What is Offshoring? 

Everything you need to know

An image showing a hand grabbing a factory to relocate it to a new location

Few practices have reshaped the global economy as offshoring and its close cousin outsourcing did in the mid and late 20th century. The pattern, which many saw as a clear application of economic theory, soon became second nature amongst large companies. In a matter of years, corporations came to embrace a multinational approach, making offshoring a norm. 

Some data points already suggest the prevalence of these strategies. In 2022, for instance, outbound Foreign Direct Investment (FDI) from OECD countries alone had reached over $1T—as much as the entire GDP of Mexico. Although data from 2023 is still not yet available, FDI for the first three quarters of the year amongst OCDE countries already accounted for some $906 bn, thus signaling the importance to the private industry of investing abroad. Similarly, on the outsourcing front, a 2022 survey by Deloitte found that 52% of top executives had outsourced some business functions, while 76% reported the same practice when it came to IT.

Simply speaking, offshoring is a reality of modern economies. But what does this mean and how has it actually impacted the world?

Outbound FDI for OCDE Countries (in Billions of USD)

Line graph of outbound FDI for OCDE countries over time

(Source: OCDE)

What does offshoring mean?

Broadly speaking, offshoring is the process through which a company relocates a part of their operations to a different country. To do this, the company must be large enough to encompass various business or manufacturing services, thus allowing it to place one or more of them abroad while maintaining core operations in their home country. 

The name itself comes from the international nature of the process. Instead of having all of their processes in a singler country, companies look for other shores upon which they can expand. That is, they search for shores out of their current headquarters or, as the name would suggest, they “offshore” a part of their current procedures.

“Offshoring is the process through which a company relocates a part of their operations to a different country”

Quite crucially, companies must have a clear understanding of their internal processes and which could be performed optimally abroad with adequate supervision. As we will discuss in the following section, offshoring comes from a pursuit of economic gains most commonly related with labor-intensive parts of a manufacturing process.

It is important to note that, differing from other practices, offshoring implies that a company still maintains full ownership of their processes. In relocating a part of their business abroad, they are also performing large investments by way of acquiring facilities or training personnel. But, regardless of the form, offshoring requires companies to also own the part of their process being offshored.

The precursors to offshoring

Perhaps the best way to think about the rise of offshoring is to look at the essential building blocks for it—all of which have become standard in recent years. If offshoring is now a common phenomenon it is, in great part, due to large technological advancements and an overall political sentiment that favored the practice. 

 In particular, there are three pillars that are crucial to offshoring as a whole: effective communication, efficient transportation, and low trade barriers.

Let’s look at the first point. For a company to successfully run an operation across various countries it needs to be able to effectively communicate across borders with little to no friction. Otherwise, it will suffer from large inefficiencies and struggle to coordinate the production of its goods or the execution of its services. For most of human history, this was simply impossible. But in the last 150 years humanity went from inventing the phone to developing the internet as a tool for mass communication. Now, it is estimated that nearly 4.7 billion people are connected to the internet worldwide, making communication a problem of the past.

A similar argument can be made for transportation. Since, as we will see in the next section, offshoring often deals with labor-intensive parts of a company’s functions, this almost inevitably requires the transportation of goods from one country to another. Maritime trade has been a crucial element in human history for hundreds of years, but it wasn’t until recently that we developed the technology to transport large amounts of cargo. In 1855, for instance, a typical cargo ship was able to carry some 700 tons of cargo. By 2006, that number had risen to 12,936 tons—roughly 18.48 times the size. The same is true for the speed of vessels which went from an average of 7.5 maritime knots in 1855 to 15 knots in 2006.

Tonnes of Average Cargo Registered in Ships over Time

A line graph showing the average registered tonnage for cargo ships over time

(Source: Maritime Economics)

Finally, it wasn’t just technological developments that fueled offshoring as a modern practice. In great part, it was also a political shift in the late twentieth century towards global integration and lowering trade barriers. In the aftermath of WWII, many institutions were developed hoping to tie economies together and reduce the potential for armed conflict. Such was the case of the General Agreement on Trade and Tariffs, an early precursor to the World Trade Organization (WTO). But it wasn’t until the 1980s that political leadership in the US and UK began to actively favor international trade in hopes of exploiting the benefits of a globalized world. What followed was a period of trade agreements such as the European Union, and the North American Free Trade Agreement (NAFTA) which heralded an era of multinational cooperation and, eventually, enables offshoring as a practice.

Without such free trade policies, companies would have to pay signfiicant taxes on their goods. This would, in turn, make offshoring almost impossible, as the added value from lower labor costs would be offset by hacing to pay large tariffs.

“There are three pillars that are crucial to offshoring as a whole: effective communication, efficient transportation, and low trade barriers.”

Why do companies engage in offshoring?

The main driver for offshoring is the pursuit of lower costs than those currently being incurred. Most notably, this comes from lowering labor expenditures by finding countries with skilled workers charging less for their time. Take, for instance, the US, where manufacturing wages are roughly of some $27.31 per hour. In contrast, countries like China or Vietnam have manufacturing wages of just $5.51 and $2.73 per hour respectively. So, in general, companies will look for places where they can perform the same functions 

Manufacturing Wages in China, Mexico, and Vietnam (2016-2020)

A stacked line graph showing the wages for manufacturing in Mexico, Vietnam, and China across time

(Source: Statista)

A generous interpretation to this pursuit for low wages is that companies are taking advantage of natural patterns emerging from international trade. General economic theory holds that countries will naturally specialize in producing some goods over others, thus developing a comparative advantage—most commonly expressed in the work of David Ricardo. These countries will then become more efficient in their production and, as a result, will charge less for labor. So, in an ideal scenario, countries will offshore parts of their supply chain looking for the places that are most efficient in the particular task they are in need of fulfilling. 

“The main driver for offshoring is the pursuit of lower costs than those currently being incurred, commonly by lowering labor expenditures.”

The above, of course, is neglecting existing conditions of inequality across countries that might influence wages just as much as comparative advantages. But regardless of the reason, offshoring as a practice is almost always focused on searching for lower costs in labor-intensive segments of a manufacturing process.

What is the difference between outsourcing and offshoring?

While offshoring and outsourcing are often used interchangeably in everyday speak, they are actually different strategies companies use to lower costs. As we mentioned before, offshoring is the practice through which a company locates a part of their current processes in a different country to lower costs. Outsourcing, on the other hand, involves a company hiring a third-party to perform a part of their current business. This does not necessarily imply an international nature as offshoring does. Outsourcing is merely the practice of hiring another company to perform a part of an existing process. 

The key difference between offshoring and outsourcing is that while offshoring implies a company maintains full ownership over their processes, outsourcing requires a company yielding a part of their operations to a third party. When a company outsources a part of their processes, it is often in hopes of focusing their time and resources in areas they are best suited to perform. That is, companies will most commonly outsource parts of their process that take too much time and resources to perform.

Similar to offshoring, the logic behind outsourcing is to search for lower costs and increased efficiency. At times, this will result in hiring a third party contractor in a country with lower labor costs or higher productivity, but the practice is not synonymous with globalization. It could well be the case that a company outsources a part of their process domestically to a specialized firm. 

Which countries benefit the most from offshoring?

It is difficult to determine which countries are to benefit more from an offshoring transaction. Theoretically speaking, both parts stand to gain from a startegic relocation. On the one hand, the country offshoring a part of it’s business wins in the form of reduced costs and increased efficienty—synonymous with larger outputs. On the other hand, countries receiving offshored facilities are set to benefit in the form of increased investment and job creation.

However, studies do show that countries doing offshoring tend to benefit more than those receiving the offshored facilities. McKinsey & Co went as far as estimating that, in the case of the US, the country receives 78% of the economic value generated from its offshoring, while countries hosting offshored facilities receive just  22% of increased gains.

Interest in offshoring changes year to year. Most recently, for instance, Mexico has become a point of interest as developed countries look for alternative destinations so offshoring that are lesser reliant on China. But other nations such as India, Malaysia, and Indonesia continue to rank highly in the minds of investors. In fact, in 2021, Statista ranked India as the most attractive country to offshore one’s business based on its own offshoring ranking. China followed on the second spot, with Malaysia taking the third.

Ranking of Leading Countries in Offshore Business Services (2021)

Bar graph showing the attractiveness scores for offshoring given to various countries by Statista

(Source: Statista)

So, what is offshoring?

Put togeteher, offshoring is a global trend that allows businesses to lower costs by ways of accessing new markets. It is the result of technological developments and strategic decisions in the political realm favoring the free trade of goods. It implies a company relocating a part of its current process to a new country, taking advantage of low labor costs and, at times, existing trade agreements. But, most importantly, offshoring is a crucial part of modern economics and should be understood as a global phenomenon.

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