Outsourcing And Its Effect on Value Creation

Outsourcing And Its Effect on Value Creation

Today we see every company trying to become a 𝙘𝙖𝙥𝙞𝙩𝙖𝙡-𝙡𝙞𝙜𝙝𝙩 𝙗𝙪𝙨𝙞𝙣𝙚𝙨𝙨, including capital-intensive businesses like manufacturing and auto OEMs. But unfortunately, most of these companies resort to contract manufacturing to take off their CAPEX in their balance sheet.

𝐃𝐨𝐞𝐬 𝐎𝐮𝐭𝐬𝐨𝐮𝐫𝐜𝐢𝐧𝐠 𝐢𝐦𝐩𝐫𝐨𝐯𝐞 𝐭𝐡𝐞 𝐯𝐚𝐥𝐮𝐞 𝐜𝐫𝐞𝐚𝐭𝐢𝐨𝐧 𝐨𝐟 𝐚 𝐛𝐮𝐬𝐢𝐧𝐞𝐬𝐬?

In my view, it need not, and sometimes it makes sense for companies to do their work in-house rather than outsource.

Let me substantiate by taking companies that outsource and do not and whether this decision adds value.

When a company outsources 100% of its production to a third party, it 𝗱𝗼𝗲𝘀 𝗻𝗼𝘁 𝗶𝗻𝗰𝘂𝗿 𝗖𝗮𝗽𝗲𝘅 𝗮𝗻𝗱 𝗱𝗲𝗽𝗿𝗲𝗰𝗶𝗮𝘁𝗶𝗼𝗻 𝗰𝗵𝗮𝗿𝗴𝗲𝘀, 𝘁𝗵𝘂𝘀 𝗿𝗲𝗱𝘂𝗰𝗶𝗻𝗴 𝗶𝘁𝘀 𝗶𝗻𝘃𝗲𝘀𝘁𝗲𝗱 𝗰𝗮𝗽𝗶𝘁𝗮𝗹. However, its operating expenses increase which would impact its margin. However, its ROIC is high due to low invested capital.

If ROIC>>WACC, the firm with Outsourcing might look attractive, but it is not. In my view, in such scenarios where invested capital is meagre, it is better to use 𝗘𝗰𝗼𝗻𝗼𝗺𝗶𝗰 𝗽𝗿𝗼𝗳𝗶𝘁 𝗮𝗴𝗮𝗶𝗻𝘀𝘁 𝗥𝗢𝗜𝗖 as a metric to evaluate a firm’s attractiveness.

For a firm that outsources, its WACC is slightly lower due to lower operating leverage.

𝐅𝐨𝐫 𝐅𝐢𝐫𝐦 𝐭𝐡𝐚𝐭 𝐨𝐮𝐭𝐬𝐨𝐮𝐫𝐜𝐞
ROIC = 88%
WACC = 6.5%
Invested Capital = $5 million
𝙀𝙘𝙤𝙣𝙤𝙢𝙞𝙘 𝙋𝙧𝙤𝙛𝙞𝙩 = (88%-6.5%)*5 = $4.08 𝙢𝙞𝙡𝙡𝙞𝙤𝙣

𝐀 𝐟𝐢𝐫𝐦 𝐭𝐡𝐚𝐭 𝐝𝐨𝐞𝐬 𝐢𝐭𝐬 𝐚𝐜𝐭𝐢𝐯𝐢𝐭𝐲 𝐢𝐧𝐡𝐨𝐮𝐬𝐞
WACC = 7.5%
ROIC = 16.29%
Invested Capital = $55 million
𝙀𝙘𝙤𝙣𝙤𝙢𝙞𝙘 𝙋𝙧𝙤𝙛𝙞𝙩 = $4.84 𝙢𝙞𝙡𝙡𝙞𝙤𝙣

I view outsourcing non-core activities to low-cost locations 𝗴𝗶𝘃𝗲 𝗳𝗹𝗲𝘅𝗶𝗯𝗶𝗹𝗶𝘁𝘆 𝗯𝘂𝘁 𝗱𝗼𝗲𝘀 𝗻𝗼𝘁 𝗮𝗱𝗱 𝘃𝗮𝗹𝘂𝗲, especially with other risks like supply chain and inflation.

Further, 𝗰𝗼𝗺𝗽𝗮𝗻𝗶𝗲𝘀 𝘀𝗵𝗼𝘂𝗹𝗱 𝗻𝗲𝘃𝗲𝗿 𝗼𝘂𝘁𝘀𝗼𝘂𝗿𝗰𝗲 𝘁𝗵𝗲𝗶𝗿 𝗰𝗼𝗿𝗲 𝗮𝗰𝘁𝗶𝘃𝗶𝘁𝗶𝗲𝘀 as it only creates dependency and not flexibility.