Adam Smith’s was the first to describe outsourcing and labor arbitrage. As a part of his concept, “the division of labor,” he described segmenting the work necessary to manufacture a product into discrete tasks and then distributing the labor to focused groups of laborers. In his view the distribution of labor extended to whatever group, organization or geographic area could provide the service the best. In 1776 the differences in the cost-of-labor varied widely from area to area and country to country. However in 1776, the cost and time lost in transporting goods produced using lower-cost offshore labor to England and then transporting those goods within the country constrained the impact of offshore labor arbitrage. In Smith’s time the manufacturers of England focused more on transforming and innovating processes to lower the cost of manufacturing goods locally where the time and cost to transport products was minimal. The return on investment for transforming and processes was higher and in many cases the only option for perishable products. Relying on offshore manufacturer’s employing lower-cost labor (offshore labor arbitrage) to produce less costly goods, made sense only when the lower-cost labor created a cost advantage so great that when combined with the lost time and added transportation costs still left room for profit and meeting market demand.

However when the depressed United States economy of the 1940s was faced with the manufacturing requirements of fighting World War 2, many of the environmental constraints of Smith’s time were no longer as relevant and labor arbitrage was the ready answer. The mature, continental rail transportation system in the United States in the 1940s enabled defense manufacturers to increase production and profits by moving production from labor markets in the United States such as New York City which had relatively low unemployment to labor markets such as Phoenix, Arizona which had higher unemployment. Because, Phoenix had an over-supply of labor at a lower cost-of-living in comparison to New York City, the cost-of-labor in Phoenix was also lower.

What differentiates offshore labor arbitrage today from offshore labor arbitrage 200 years ago is availability of fast, even overnight shipping and transportation; the proliferation of high quality infrastructure (e.g. electric, telecom, facilities, etc.); and open global markets. Almost any good or service can be manufactured or delivered from anywhere in the developing world enabled by the availability of a large supply of workers willing to enter into employment for wages that would be considered below a living wage in the developed world.

The IMF and World Bank under the guiding hand of the US government unnaturally sweetened the process beginning in the 1970s. Helping to develop business cases and loan programs indebting developing countries with billions of dollars targeted to large public works projects to develop highways, power generation, and communication networks all delivered by US corporations. The low labor costs in the developing world became the opiate for corporations hungry to create quick and seemingly brilliantly delivered profits at the end of the 1980s. Wall Street bankers and short-term investors fueled the fire praising the practice. The US government followed suit by blindly encouraging offshore labor arbitrage, changing regulations and policy such as: reducing investment credits (that drive investment in domestic innovation) and tightening immigration practices (that might have otherwise increased US tax revenues) in the 1980s and 1990s.

Unconstrained access to offshore labor arbitrage in the past 25 years has increased the potential short-term cost benefits, but also the complexities and the risks. United States and European companies that have been heavy users of offshore labor arbitrage are forced to align their brightest leaders to deliver these benefits. This saps the intellectual strength from organizations that might otherwise find innovations that would reduce the need for labor versus just lowering the cost of the labor.

For workers in the developed world the result of offshoring in the past 25 years has been the flight of work to lower-cost workforces in the developing world for quick and sustainable profits. Corporate shareholders also are feeling the pinch of the short-term focus of these corporations which have been unable to respond to decreased demand or new market opportunities. After years of milking offshore labor arbitrage for profits, organizations that have committed increasing amounts of internal leadership to managing complex arrangements of global workforces have less or no time to focus on innovation and transformation. The offshoring boom of the 1990s and early 2000s has left many corporations with brittle and rigid processes that have seen little innovation and transformation and under-satisfied customers.

The innovational strength that has powered the global economic growth since the beginning of the Industrial Age has been the ability of organizations to increase productivity by decreasing the labor hours per transaction or unit manufactured through innovation. Adam Smith understood this,

“First, the improvement of the dexterity of the workmen, necessarily increases the quantity of the work he can perform; and the division of labour, by reducing every man’s business to some one simple operation, and by making this operation the sole employment of his life, necessarily increases very much the dexterity of the workman.

Secondly, the advantage which is gained by saving the time commonly lost in passing from one sort of work to another, is much greater than we should at first view be apt to imagine it. It is impossible to pass very quickly from one kind of work to another, that is carried on in a different place, and with quite different tools.

Thirdly, and lastly, everybody must be sensible how much labour is facilitated and abridged by the application of proper machinery. It is unnecessary to give any example. I shall only observe, therefore, that the invention of all those machines by which labour is so much facilitated and abridged, seems to have been originally owing to the division of labour. Men are much more likely to discover easier and readier methods of attaining any object, when the whole attention of their minds is directed towards that single object, than when it is dissipated among a great variety of things.”

Adam Smith’s observations on innovation are still as relevant today as they were in 1776, summarizing Smith above he saw three approaches to transforming operations: (1) Training, (2) Process Improvement, and (3) Automation.

Applying Adam Smith’s observations to today’s world of contact centers we begin by segmenting the current call transactions into more discrete customer intention-oriented customer contact transactions. The traditional first-step is separating simple transactions from complex transactions. A live-agent on the phone with a customer adds little to a simple transaction such as reading off an account balance, whereas a live-agent on the phone may be critical to a sales process. The simple transactions (e.g. password resets, inputting account or customer information, frequently asked questions, etc.) can be automated using an interactive voice response system (IVR), or completely automated using internet applications or other kinds of electronic transactions (e.g. pre-authorized electronic payment). Agents are then organized so that calls can be delivered based on skills, and specialization with additional focus on delivering the customers intention through the use of optimized processes documented in knowledge management toolsets. The end result is the same or more customers are served with less work translating into fewer workers per transaction. In labor intensive operations this means not just less total wages, but lower fixed costs for facilities and infrastructure, and less variable cost services such as telecommunications. More importantly, these improvements mean a smaller operation can serve more customers, and by providing customers with the services that meet their intentions, customers are likely to be more satisfied, encountering fewer mistakes, and being served faster.

When leaders feel the need for short-term profits they often feel they cannot wait for innovation. In the call center industry they start thinking about simply shifting the same process they use in the United States to an offshore workforce. In the early 2000s, if the local language was English, this meant business leaders could theorize saving 40-50% on wages per hour by moving to the Philippines or India. However, while the decrease in the wages may be immediate on paper, it was a time consuming, expensive, and sometimes risky undertaking. Consider two similar businesses Beta Electronics and Epsilon Electronics that have similar products with similar features, quality, pricing, revenues, and profits, and both use a similar processes to create their products.

Assume that Beta Electronics shifted production from the United States to the Philippines using the same process they used in the United States with 25% cheaper labor, and higher non-labor expenses (e.g. transportation) netting a 15% increase in profits. Now assume Epsilon Electronics transforms its processes, cuts the labor requirement by 25%, doesn’t increase transportation costs, but incurs investment expense in transformation netting a 15% increase in profits. Wall Street rewards both companies for improving their price to earnings ratio, but which company is really healthier?

Beta Electronics, took advantage of the opportunity to simply change venues for manufacturing. However, the very act of shifting business from the US to the Philippines (RP) creates an economic improvement in the Philippines that begins to diminish the labor arbitrage opportunity. As more companies see Beta’s success in shifting work to the Philippines, salaries in the Philippines increase as the supply of workers begins to decrease. In addition the exchange rate of the depressed RP Peso to US Dollars begins to rise. Beta Electronics begins to see savings derived from labor arbitrage cost improvements decrease year-over-year. Additionally the added costs of maintaining an offshore workforce and any non-labor costs associated with repatriating Beta’s finished products with overseas transport begins to evaporate benefits long before labor markets achieve equilibrium.

Meanwhile Epsilon Electronics’ innovation program yields a more balanced operation based on improvements in their processes as well as a more integrated feedback loop improving the base product. Innovation which is as much a practice as a process becomes easier to accomplish over time. While Epsilon becomes more resilient and flexible, Beta becomes increasingly rigid and fragile. Eventually new competitors in the market as well as Epsilon will capitalize on Beta’s problems and begin to take their market share.

Companies like Beta Electronics that gorge themselves on offshore outsourcing services driven only by labor arbitrage are unable to support an innovation program, because the cycle of taking labor arbitrage profits to the bottom line versus reinvesting in transformation is a cycle that is hard to break. Once the labor imbalance begins to dissipate at Beta Electronics, the arbitrageurs generally will have left the building as well, and are often replaced with corporate managers that must quickly innovate with limited investment budgets, or watch their companies die in the face of rising operating costs no longer counterweighted by arbitrage reward.

Our collective expectation as a free market society is that successful business people will innovate whenever possible. Society expects good leaders to destroy processes, organizations, and even disband workforces as necessary to create new and improved processes, organizations, and workforces through innovation.

Innovation is the underlying agreement between governments, corporations, investors, and workers in a society that values a free-market economy. In this environment workers are willing to risk becoming temporary casualties of the innovation process. Workers in free-markets have come to expect that income stability is related to the efficiency of the processes, and the health of the businesses that they support with their labor. Innovation flushes out less efficient work and replaces it with the latest and most efficient process. This most often translates into less overall labor cost in the newly innovated process, but generally more valuable and more stable work. Workers also expect that their governments will regulate as well as provide incentives for innovation in order to stimulate and support the Innovation Agreement. Unfortunately, the impact to US workers as a result of offshore labor arbitrage indicates that workers have been the only party supporting the agreement in recent years. With notable exceptions, many companies have turned their backs on the implied agreement, urged on by Wall Street, and enabled by a pro-arbitrage government that has instituted ever-tightening, immigration laws that make it nearly impossible for a foreign-worker to become a productive, tax-paying, US citizen. Contrarily the US government has not only eliminated barriers for a company to send all of its jobs offshore, but they have created eliminated incentives promoting onshore research and development.

At the extremes the Innovation Agreement is the labor compact that supports the Capitalist Agenda while the abrogation of the Innovation Agreement is the catalyst for a Socialist Agenda. Workers and Investors are the trusting party in the Innovation Agreement. When workers feel exploited their only recourse is to become involved in controlling the business through Labor Unions or in the extreme gain control of the government to up-hold the tenets of the agreement. Investors (e.g. shareholders), are the other party that cannot directly control the Innovation Agreement, but are a party to it. Generally investors describe a long-term focus as an important distinction of a healthy portfolio, but it is important for investors to not only reward long-term behavior, but penalize short-term behavior. While hedge funds often are described despairingly for destroying companies, the ability to identify opportunities to short-sell arbitrageurs can be an important hedge for the entire market. Penalizing bad corporate behavior early can shock a company and a board of directors into a more supportable long-term position.

The damage created by labor arbitrage in the global economy is not only in the developed economy that originates the arbitrage, but also in the developing economy that provides the low-cost workforce. The “Catch-22” for developing nations is that their success as a labor arbitrage destination eliminates the labor cost imbalance which created the opportunity in the first place. As the supply of labor tightens, wages rise, and the labor imbalance evaporates. These countries quickly exhaust the supply of cheap labor in their major cities like Manila in the Philippines, and must invest quickly in the stagecraft of labor arbitrage. The focus of investment becomes limited to outsourcing infrastructure (e.g. Telecom, Power, Roads and Office Building, etc.) less attention is provided to public works and infrastructure to support the population. An unpopular, but thoughtful reaction to the labor-rush in these countries would be corporate taxes designed to invest in long-term infrastructure that will be able to leverage the inertia created during the arbitrage-boom for the post-arbitrage bust. However, the mass unemployment in China and India in 2009 underscores the failure of most experienced governments to focus on the long-term.

As seen since the beginning of 2009, demand for offshore services plummeted. The work that was sent offshore is typically inefficient and tied directly to demand, and as consumer demand faltered in the United States, weak companies like Indian outsourcer Satyem was quickly brought low. Satyem’s CEO was hiding their financial weakness from his board and investors by attempting to stay one-step ahead of labor market equilibrium by constantly re-forecasting with new and more rural labor locations (e.g. market imbalanced). However, they were unable to survive the slightest decrease in demand. Their house-of-cards collapsed almost immediately, because their profit had become so dependent on providing labor arbitrage driven services. Unable to deliver any true innovation, they were abandoned immediately by their arbitrageur clients as soon as demand began to falter. While the potential impact of labor arbitrage may have been a redistribution of wealth, and a global expansion the middle-class, this positive impact may be as temporary as the labor imbalance that fueled it. As Satyem has proven, too few, benefited too much, and very little true value was created.

In 2007, I attended a conference on Globalization where a well-spoken gentleman from India politely told the room full of business executives primarily from North America and Europe that it was inevitable, if not pre-destined that the future order of the world will be China first, India second, and the United States third, with Europe falling off the list to 5 or 6. While we would all agree that the expansion of the global middle-class is one of the most exciting events of our generation, it was appalling and obviously bad math that the formula had a zero-sum, where the GDP of the United States and Europe must be ground-up and fed to China and India in terms of manufacturing and services.

The billions pumped into offshore labor arbitrage over the past 25 years will contribute to eliminating the great economic imbalance between those countries and the developed world. However, it is not clear that the impact will be long lasting. The middle class in these countries are still a minority of the total population and the public services and living conditions are not in balance with the developed world.

Equilibrium and self-interest is inescapable, and it is simply not sensible to believe that the developed-world will be so complacent as to not awake from their unbridled self-interest in short-term profits before they are economically strangled. Like a bartender flashing the lights at closing time to signal his drunken patrons that it is time to go home, the economic downturn of 2009 has signaled the beginning of the end to the offshoring boom. The United States and Europe are beginning to awake from their stupor as quick profiting arbitrageurs are being replaced by stalwart corporate managers focused on real value and innovation. Unraveling the aftermath of twenty years of short-term profit taking won’t be as simple as the technology boom of the 1990s.

A long-term solution will require a holistic approach to both process and technology innovation. Technology will be a key part of the equation, but corporate executives will need to become innovators (e.g. risk takers) again, supported by their shareholders, stimulated and provided incentives by their Government, investing in transforming their operations.

Adam Smith, 1776, An Inquiry into the Wealth of Nations, Book 1, Chapter 1