Outsourcing the service sector doesn't always make sense

Bruce Bartlett

8/26/2003 12:00:00 AM - Bruce Bartlett

For years, manufacturers have been outsourcing operations to foreign countries to obtain lower wage costs and escape from high taxes, burdensome government regulations and intransigent unions here at home. Now, it appears that the service sector is joining the trend.

As manufacturing workers worry about their jobs moving to China, service workers see India as the threat. With its large pool of educated, English-speaking workers available for wages 80 percent lower than here, many large companies, especially banks, have set up Indian operations or contracted with Indian companies to provide information technology services.

A new report from Deloitte Research projects that outsourcing of IT jobs to India will accelerate in coming years. It estimates that $356 billion worth of global financial services will relocate to India in the next five years, producing a cost saving of $138 billion for the top 100 financial service firms. It further estimates that 2 million jobs will move to India -- 850,000 from the United States, 730,000 from Europe and 400,000 from other Asian countries.

However, another report from Deloitte Consulting throws cold water on these estimates. It notes that while direct wage costs may be 80 percent lower in India, total labor cost savings are much more modest -- 10 percent to 15 percent for most companies. The reason is that there are important added costs to doing business in India that eat up much of the savings. Higher costs for travel, communications, equipment and managerial oversight are some of these. But the largest costs are for lower productivity, cultural differences and incompatible systems.

The Deloitte Consulting report goes on to detail several case studies where companies went into India thinking they would achieve significant savings only to find that it was not worth the effort. Other companies undoubtedly will make the same discovery.

Another reason service providers may find outsourcing to be unprofitable is that productivity in the U.S. service sector is rising sharply, as the result of heavy investments in computers, software and telecommunications in recent years. Two new studies document this fact.

Economists Jack Triplett and Barry Bosworth, both of the Brookings Institution, look at recent trends in service-sector productivity. They note that historically productivity in this area has been far below that in manufacturing. One reason is that one really can't do many things any faster today than was the case even hundreds of years ago. Economist William Baumol points out that it still takes a string quartet the same amount of time to play a minuet as it did in Mozart's day.

While Baumol's point is true as far as it goes, it mismeasures the nature of productivity in music. In Mozart's time, the only way to hear a minuet was to be physically present when it was played. Obviously, that greatly limited the number of people that could potentially hear his music. But today, that same minuet can be played simultaneously on radio, television and the Internet, potentially reaching billions of people at once. Moreover, the performance can be recorded on a CD, DVD or videotape, making it available for future generations as well.

Therefore, we can say that productivity among string quartets has in fact risen astronomically when the potential number of listeners is considered the output measure. Something like this is happening in many industries once thought to be immune from productivity increases. For example, if one measures a physician's output by the number of patients he sees in a day, his productivity may not have risen much over the years. But if one measures his output by the number of patients cured or the lengthening of their life spans, then medical output can be seen to have risen a great deal.

Triplett and Bosworth, partly by taking advantage of better measures of service output, have concluded that there has been a big jump in service-sector productivity in recent years. They surmise that the rate of increase in service productivity is now equal to that in manufacturing. This conclusion is confirmed by a new Federal Reserve Bank of Chicago study, which found that services are now reaping the benefit of past investments in IT that will continue for years to come.

Rising productivity at home offsets most, if not all, the advantages India can offer in the realm of cost savings. As companies study the trade-offs more carefully, I think they will find that there is no pot of gold waiting for them there. At the same time, worker apprehension over outsourcing will diminish once the economic expansion takes hold and begins reducing the unemployment rate. As economist Brad DeLong notes, "Few would be worried about outsourcing if the U.S. unemployment rate were still closer to 4 percent, rather than at the over 6 percent level that it is."