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8.3 The Growth in Knowledge-Based Outsourcing

In the last 20 years companies have outsourced many activities, including manufacturing, back-office functions, information technology (IT) services, and customer support. Now the focus is shifting to more knowledge-intensive areas, such as product development, R&D, engineering, and analytical services.Myers and Cheung (2008, Summer). For example, as noted above, pharmaceutical companies depend on a steady pipeline of new products from R&D. The competitive pressures on these firms to bring out new products at an ever rapid pace to meet market needs are increasing. With it, the pressures on the R&D function are increasing. In order to alleviate the pressure, firms have to either increase R&D budgets or find ways to utilize the resources in a more productive way. There are situations when a firm should consider outsourcing some of its R&D work to contract research organizations or universities, for example, when (a) in-house new product design is ineffective or too slow, (b) the company is plagued by consistent project time and cost overruns, (c) loss of key talent has slowed new product development, (d) there is a need for an immediate competitive response, or (e) when problems of quality or yield reduce R&D effectiveness.

The growth in knowledge-based outsourcing is mainly driven by cost imperatives, but, increasingly, shortages of talent in home markets and the growing availability of skills in nations such as India, China, and Russia play a role. A second driver behind the growth in knowledge-based outsourcing is the increasing “commoditizationOccurs when all competing products or services have adopted the same or similar features or attributes, making them appear virtually identical to consumers.” of standard business processes and IT services, depressing margins on such activities for outsourcers. This has further encouraged service providers to switch to other activities for which profits are potentially greater—including “innovation services” such as new product development (NPD), R&D, and engineering. According to Booz & Company, there has been 95% growth in the provision of such capabilities since the millennium.Bliss, Muelleer, Pfitzmann, and Shorter (2007). At the same time, providers of standardized services have come to recognize that they need to focus on efficiency and more seamless client integration if they are to continue making sufficient returns. By contrast, innovation services, including everything from prototype design to credit analysis, are more complex and client-specific, and therefore are more likely to command a premium.

For companies considering knowledge-based outsourcing, the lack of standardization means that partner vetting is critical and that outsourcers need to consider investing in captive or near-captive operations that can be sufficiently customized. That may mean turning to smaller providers—that is, those with fewer than 500 employees—that are better able to meet exacting requirements. The process of contracting with multiple, small service providers in different parts of the world is challenging. Many companies are still struggling to integrate more standardized processes with their existing core operations. Outsourcing knowledge-intensive activities will involve a whole new level of managerial complexity, potentially upending fundamental notions of how companies see themselves and what they do. Outsourcing vital activities such as prototype design and engineering support will be fraught with risk, with potentially significant downsides. However, organizations will have little choice: the need to identify talent outside the home territory will force them to work with partners overseas, whatever the pitfalls.

Companies that successfully manage knowledge-based outsourcing are looking to create collaborative management models that share responsibilities, risks, and rewards, enabling both sides to reach their objectives. This “comanagement” approach involves outsourcers treating contractors as valued collaborators even in cases where competitors are employing the same company. It will also necessitate joint investment in offshore staff development, helping providers to retain talent and maintain their revenue margins.

Increased use of knowledge-based offshoring could have significant ramifications on how companies are organized. Rather than multinational organizations with business units staffed by expatriate managers and orchestrated from a central headquarters, the organization of the future will be more globally distributed, with managers seeking out talent wherever it is located and plugging in capabilities when needed. Unlike the outsourcing of the past, knowledge-based offshoring is not simply about labor arbitrage; it is about transforming companies into more nimble, flexible entities.

Minicase: Outsourcing of R&D in the Pharmaceutical IndustrySpecial report on outsourcing (2006, January).

To cut costs and speed development, Eli Lilly outsources a substantial portion of its R&D—including clinical trials—to countries such as India and China. Lilly is not the only pharmaceutical company that has relocated R&D operations to the developing world; Pfizer tests drugs in Russia, and AstraZeneca conducts clinical trials in China. The main driver is rising development costs, estimated at some $1.1 billion per drug—including expenses on all the products that do not make it to the market—and expected to increase to $1.5 billion by 2010.

More recently, Lilly and other drug makers have begun to expand their R&D efforts in India and China to include clinical trials. These are the late-stage experiments to prove a drug can be used on humans. These tests are enormously expensive; Lilly estimates that each Phase III test costs at least $50 million a year. To reduce costs, Lilly plans to move 20% to 30% of this testing in the next few years. While cost reduction is the main reason for the migration, this migration is made possible by the investments these nations have made in the necessary research labs, hospitals, and professional staffs to conduct studies that meet the stringent regulations of the U.S. Food & Drug Administration or drug regulators in the European Union.

While these outsourcing initiatives are extremely successful, it is unlikely that Lilly will move its entire R&D portfolio abroad. It will likely keep a number of centers of excellence in the United States, renowned for their path-breaking research in cancer and heart disease, to maintain its leadership in these areas and to keep a research presence in the country. Another reason that prevents pharmaceutical companies from outsourcing all of its research is that they may not be able to sell their newest products in countries like India and China because patients cannot afford them or because of worries about patent protection.