the locations of companies and corresponding changes in the places of production and services activities have an impact on the economy in Indonesia.
Although scientific research shows that offshoring and outsourcing have been steadily increasing, it is still low. However, the recent media and political attention on production and service offshoring from developed to developing countries gives the impression that outsourcing and offshoring are exploding. As a result, workers in industrial countries are anxious about job losses (Amiti and Wei, 2004).
One of the first questions that comes up when studying these relocations is; what is exactly the difference between outsourcing and offshoring? So far, these two concepts have been used interchangeable. However, there is a difference. Outsourcing and offshoring are related to the ‘make or buy’ decision. A firm can decide to subcontract part of the production capacity or services to another company, which is called outsourcing. If a firms decides to relocate part of their activities abroad, this is called offshoring. Offshore outsourcing is subcontracting a part of the activities of a firm to a foreign country. Offshoring without outsourcing means that the firm will take over an existing firm or set up a new firm abroad (Poort et al., 2004 and Ministry of Economic Affairs, 2005).
Outsourcing and offshoring can be seen as part of international trade. Instead of producing a product in a developed country, it is now imported from developing countries where labor is cheap and abundant. However, the renewed attention for offshoring is caused by the fact that the relocation of production is no longer confined to the situation where only low skilled production was transferred to low wage and labour abundant countries, as would be expected by examining the neoclassical trade theories. Increasingly, high skilled jobs, (for example ITservices) previously thought to be safe from competition from low wage countries are also shipped abroad.
A requirement that foreign companies sell 51 percent of their mines to Indonesians within 10 years of production is hurting exports such as nickel and copper ores. But at least in the latest quarter, new investment has started as miners seek to comply with new rules that they build local smelters or process ore domestically by 2014.
In contrast to this pessimistic view, outsourcing and offshoring can contribute to the maintenance and development of employment in the developing countries. Because of savings, improvement of the competitive position and perspectives for new investments, new high skilled jobs can be created. According to Deloitte (2006), the process of offshoring in Indonesia is already on its return. Most profit is to be gained in the optimization of the production process and the improvement in the chain management (Deloitte, 2006). This means that the separate locations will have to be integrated into one production network with planning on a broader scale. Relocations consequently only make sense if it happens in combination with a thorough thought and centrally led production chain.
That offshoring and outsourcing are still very low can also be shown from the fact that in many industrial countries ‘insourcing’ is greater than outsourcing (Amiti and Wei, 2004). Insourcing can be described as the opposite of outsourcing and offshoring (investments from foreign located firms to domestic firms). Amiti and Wei (2004) used the exports of business and computing services from the IMF Balance of Payment Statistics Yearbook 2002 as a proxy for insourcing.
However, scaling the export value by the size of the GDP, smaller economies tend to be more insource-intensive than the larger ones. The top three now consists of Vanuatu, Singapore and Hong Kong (Amiti and Wei, 2004). It is arguable whether business and computing services is a good proxy to measure insourcing. Although studying the effects of outsourcing and offshoring on recipient countries goes beyond the scope of this thesis, it is an important aspect of firm relocations. According to Folmer (Volkskrant 13 april 2004), offshoring and outsourcing are new ways of development aid because developing countries become an interesting firm location. Furthermore, there is a shortage of labor in developed countries in sectors like the IT and care, and personnel in developing countries can help to reduce the scarcity. As a result, migration from developing to developed countries will decline.
Defining outsourcing and offshoring
First of all, the distinction between outsourcing and offshoring has to be clarified. This distinction is not clear-cut and the two concept are often used interchangeable. According to Biermans and Leeuwen (2006), the meaning of the term outsourcing has changed the last couple of years, but the original definition is still in use:
Outsourcing describes the act of obtaining services and/ or goods from an external firm (Biermans and Leeuwen, 2006).
The definition of offshoring most frequently used in the literature is very broad. Biermans and Leeuwen (2006) describe it as ‘the relocation of production abroad’ (p. 9). Ter Beek et al. (2005) defines it as ‘the relocation of labor to low income countries’ (p.4). The definitions of Poort et al. (2004) and Berenschot (2004) are similar: ‘offshoring is the relocation of activities to low income counties’.
The most important aspects of offshoring are:
– low income countries
Outsourcing can be seen as a part of the offshoring process, however, outsourcing does not have to include offshoring and it is also possible to offshore without outsourcing. This can be clarified by making the distinction between the location of the activities (national or abroad; onshore or offshore) and the type of ownership (the make or buy decision; in-house or outsourcing).
However, there are some more considerations concerning offshore outsourcing and foreign direct investments that have be kept in mind.
1. These foregoing definitions do not take into account the distance to place of the relocation.
2. Another consideration is the type of activities that will be moved abroad: production
(e.g. the production of electronics in China) or services (e.g. the call centers in India). Offshoring services, in particular IT-services, can be done in three ways: captive service provisioning, native service provisioning and foreign service provisioning (Beulen, 2005). Captive (or in-house) service provisioning means setting up an own service center in a low income country. The firms has to make considerable investments (FDI) in this country. In the case of native service provisioning, a company outsources the work to a local IT-supplier, and this local IT supplier gets the work done offshore. In the case of foreign service provisioning, the company outsources the work directly to an offshore IT-supplier. Both native service provisioning and foreign service provisioning come under the heading of offshore outsourcing. A familiar example is an IT-company in India that develops software for
a company in Indonesia. If this Indonesian company is a non IT-company, it is called foreign service provisioning, and if in case of an IT-company, it is called native service provisioning.
Low skilled service and production jobs where personal contact is necessary won’t be offshored, which means that demand for hairdressers, cleaners and plumbers in developing countries will continue to exist.
One relatively recent aspect of service offshoring is that people in developing countries go to developed countries for a medical operation or cosmetic surgery. This market has especially been booming in countries like Turkey, Thailand and Brazil. This is also a part of the offshoring process, as it does fit into the broad definition of offshoring as an relocation of labor to low income countries. One of the reasons of this is of course the differences in prices for these operations.
3. Third, an essential question is which markets are being served by this new location. A distinction can be made between horizontal FDI and vertical FDI. Horizontal FDI serves foreign markets, new markets will be opened up to sell the products. This has not necessarily negative effects on employment in the home country. Vertical FDI combines serving the home country and opening up new markets with the (partly) replacement of production or services in the home country. The effects of an expansion of vertical FDI on the home country are ambiguous (Biermans and Leeuwen, 2006).
4. As said before, offshoring does not necessarily lead to (total) outsourcing. It is possible to open an own company or set up operations with other firms. Deloitte, cited in Ter Beek et al. (2005), distinguishes five ways to offshore activities:
– outsourcing: total subcontracting to a third party
– joint venture: setting up a new operation together with a third party
– wholly owned: set up a new firm as a subsidiary company
– turnkey: asking for the help of thirds, but keeping the full control over the operation
– indirect: collaboration with a third party who uses offshoring
Public policy and offshoring
In deciding what policy to use to influence the decisions of companies whether or not to relocate a low cost country, two points are important:
1. Keeping existing firms in the region. However, this doesn’t means that the work needs to remain the same.
2. Attracting new firms to the region. Attention will be paid here to the different ways that regional policy in Indonesia is able to influence the companies within the country. Embeddedness, innovation and education play important roles in formulating these policies. Both the new economic geography and the institutional theory provide a theoretical framework for this.
In general, public policy concerning offshoring should target the improvement of the competitiveness and entrepreneurial climate in Indonesia. Policies that prevent offshoring (and the loss of employment) might backfire because the choice facing some industries is to offshore or cease to exist (Robert-Nicoud, 2006). This means that eventually these companies will leave the region even when measures are implemented that will prevent the company from leaving the region. Some of the measures include giving companies a tax advantage when keeping employment in the country or region, introducing a tax when companies want to relocate labour and letting an independent organization test the offshoring plans of companies (Poort et al., 2004). Furthermore, these tax measures will probably cause companies to go for offshore outsourcing, in which formally no labor is being relocated, because of ownership changes. These measures might not be the optimal choice for a company, reducing the competitiveness of the company.
Improving the position of Indonesia by keeping existing firms in the region and attracting new firms can be done in different ways, that reinforce each other when implemented the appropriate way. Points of attention include embeddedness, innovation and education. These aspects are also important in the report of the Ministry of Economic Affairs.
– The government needs to address the shortage of skilled talent, especially for technical professions. Investments in science and technical educations need to increase to ensure continued global competitiveness.
– Increase the education of the labor force, making sure that the labor force meets the demand of the companies in the North. The labor force needs to be used up to its maximum. This means promoting and investing in higher technical education.
– Create embeddedness; strong social relationships and strong networks between companies in the country.
– Use city and region marketing as a tool for making the region more attractive for (innovative) companies to locate. Create an innovative environment for these companies. Infrastructure, living and housing conditions, educational opportunities and the supply of business areas need to meet the demands of the companies and its employees.
– Improve the innovativeness of the existing and new firms in the whole regions by creating strong relationships with the Universities (innovation campus) and other higher education in each region.
– Set up retraining programs for (older) employees that are laid off. They have often worked for one company a lot of years and it is hard to find a new job in the same sector.