What it means
The decision is a version of the classic make or buy question. You compare the fully loaded cost of doing the work yourself, including salaries, employer taxes, software, space and supervision, against the supplier's price plus the cost of managing the relationship.
Cost is rarely the whole story, and treating it that way is where most disappointing outsourcing deals begin. Specialist providers often bring better systems, round the clock cover and access to skills a smaller company could never justify hiring, which can matter more than the headline saving.
The financial appeal is partly about the shape of the cost rather than its size. Employing a team creates fixed costs that continue in a downturn, whereas a contract priced per transaction or per user flexes with volume, which lowers the break even point of the whole business.
Against that, outsourcing creates a supplier dependency that grows quietly over time. Once the internal team has gone, bringing the work back becomes expensive and slow, which weakens your negotiating position at every contract renewal and makes the exit clauses in the original agreement genuinely important.
The common variants are offshoring, where the work moves to a lower cost country, nearshoring to a neighbouring one, and business process outsourcing, where an entire function such as finance operations moves out. A frequent middle path is co sourcing, where a supplier handles routine volume while a small internal team keeps the knowledge and controls the supplier.
In practice
Real-world examples.
Example
A 40 person architecture practice outsources bookkeeping and payroll to an accounting firm for $2,400 a month, replacing a part time finance assistant. The saving is modest, but the practice gains proper monthly management accounts it never previously produced.
Example
A consumer electronics brand outsources all manufacturing to a contract assembler in another country, keeping only design and marketing in house. Unit costs fall sharply, but a factory fire at the supplier later halts shipments for six weeks and exposes the risk of a single source.
Example
A hospital group outsources its night time radiology reporting to a specialist provider in a different time zone. Reports come back within the hour instead of waiting for the morning, and the group avoids paying premium rates for overnight staffing.
Think of it
“Outsourcing is hiring outside companies to do work you used to do yourself.
Formula
Calculation
Annual saving = fully loaded in house cost - (outsourced contract cost + transition and management cost)
A company is considering outsourcing its six person customer service desk. In house cost is 6 staff x $55,000 = $330,000 in salaries and employer costs, plus $70,000 of premises and supervision and $20,000 of software licences, giving a fully loaded cost of $420,000 a year.
The outsourcing provider quotes $28,000 a month, which is $28,000 x 12 = $336,000 a year, with a one off transition cost of $30,000. The ongoing annual saving is $420,000 - $336,000 = $84,000, or 20% of the in house cost. In year one, total outsourced cost is $336,000 + $30,000 = $366,000, so the first year saving is $420,000 - $366,000 = $54,000.Case study
Seen in the real world.
This illustrative story features an invented company. Ashfield Insurance Services, a fictional mid sized broker, outsourced its entire claims handling team to a large provider on a five year contract, expecting to save $600,000 a year against an in house cost of $2,200,000. The board approved it on the strength of that number alone.
The first two years were fine. In year three, the provider raised prices at contract renewal, and Ashfield discovered that the two managers who understood the claims process had long since left, meaning nobody internally could challenge the supplier's assumptions or credibly threaten to bring the work back.
The fictional resolution was a co sourcing model. Ashfield rebuilt a four person internal team to own the process, the standards and the data, while the provider kept the routine volume, and the renegotiated contract came in around 12% below the price the supplier had first demanded.
Watch out
Common mistakes.
- Comparing supplier prices with salary costs alone, ignoring premises, software, holiday cover, supervision and recruitment costs that also disappear.
- Budgeting nothing for managing the contract, when a serious outsourcing relationship usually needs at least one internal owner and a monthly review.
- Signing a long agreement with weak exit terms, leaving the business unable to move or bring the work back without a punishing bill.
Questions
People also ask.
Which functions are safest to outsource?
Standardised, rule based work with clear measures, such as payroll, IT infrastructure and first line support, tends to transfer well.
What should never be outsourced?
Anything that is the source of your competitive advantage or that requires judgement about your customers, because you will slowly lose the ability to do it.
How is outsourcing treated in the accounts?
The supplier's fees are operating expenses, and the cost usually moves from staff costs to a service line, which changes staff cost ratios without changing total profit.
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