How SME's Manage Outsourcing: Offshore Outsourcing

Abstract

As China emerges as the world's manufacturing center, an increasing number of small and medium-sized enterprises (SMEs) in China are outsourcing their production and related supply chain management. However, due to the limited size and resources of SMEs, it is difficult to manage them effectively. This paper takes offshore outsourcing as an example, from the perspective of the contract-issuing party[1], analyzes and discusses the existing problems and potential risks, and gives corresponding measures to help SMEs better manage outsourcing business.

Preface

Outsourcing refers to that enterprises entrust the non-core business and partial control rights to external independent professional companies while focusing on core business themselves. When outsourcing crosses national boundaries, it is called Offshore Outsourcing. Its essence is that an enterprise, based on the construction of its own core competitiveness, and gains long-term competitive advantage by making full use of external resources to improve its competitiveness. [1]

Current Situation

From January to April 2018, the total amount of service outsourcing in China reached us $32.77 billion, up 17.7% year on year. Among them, the implementation amount of offshore service outsourcing accounts for about 26.6% of China's total service export, and contributes about 23.1% to the growth of service export. [2] However, at the same time, we should pay attention to the factthat, with the improvement of market scale and system, China has begun to contract with developed countries in order to make use of their productive factors, especially the productive service factors.

Nowadays, with the economic globalization, offshore outsourcing is developing rapidly. With its advantages of reducing operating cost, improving core competitiveness, enhancing agility and integrating global resources, it has quickly become a new business strategy for enterprise development. While offshore outsourcing brings benefits to SMEs, due to the limited size and resources of SMEs, it is difficult to effectively manage international outsourcing and supply chain, which result in a series of problems and potential risks. Without timely and reasonable response measures, it is likely that enterprises will be in trouble.

Problem Analysis

Transfer of Corporate Responsibility

After outsourcing the business, enterprises can not fully understand the progress of those businesses. Because the enterprise has no access to conduct on-site monitoring, it can only contact with the contractor[2] by telephone or other means. This leads to the transfer of corporate responsibility, and also increases the difficulty of management over product or service.

Vague Intellectual Property Rights

Intellectual property rights are exclusive to the right holder. In the process of outsourcing business, sometimes involve various patent issues, such as product trademarks, production technology, etc. If the ownership of copyright is not clearly stipulated when enterprises sign agreements with contractors, unnecessary troubles will arise when they cooperate.

Reduced Employees' Working Enthusiasm

As outsourcing becomes more common, one of the problems is low morale. When an enterprise outsources its business, its employees will inevitably be laid off, so other employees will worry about when they may be fired. In this case, employees tend to lose confidence for the enterprise, lose enthusiasm for their work, and therefore work efficiency will decline, eventually leading to decreased performance of the enterprise.

Uncertain Loyalty of Contractor

There is only a cooperative relationship between the enterprise and the contractor. The contractor only needs to finish the work according to the contract signed by the two sides, and the contractor does not need to have loyalty and responsibility to the employer. According to the past real cases, some contractors, driven by interests, leaked the employer's corporate secrets, even though the two parties signed a confidentiality agreement before, which causing serious losses to the employer.

Risk Analysis

In addition to a series of obvious problems mentioned above, offshore outsourcing will also expose enterprises to many potential and unknown risks in the process. These risks are mainly reflected in the following aspects.

Internal Risks of Enterprises

Decision Risk

Decision-making risks mainly come from two aspects: First, when deciding to choose offshore outsourcing, enterprises must be clear about outsourcing, that is, which business is the core business of enterprises and which business is not. If the core business and non-core business are not defined accurately, then the decision will be wrong, and not only the capital but also the competitive advantage of the enterprise may be lost. Second, enterprises will inevitably face the choice of contractors when outsourcing offshore, that is, whom to outsource. The relationship between the enterprise and the contractor is a "principal-agent" relationship, which is two independent individuals. If there is information asymmetry between the two, the enterprise cannot really understand the qualifications of the contractor, so they cannot choose the right contractor, which is easy to cause adverse selection, and will ultimately affect the quality of the company's products and reputation.

Cost Risk

Cost reduction is the driving factor for multinational corporations to choose offshoring. When deciding whether to carry out offshore outsourcing, decision makers give priority to cost factors, but most decision makers tend to ignore some potential costs, namely transaction costs. Transaction costs include search cost, information cost, bargaining cost, decision-making cost, supervision cost and default cost. Many enterprises often underestimate or even ignore these potential costs. It is due to the existence of transaction costs that offshore outsourcing not only brings benefits to enterprises in reducing costs, but also cost risks.

External Risks of Enterprises

Exchange Rate Risk

Exchange rate risk is an important risk issue that enterprises need to consider when carrying out international trade. Offshore outsourcing contracts are generally denominated in foreign currency, and most countries have a floating exchange rate system. The fluctuation of the exchange rate will lead to losses for enterprises when they receive and pay, thus resulting in exchange rate risk.[4]

Policy Risk

Policy risk refers to the loss caused by the change of macro policy at home and abroad. Offshore outsourcing will reduce the employment rate of the country where the contract-issuing party is located, and then may lead to trade protectionism and "anti-globalization", which will have a negative impact on the operation of offshore outsourcing. In addition, the adjustment of host country's economic structure and the introduction of new economic policies will have a certain impact on offshore outsourcing.

Customer Relationship Risks

Risk of Cultural Differences

Due to cultural differences between different countries and regions, the contract-issuing party and the contractor have different values, management methods and understanding of things, which will bring certain risks to offshore outsourcing.[3]

Moral hazard

According to the theory of information asymmetry, moral hazard refers to that contractors take hidden actions that cannot be observed and supervised by enterprises by utilizing their information superiority, aiming to damage the interests of enterprises and increase their own interests. In offshore outsourcing, the contract-issuing party and the contractor are in a "principal-agent" relationship, and the interests of the two parties are not completely consistent. In order to increase their profits, the contractor may take actions against the transnational corporation, thus causing moral hazard. And the existence of moral hazard will increase the difficulty of offshore outsourcing management and control.

Trust Risk

When a company chooses to conduct offshore outsourcing with a contractor, the two companies are in a cooperative relationship. In order to achieve the expected benefits of offshore outsourcing, the two companies need to trust each other. Trust between two parties can reduce transaction costs, that is, the cost of repeatedly selecting contractors and collecting information. Conversely, if both parties only consider their own interests and distrust each other when confronted with troubles, it will lead to the risk of trust and interrupt offshoring.

Communication and Coordination Risk

Contractors and outsourcing enterprises are two independent economies. In offshore outsourcing, contractors replace the status and control of outsourcing enterprises in the original business. Due to their differences in strategic objectives, management methods, corporate culture and other aspects, if the two sides cannot communicate and coordinate well, it will inevitably have a certain impact on the operation of offshore outsourcing, put outsourcing enterprises at a disadvantage in the competition, and affect the development of enterprises' core capabilities.

Countermeasures

In view of the above problems and potential risks, this paper proposes corresponding solutions and preventive measures from the root causes of the problems and risks.

Form a Comprehensive Information Strategy

For the contractor, the essence of information asymmetry is incomplete information. To reduce or eliminate risks, it is necessary to start with information. The risk control of offshore outsourcing is to use all aspects of power to help the contractor obtain comprehensive information, reduce or eliminate various risks caused by information asymmetry. The contract-issuing party can collect information from the following two aspects. One is to prove that the contractor meets the requirement through relevant information presented by the contractor at the very beginning. Second, the contract-issuing party takes the initiative to collect comprehensive information about contractor, such as field visits, questionnaires on contractors, inquiries about offshore outsourcing consulting companies or experts, reference service outsourcing monographs, etc., to obtain relevant information with contractor.

Establishing a Strict Constraint System

Scientific and reasonable restraint mechanism plays an important role in reducing the risk of offshoring caused by information asymmetry. There are policy constraints, legal constraints, contractual constraints and moral constraints on offshore outsourcing contractors. The terms of the outsourcing contract have a strong binding effect, but the contract is signed and executed under a certain background and environment, the performance of the contract will be subject to various restrictions. Specifically, contract constraint includes contract clause constraint and contract periphery constraint. Contract treaty is the most basic constraint, which contains policy constraint, legal constraint and ethical constraint. It is one of the important measures to restrain the behavior of service contractor through outsourcing contract to reduce the risk of offshore outsourcing.

Strengthen the Completeness of Contract

Due to inconsistent goals or vague performance, conflicts may arise in the cooperation between outsourcing companies, and litigation and disputes may be caused. Therefore, the outsourcing contract of should have comprehensive and detailed provisions on outsourcing costs, service levels, risk liability and penalty terms. In order to increase the flexibility of the contract and reduce the costs of litigation, specific explanations can be given to the standard of transaction quality and possible contingencies, especially when there are unfamiliar technologies in the outsourcing business of the enterprise. If the boxes in the contract are too standard, the enterprise is prone to lock in the risk. 

Enhancing Risk Awareness

Enterprises should raise risk awareness and improve risk identification ability when choosing offshore outsourcing. Risk identification is the foundation of risk management. Firstly, enterprises can't choose offshore outsourcing blindly in order to pursue market share. Instead, they should judge whether they need to outsource according to their level. At the same time, they should consider the present and future economic environment. Because the policy changes of their own countries and contractor countries will affect the success of outsourcing. Besides, The fluctuation of exchange rate will also have a certain impact. Secondly, since risk runs through the whole outsourcing process, the enterprise should establish the risk consciousness of the whole process. More specifically, enterprises should take risk identification as a long-term work and pay close attention to the current and new risks in the offshore outsourcing process. Only by identifying the risks in outsourcing can enterprises effectively avoid risks.

Improving the Decision-making Ability

It is crucial to determine the boundaries of outsourcing before deciding to choose offshoring from a strategic perspective. The outsourcing business must be the non-core business of the enterprise, otherwise it will not only lose capital, but also lose the competitive advantage. In order to improve the profit of offshore outsourcing and reduce the risk of outsourcing, it is necessary to select the right contractor, by knowing the contractor fully from the perspectives of time, quality and corporate culture. Moreover, some scholars believe that the key to the success of contractor selection in outsourcing activities is the trust of contractors. However, excessive trust of contractors may lead to the failure of outsourcing and bring disastrous losses to enterprises. Therefore, multiple contractors could be taken into consideration to spread risks.

Building Trust & Communication Mechanism

Inevitably, there are differences between the contractor and the enterprise in terms of geography, organization, culture and other aspects, and the two sides tend to lack mutual trust, which is crucial in the process of offshore outsourcing. Trust is mainly an enterprise's dependence on another enterprise in the face of future uncertainty. Trust can reduce the risk of uncertainty, accordingly, contractors and enterprises need to establish an effective trust mechanism to cultivate good relationship. The establishment and maintenance of trust between the two sides are based on communication. In the process of offshoring, communication can be served as  effective means to solve conflicts and frictions.

Establishing Offshore Outsourcing Partnership

The establishment of offshore outsourcing partnership helps to reduce costs, reduce conflicts between outsourcing parties and lower outsourcing risks. From the perspective of the whole transaction process, based on long-term partnership, maintaining communication between the two parties can effectively solve the coordination problem of outsourcing transaction. Besides, stable and mutually beneficial partnership can also reduce various performance risks. In order to maintain a long-term contractual relationship, the counterinsurgency outsourcing partners generated in the whole process of the transaction can be solved through negotiation, avoiding the costs caused by the litigation of one party. The establishment of outsourcing partnership will encourage the organizations between partners to learn from each other, so as to improve the cognitive ability of both parties to the uncertain environment, narrow the gap in concepts of both parties, and reduce the possibility of organizational conflicts. At the same time, offshore outsourcing partnership can reduce the possibility of opportunistic behavior of contractors to a certain extent. In outsourcing partnership, a betrayal will lead to relative punishment and revenge, and the contractor may also be given up by the contract-issuing party. Therefore, outsourcing partnership can minimize the loss of opportunism and achieve win-win results for both sides.

Establishing Outsourcing Management Team

Contractors must ensure that they have people with the right skills to manage outsourcing. The effective management of the contract can solve the problem of vague description in the contract to some extent. Once the contract-issuing party decides to sign the service outsourcing contract, it needs to form a team as the contract manager, service provider or system integrator. This team monitors the performance of the service provider to ensure that the service provider is doing its job and that all reasonable requirements are met. When the service provider fails to meet the requirements of the contract box, the outsourcing management team should raise doubts, handle the dispute of contract interpretation and weigh the penalty terms. The outsourcing management team needs to include personnel with extensive contract management skills, technical personnel who have a thorough understanding of enterprise information technology, and integration personnel who ensure that internal and external information technology systems can be closely connected with the system.

Good contract management is the key to the success of offshoring outsourcing. Someone with the right background, attitude and skills will help the relationship run smoothly. Business managers and end users will also have more confidence in service outsourcing as the contract is managed by someone they trust, and as a result the service provider will attach greater importance to it. On the contrary, incompetent contract managers may damage the relationship between outsourcing parties, and contract managers who are not supported by business managers and users are easily despised by service providers.

Establishing Conflict Resolution Mechanisms

During the execution of outsourcing contract, there will be inevitable conflicts between the outsourcing parties to a certain extent. The outsourcing parties should keep in touch with each other, reach a consensus on the issues of conflicts, and properly deal with the conflicts in the execution of outsourcing contract. First, establish effective communication mechanism. Effective communication in outsourcing can not only avoid mistakes in the cognition of technology, capability and characteristics, but also reach consensus on controversial issues. Smart outsourcing parties should try their best to implement a win-win strategy, carry out effective communication and dialogue, and try their best to turn the existing problems into open and neutral ones, which is beneficial to the settlement of disputes. Secondly, introduce a third party consultant. The third-party consultant can play the role of mediating, communicating, explaining and correcting the information when the conflict is intense and lasts for a long time, and the employees of both parties don't trust and cooperate with each other. To some extent, the third-party consultant can re-establish the cooperation between the outsourcing parties, and reduce the possibility of conflicts. Finally, the strengthening of offshore service and mutual learning and communication between the two sides can effectively reduce the misunderstanding between the two sides, reach a consensus and achieve a win-win situation.

Conclusion

Offshoring outsourcing has become a brand-new business development strategy of SMEs, which can bring benefits such as reducing costs, diversifying risks, improving core competitiveness, enhancing agility and integrating global resources. However, there are also many problems in the course of offshore outsourcing, such as the transfer of corporate responsibility, vague intellectual property rights and uncertain loyalty of contractors. Meanwhile, enterprises also face many potential risks, such as internal risks, external risks and customer relationship risks. In order to deal with the risks arising from the outsourcing process, it is necessary to enhance risk identification ability, improve the decision-making ability, build a trust and communication mechanism, as well as attach importance to customer relationship management. Through those measures to minimize the risk to the lowest, and achieve sustainable development of enterprises.

References

• [1]Chen Xin. Research on Risk Prevention and Management of Offshore Outsourcing.  International Economy and Trade Press, 2017.06.
• [2]China Service Outsourcing Research Center. China's Service Outsourcing Industry Made a Good Start in 2018. http://coi.mofcom.gov.cn/article/t/201808/20180802780604.shtml. 2018.08.29.
• [3]Zhang Meng. Research on IT outsourcing and risk control of Banks [J]. Business Economics Research, 2013.09.179.
• [4]China Service Outsourcing Research Center. China Service Outsourcing Development Report 2017 [M]. Beijing: Business Press, 2017.

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[1] contract-issuing party: the party giving out a contract for a project

[2] contractor: person or company that does work for other people or organizations.