The Outsourcing Craze: Your Future Might Be "Dumber" Than You Think

Business owners, here’s an outsourcing opportunity: offload those low-skill tasks to places with lower labor costs to save money. Does that sound appealing? Don’t be too quick to call this a fool’s errand, because a report from the National Bureau of Economic Research points out that if you outsource for too long, you might end up “unable to innovate”! We all know that the core logic of outsourcing is this: let cheap labor handle low-skill tasks so you can focus your efforts on conquering the high ground of innovation. That’s exactly how Western companies used to think, but this report reveals a counterintuitive phenomenon: even though they’re saving money, they’re not investing in R&D. There are two sides to this: saving money and spending money. The logic behind saving money is clear: production costs go down, but selling prices stay the same, so the more you manufacture, the more you save. But what about spending? Previously, no one had thoroughly studied this; people simply assumed that R&D funding came from profits, and that as profit margins increased, R&D investment would naturally follow. Business schools consequently promoted the concept of “complementary innovation outsourcing,” encouraging companies to outsource low-end work. However, a decade-long study of 6,024 Canadian companies showed that after outsourcing took off, R&D spending decreased by 15 percent, and companies that had previously invested little in R&D stopped launching new projects altogether. If this trend continues through 2022, total R&D investment will decline by 28 percent. Why? Because in actual production, innovation is not just a slogan. When decisions are made using rational models, the purpose of innovation is to update and upgrade products—provided there are excess profits—which is what incentivizes companies to invest in R&D. Once intermediate goods are outsourced, the supply chain matures. Intermediate goods “Made in China” used in older products become increasingly high-quality and cost-effective, boosting competitiveness. At this point, both the risks and returns of developing new products are significantly reduced—to the extent that they may not even cover fixed costs. So why not continue producing and optimizing existing products? Because relative costs act as a deterrent to innovation. Only a very small number of large enterprises—due to significant economies of scale, where investment yields substantial profits—choose to pursue R&D. However, the vast majority of small and medium-sized enterprises (SMEs), lacking market share expansion to offset the diminished returns on innovation, opt to maintain the status quo. This leads to a dual suppression of R&D by outsourcing: it reduces existing R&D budgets and lowers the likelihood of investment in new projects. Although this report is two decades old, its logic and conclusions remain entirely relevant today. Many in the West are now deeply concerned about so-called “industrial hollowing-out” because of a lack of shared foundations—particularly in R&D investment. Outsourcing, however, replaces these potential gains and locks companies into existing technological pathways. Consequently, amid the outsourcing craze, your company may be gradually losing its ability to innovate. Today, many companies are also adopting outsourcing, but the contractors are no longer foreign firms—they are “small hardware companies” with lower labor costs, which boost profitability by cutting social security benefits and other mandatory contributions. This employment model is, in essence, a negative subsidy on innovation, trapping companies in a “comfort zone” of low-level repetition and making them reluctant to invest in high fixed costs for R&D to pursue future incremental profits. Business owners, if you’re having a great time with flexible employment models, you might want to start thinking about your own future.