Corporate restructuring through off-shoring and out-sourcing is widely regarded as nec-essary for transforming cost structure and return on capital, particularly in situations ofsevere price erosion in globally competitive markets. This paper constructs an accountingframework to assess the extent to which out-sourcing and off-shoring have transformedUS corporate financials. The contention in this paper is that off-shoring and out-sourcingmay be necessary to maintain price competitiveness but we would add a health warningthat these responses may not be sufficient to transform return on capital or shareholdervalue for wealth accumulation.
Off-shoring and out-sourcing are significant elements in the corporate management and consultancy restructuring port-folio, where narratives often promise financial transformation. Both out-sourcing and off-shoring offer the potential to lowercosts and increase efficiency (Organization for Economic Co-operation and Development, 2007). In turn, this should translateinto increased earnings capacity (profit or cash earnings on capital employed) where organizational unbundling (Jacobides,2003) reconfigures the mix of business activities undertaken by a firm along a value chain and where, ideally, internal costreduction is not offset by increased external expenses and balance sheet capitalization. Gereffi (1994) shows how leadingbrand companies seek to re-structure their global value chains and the implications for corporate governance, technicaltransfer, the division of competencies, and the utilization of power within global markets to extract higher returns (Kaplan& Kaplinsky, 1998; Sturgeon, 1997). A recent report by the Organization for Economic Co-operation and Development (OECD,2007) observes,
This globalisation of the value chain is driven by companies’ desire to increase efficiency, as growing competitionin domestic and international markets forces firms to become more efficient and lower costs, as well as the desireto enter new emerging markets and gain access to strategic assets that can help tap into foreign knowledge. (OECD,2007: 1; http://www.oecd.org/dataoecd/45/56/38979795.pdf)
This same policy brief observes, “What is new is the speed and scale of the current wave of globalisation, and the associatedphenomena of outsourcing and off-shoring” (OECD, 2007: 2). During the 1990s, both manufacturing capacity and serviceswere amenable to out-sourcing and off-shoring. Gordon, Haslam, McCann, and Scott-Quinn (2009) states:
∗ Corresponding author at: Department of Accounting, Finance and Economics, University of Hertfordshire Business School, De Havilland Campus,Hatfield, Herts AL10 9AB, United Kingdom. Tel.: +44 1707285481.
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Since the end of the 1990s, however, service activities in advanced economies have taken initiatives to shift a muchwider range of information-related functions to offshore locations in pursuit of labor cost savings, as they in their turncome to face more intense price competition. (Gordon et al., 2009: 373)
A survey by the United Nations Conference on Trade and Development (UNCTAD) and Roland Berger Strategy Consultantsnotes the following:
So far, the focus is on back office services, but most service processes are potential future candidates for off-shoring. While they lag behind their U.S. rivals, European companies – especially from the United Kingdom – seeoff-shoring as a way to reduce costs and improve their competitiveness. (UNCTAD, 2004: 1; http://www.unctad.org/sections/press/docs/SurveyOffshoring en.pdf)
Research conducted by CAPCO consultants and the London Business School (Gupta, 2008) compares the current off-shoring project of financial services with that of car manufacturing in an earlier period (Williams, Williams, Haslam, & Johal,1994). CAPCO employs the term “componentization” to describe how processes and functions can be decoupled from theirexisting geographic location to arbitrage labor costs (and exploit other non-price and knowledge based assets) to reduceoperating costs and improve earnings. In a global investment bank, for instance, the following was observed:
The offshore centre in India took over the responsibility of initiating (phone calls, faxes, e-mails, etc., to thecounterparties) while the more experienced resources based in London processed exceptions. Using this modelthe investment bank was able to minimize their investment in knowledge transfer and training of the India-based staff while reaping as much as 40 percent savings in operating costs. (http://www.capco.com/files/pdf/66/02 FACTORY/08 Financial%20services%20factory.pdf)
According to a report by the Centre for International Business Education and Research (Lewin et al., 2009: 19–20), thefinancial crisis adds to the urgency of off-shore to save labor costs.
The most prominent change is labor cost savings. The findings from the ORN survey conducted in November 2008show that labor cost savings have become even more important (relative to ORN 2007/2008 findings) in the currenteconomic situation. Follow-up interviews and comments from respondents indicate that companies are concernedabout pressure on margins and declining top-line growth. Not surprisingly, a renewed and increased emphasis on“taking strategic driver for continuing with plans to expand existing outsourcing projects offshore as well as initiatingnew projects.[”] (https://offshoring.fuqua.duke.edu/pdfs/Shared%20Services%20News ORN.pdf)
This acceleration and deepening of the global out-sourcing and off-shoring project by US and European firms coincidewith changes in corporate governance. In an era of shareholder value, financial incentives based on performance becomecoupled to managerial remuneration. Mahoney, Milberg, Schneider, and Von Arnim (2006), Millberg (2008) and Millbergand Winkler (2009) integrate the motivation to out-source and off-shore with the pressure to generate higher returns toshareholders in the US. They argue that although the out-sourcing and off-shoring of services from the US boosts profitsthe increased earnings extracted are not deployed into investment and productive renewal but instead are distributed toshareholders.
At the same time the cost savings from off-shoring are considerable, and the recent rise in off-shoring has correspondedwith historic highs in the profits share of national income. Despite the profit increases, rates of investment have notgrown accordingly. (Mahoney et al., 2006)
Management consultants are especially prone to deploying narratives that support the financial benefits of off-shoringand out-sourcing.
Companies that have allocated over 60% of their R&D expenditure offshore have displayed greater share-holder return, operating margins, market capital growth and return on assets. (http://www.globalbusinessinsights.com/content/rbcr0007m.pdf)
Financial institutions that only move a single function off-shore typically report average cost savings of twenty percent. In contrast companies that offshore multiple functions enjoy an average cost saving of 40 to 50 per cent ormore, suggesting that there are significant benefits to expanding the scope for off-shoring activities. (http://www.arengufond.ee/upload/Editor/teenused/finants%20lugemine/offshoring trends Deloitte.pdf)
Always under intense financial pressure, in recent years executives have turned to off-shoring their IT workin search of immediate relief. Labor arbitrage advantages delivered rapid cost cuts, to the accolades of share-holders and chief financial officers alike. (http://www.accenture.com/Global/Outsourcing/Application Outsourcing/R and I/YoureOffshoringNowWhat)
The recent financial crisis and its aftermath have only served to amplify the potential for off-shoring and out-sourcingto transform corporate financial performance for value creation and wealth accumulation. Consultants and infrastructureproviders suggest that corporations need to off-shore and out-source more than ever.
20 E. Lee, Y.P. Yin / Accounting Forum 36 (2012) 18– 26
Table 1Key financial operating ratios and earnings capacity.
FIRM At0 At1
Total revenue/income 100 100External procurement costs −40 −47Value retained 60 53Employee expenses 42 28Cash retained 18 25Capital/assets employed as % of sales 100 100Cash ROCE/cash to assets 18 25
Source: Author.Notes: Capital employed is computed as long-term debt plus equity. Assets are tangible plus intangible assets minus working capital (short-term assetsminus short-run liabilities), and capital/asset intensity is determined by dividing capital/assets employed into total revenue/income.
Now more than ever, the business environment in which we operate tests even the strongest organizations. A conflu-ence of challenges—including tight economic conditions, increased competition, and rising business costs-combineto act as a catalyst for organizations to look for and implement new and innovative ways to gain a “competitive edge”in order to survive. (http://www.juniper.net/us/en/local/pdf/solutionbriefs/3510319-en.pdf)
Academics Pisano and Shih (2009) in their Harvard Business Review article allude to the way in which business schoolacademics have provided intellectual support for out-sourcing and off-shoring as a way to preserve core capabilities andrelease financial resources for investment in innovation and intangible assets. Pisano and Shih note that the continueddeepening of US corporate off-shoring threatens to undermine the future wealth-generating capacity of the US nationalbusiness model.
Companies in the U.S. were steadily outsourcing development and manufacturing work to specialists abroad andcutting their spending on basic research. In making their decisions to outsource, executives were heeding theadvice du jour of business gurus and Wall Street: Focus on your core competences, off-load your low-value-addedactivities and redeploy the savings to innovation, the true source of your competitive advantage. But in reality,the out-sourcing has not stopped with low-value tasks like simple assembly or circuit board stuffing. Sophisti-cated engineering and manufacturing capabilities that underpin innovation in a wide range of products have beenrapidly leaving too. As a result the U.S. has lost or is in the process of losing the knowledge, skilled people, andsupplier infrastructure needed to manufacture many of the cutting edge products it invented. (http://hbr.org/hbr-main/resources/pdfs/comm/fmglobal/restoring-american-competitiveness.pdf)
In both the practitioner and academic narratives on the benefits of off-shoring and out-sourcing, there is a general beliefthat in contested global markets, arbitraging employment costs is critical for sustaining earnings as price structures erode.This paper is concerned with the extent to which off-shoring and out-sourcing have transformed cost structures for valuecreation and wealth accumulation for the US corporate sector. As Froud et al. (2006) observe, “It helps if narratives aboutstrategic initiatives align with financial performance”. To explore possible discrepancies between claims and outcomes,these authors also note that financial numbers can be used by outsiders to critically assess narratives issued by seniormanagement, academics and consultants. In the next section of this article, we present a financial framework grounded inaccounting that employs a nature of expenses format (ASSC, 1975; Andersson, Haslam, Lee, & Tsitsianis, 2008; Andersson,Haslam, Lee, Katechos, & Tsitsianis, 2010). This format can be employed to discriminate between external and internal costsin the corporate financial value chain and to assess the extent to which cash margins are transformed by recalibratingcorporate cost structures. Introducing a measure of assets or capital employed reveals the extent to which the US corporatesector has transformed a key shareholder value metric through off-shoring and out-sourcing.
2. US corporate off-shoring and out-sourcing: revealing financial transformation
In Table 1, we present a hypothetical example of how earnings capacity (cash ROCE or cash earned on assets employed)can be improved as a result of out-sourcing and off-shoring. We assume that it is possible to arbitrage global labor marketsand, by displacing domestic for foreign labor, to reduce internal employment costs by one-third, from 42 to 28% of totalincome. We assume that this process of out-sourcing and off-shoring labor-intensive functions would only increase externalprocurement costs in total income by seven percentage points (i.e. from 40 to 47%) because overseas external suppliers offera one-third labor cost savings. Out-sourcing thus increases external costs by 7% and reduces the value retained (after payingsuppliers) from 60 to 53% of total income. In combination, however, the reduction in internal labor costs of 14% is offsetby a smaller increase in external costs of 7%, so the cash margin increases from 18 to 25% of total income. Assuming thatthe firm’s capital/asset intensity remains constant (capital/assets employed to generate a financial unit of total income), thereturn on capital/assets would also increase from 18 to 25% (see Table 1).
The hypothetical case presented in Table 1 suggests that out-sourcing and off-shoring might (in the absence of a significantadjustment in capital intensity) deliver a higher cash margin (from labor market arbitrage) and a higher return on capitalfor shareholders, thereby increasing the probability of further wealth accumulation as stock prices increase.
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Table 2US parent and foreign affiliate employment and employee costs.
1999 2008
Labor costs(mill $)
Employment(mill)
Average employeecosts ($K)
Labor costs(mill $)
Employment(mill)
Average employeecosts ($K)
Employment change1999–2008%
US parent 1104 23.0 48 1373 21.0 65 −8.7ForeignEurope 153 3.5 43 257 4.2 61 19Asia Pacific 41 1.5 27 78 2.6 29 74Of which China 2 0.3 7 9 0.8 11 207L America 24 1.5 16 40 1.9 21 26Rest of world 37 1.2 31 64 1.3 48 12Total 255 7.8 33 438 10.1 43 30
Source: Bureau of Economic Analysis, http://www.bea.gov/international/di1usdop.htm.
Using the accounting format described in Table 1, it is possible to compare US parent company financials with theirmajority-owned foreign affiliate operations (excluding finance and depository institutions). The US industrial sector hasa long history of investment overseas, and it is possible to identify the financial operating characteristics of US parentcompanies and their foreign overseas affiliates from the US Bureau of Economic Analysis (BEA) datasets.1 In 2008, majority-owned US foreign affiliates accounted for assets, sales revenue, and value added equivalent to roughly one-quarter of theassets, sales revenue, and value added of their US parents. Over the 1999–2008 period, US parent company employment fellby 2 million, from 23 to 21 million (see Table 2), but employment in foreign affiliates increased by 2.3 million. The majorityof the increase in overseas employment was located in developing regions, namely Asia-Pacific, China and Latin America,where labor costs are one-half to one-sixth of those in the US parents (see Table 2). For example, the growth in employmentin US majority-owned affiliates in China was 0.5 million (1999–2008), and average employment costs in China were, onaverage, one-sixth of those of the US parent company.
A significant challenge facing US companies is the nature of contested, globally fragmented markets, where price erosionis the norm and reducing labor costs is important to sustain price competitiveness. However, we argue that cost reduction,while necessary from a global labor market arbitrage perspective, may not be sufficient to transform cost structures, cashmargins, and the return on invested assets for shareholder value for US corporations.
The Bureau of Economic Analysis has previously investigated the issue of why the return on asset (ROA) performance ofUS foreign affiliates remained below that of US parent companies in the 1990s.
A longstanding question about foreign owned U.S. companies is why their rates of return have been consis-tently below those of other U.S. companies. . .The average ROA for foreign owned nonfinancial companies was 2.2percentage points below that for U.S. owned nonfinancial companies in 1988–97. (http://www.bea.gov/scb/pdf/internat/fdinvest/2000/0300rr.pdf)
The BEA research undertaken at this time attempted to explain the difference as a “measurement” problem of comparing“like with like”. Thus, the BEA researchers identified the asset values of foreign affiliates as more current than their parentcompanies, which were more “historic”. Adjustments were made to profits (via adjusted depreciation) and asset values toconsider these differences before the research team executed a series of correlations and regressions to “explain” the residualdifference in ROA. An alternative approach, taken in this paper, is to employ reported financial data from US parents andtheir affiliates to construct their cost structure (internal and external) using the approach we describe in Table 1. In this way,we can observe what, if any, differences exist between US parents and their foreign affiliates in terms of cost structure andcash return on assets employed. Our starting point is to deduct all external costs from the total income to estimate the valueretention rate in sales for both US parent companies and foreign affiliates, as shown in Chart 1, where
Value retained or value added = [total sales or income − external costs]
This chart reveals that US foreign affiliates retain 4–5% less of their total income after paying all external expenses outof the total income relative to their US parent companies. This finding suggests that the off-shore operations of US parentfirms tend to out-source a greater share of the financial value chain. For example, US affiliates operating in the Asia-Pacificregion in 2008 had a value retention rate of 20% (out-sourcing 80%) compared to the US parent average of 27% (out-sourcing73%). The financial numbers reveal that US industrial corporations generally off-shore and out-source through their foreignaffiliates.
As Chart 2 reveals, the overseas affiliates of US parent firms operate with a lower share of total employment cost insales/total income. Although US parent firms have reduced employment costs in sales from 19 to 15%, their foreign affiliateshave also reduced labor costs from 11 to 9% of total income (see Table 3). Although US foreign affiliates out-source a larger
E. Lee, Y.P. Yin / Accounting Forum 36 (2012) 18– 26 23
Chart 3. US-producing firm’s cash margin in sales%.Source: Bureau of Economic Analysis, http://www.bea.gov/international/di1usdop.htm.
Chart 4. US parent and affiliates CROA%. Note: CROA is cash return on assets, where cash is earnings pre interest tax and depreciation.Source: Bureau of Economic Analysis, http://www.bea.gov/international/di1usdop.htm.
share of their financial value chain, they operate with lower labor costs in total revenue, and this compensates to restorethe cash margin, where
Our analysis deconstructs the operating ratios of US parent companies and their majority-owned foreign affiliates toreveal more similarities than differences in the bottom-line cash margin (cash in sales). However, in arriving at this bottom-line position, we note the differences in the shares of external procurement and internal employment expenses in total salesrevenue between the US parent and foreign affiliate and their compensatory function (see Table 3, Chart 3).
The shareholder value metrics to which we have alluded in this study focus on cash generated by assets employed (cashROA). This relevant and frequently used shareholder value metric measures the extent to which cash earnings recover thecost of invested capital for further value creation and wealth accumulation. Our analysis in Chart 4 reveals more similaritiesthan differences between the US parent and foreign affiliate cash returns on assets,2 suggesting that the strategy of US parentcompanies to both off-shore and out-source, while necessary for cost competitiveness (accessing lower employment costs),is not sufficient to transform the cost structure and cash return on assets for shareholder value creation.
2 Cash flow is value retained minus employment costs. Total assets calculated for parent and foreign affiliates exclude finance and insurance companies.
Source: Annual report and accounts 10Ks. http://phx.corporate-ir.net/phoenix.zhtml?c=116886&p=irol-sec.
3. A firm-level illustration: Molex Inc.
Molex Inc., a NASDAQ-quoted company established in 1938, conducts business for the manufacture and sale of electri-cal components. The company designs, manufactures, and distributes electrical and electronic devices, such as terminals,connectors, planer cables, cable assemblies, interconnection systems, fiber optic interconnection systems, backplanes, andmechanical and electronic switches. In recent years, Molex has off-shored an increasing share of its factory space into low-labor-cost economies. In 2002, only 30% of its factory space and 45% of its employment was located outside of the US. By2009, the share of factory space outside the US had increased to 60% and employment had increased to 70%.
As of June 30, 2010, we had approximately 35,519 people working for us worldwide. Approximately 25,738 of thesepeople were located in low cost regions. (http://www.molex.com/images/financial/pdf/annual2010.pdf)
The market for connector devices is competitive and fragmented, with the top ten firms supplying 54% of the global marketand Molex itself taking a 7.5% share. In this competitive market, there is a struggle to maintain profit margins when priceerosion is typically 3–5% per annum.3 In these circumstances, off-shoring and out-sourcing make sense because Molex, likemany other US firms, is exposed to global competition and is seeking cost reduction. Our analysis of US parent and overseasaffiliates suggests that cost reduction is not necessarily coincident with modifying cost structures and a higher return oncapital for shareholders. At the beginning of this decade, Molex committed to a significant adjustment of the geographicconfiguration of its operations. We assess the extent to which this restructuring process delivered stronger operating ratiosfor shareholder value creation.
For Molex, the period after 1990–2000 was one of relative stability in the key operating ratios. Value retained afterdeducting external costs was steady at 50%, and employment costs were relatively stable, at 25% of sales revenue. Afterdeducting both external costs and internal labor costs, the remainder, cash from operations, was also relatively steady, at25% of sales. The period after 2000 marks a break with the past as Molex more aggressively pursued its off-shoring andout-sourcing policy. First, the value retained by Molex from sales revenue dropped from approximately 50 to 40% (prior tothe 2008 financial crisis and recession). Second, labor costs drifted from 25 to 20% of total sales. However, this decline wasnot sufficient to compensate for the reduction in value retained, at 10 percentage points. The net effect of these changes isshown in Table 4 below, which indicates how the cash margin dropped from 25 to 20% of sales (Chart 5).
Molex’s cash return on capital employed also remained steady at 30% during the 1990s, but the period after 2000 reflected,again, a steady, albeit cyclical downward, trajectory, with the cash ROCE hitting 20% before the recession in 2008–2009.Molex’s average market value4 climbed from $2billion in the early 1990s to $8billion at its peak in 2000 before decreasing,with the cash ROCE, to a market value of approximately $4billion in 2010 (see Chart 6). Molex’s off-shoring and out-sourcingpolicy reconfigured its relationship with its stakeholders. It utilized the modified information pool available in its businessmodel to arbitrage and capture cost reduction in an environment in which prices were eroding. However, our analysis ofthe key financial ratios suggests that, for Molex, cost reduction is not synonymous with transforming cost structure andgenerating a higher return on capital for shareholder value creation and wealth accumulation.
In circumstances where the return on capital is consistently on a downward trajectory, analysts will eventually markdown the share price, reducing market valuation. In turn, this generates goodwill impairment charges because the marketvalue over the book value that was paid for previous corporate acquisitions becomes irrecoverable. In 2009, a $264 milliongoodwill impairment charge was made, with a sum equivalent to 10% of the value of shareholder equity from the double-entrybook-keeping process. Like many US corporations, Molex has repurchased share capital for treasury stock in anticipation ofholding gains from inflated stock prices. Molex’s investment in repurchased treasury stock was $1.1billion (average $22 pershare), equivalent to 15% of the cash generated over the period 1990–2010. In September 2011, its share price was $20 pershare, $2 below the average price paid to repurchase stock, representing an implicit holding loss of 20%.
4. Summary/discussion
The purpose of this paper was to explore the extent to which off-shoring and out-sourcing have transformed key share-holder value metrics for wealth accumulation in the US corporate sector. Even before the current financial crisis, US firms
3 http://www.molex.com/documents/William Blair Conf.pdf.4 Using the average of high and low share price during the year.
Chart 6. Molex cash ROCE (%) and market value ($bn).Source: Annual report and accounts 10Ks, http://phx.corporate-ir.net/phoenix.zhtml?c=116886&p=irol-sec.
off-shored an increasing proportion of their global sales, profits and assets into overseas markets to take advantage of lowerlabor costs (for example, in the Asia-Pacific region). The US industrial sector is exposed to globally competitive and frag-mented markets in which price erosion is the norm. In the aftermath of the financial crisis, US firms are expected to acceleratetheir out-sourcing and off-shoring. Pisano and Shih (2009) warn that this increase in off-shoring threatens to undermine theinnovative and creative capacity of the US and its longer-term wealth-creating capacity.
In this paper, we were specifically concerned with demonstrating how accounting numbers grounded in a nature ofexpenses format can be employed to deconstruct the financial performance of US parents and their majority-owned foreignaffiliates. Using the financial datasets from the Bureau of Economic Analysis (BEA), we ascertained the extent and geographicpattern of US off-shoring and revealed key financial operating ratios. The accounting numbers indicate that US foreignaffiliates tend to out-source a higher proportion of their total financial value chain relative to their parents in the US. This
26 E. Lee, Y.P. Yin / Accounting Forum 36 (2012) 18– 26
policy serves to reduce the value retained from total income in US foreign affiliates, but a lower share of internal employmentcosts from total income is necessary to compensate financially. A combination of higher external and lower labor cost sharesof total revenues deliver a cash margin in foreign affiliates that is, on average, equivalent to the average of their US parents.Introducing the value of balance sheet assets into the analysis reveals very little difference in the cash return on assets (CROA)between US parents and their overseas affiliates. In the case of Molex, a company with a clear off-shoring and out-sourcingstrategy to arbitrage global labor markets, maintaining price competitiveness is not the same as transforming the return oncapital for shareholder value and wealth accumulation.
In the aftermath of the financial crisis, US firms face two difficult choices. On the one hand, there is an ongoing struggleto reduce costs and sustain price competiveness. On the other hand, there is a need to translate these policy interventionsinto stable and secure wealth accumulation that underwrites US household pension funds. Reconciling cost reduction withhigher returns on capital for wealth accumulation is not straightforward and presents a considerable challenge to the UScorporate sector. We argue that the narratives attached to off-shoring and out-sourcing promise financial transformation butthat it is necessary to distinguish between cost level and cost structure. Using accounting numbers in a carefully constructedframework of analysis, it is possible to challenge claims about the potential of out-sourcing and off-shoring to both transformcompetiveness and secure shareholder value for wealth accumulation.
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