Outsourcing: An Executive Dilemma
by Louis M. Scarmoutzos, Ph.D.

A question often asked by many senior managers and executives is whether todevelop proprietary products in-house or to outsource the effort. This questionmay be answered quite simply in many situations by asking the following basicquestion: "Do we have the resources to develop these productsin-house?" Obviously, if the appropriate resources are lacking, thesolution is to outsource product development. The decision is less clear inthose situations where you have the resources and can either contract the workout or develop the products in-house.

The Pros and Cons

Some of the advantages of outsourcing include ready access to technology andexpertise, flexibility, costing and additional contacts. Outsourcing oftenprovides a company with technology and expertise that the company needs but isunwilling or unable to invest in. This technology can be "breakingtechnology" (or resources) to which the company might not have access, orit can be technology (or resources) in which the company is simply not yetwilling to invest.

It is often more economical for a company to outsource its productdevelopment activity. This can be due to either the capital expenditure involvedwith the project or simply the lower costs associated with hiring an outsidecontractor.

Outsourcing provides a company with a great deal of flexibility. It allowscompanies to utilize in-house capabilities to their fullest potential withoutdisrupting their on-going schedule and tap into outside sources for additionalcapacity. This additional capacity may be used to broaden the product base orsimply to test "high risk" waters.

Independent contractors and consultants usually have their own network ofcontacts and "spheres of influence" which they have built over theyears. Outsourcing can provide a company with ready access to this additionalskillbase.

The major disadvantages of outsourcing product development include loss ofproject control, potential tax impacts, and less than full utilization ofin-house resources and capacity. Many companies are uncomfortable with the lossof control that results from outsourcing and feel that they must control theeveryday product development effort. Additionally, companies are concerned thattheir proprietary information may become available to third parties orcompetitors.

Companies may lose certain tax breaks and benefits if they outsource theirproduct development efforts. Product development efforts that require capitalexpenditures or that might involve R&D may have very different taxconsequences and benefits if conducted in-house or are outsourced to independentcontractors.

Outsourcing may not fully utilize the existing product development potentialand capability of a company's own in-house resource base and capacity. In-housedevelopment of new products and technologies may also yield "hidden"or serendipitous developments. Yet in today's "lean and mean" economy,most companies no longer have the luxury of additional capacity. Productdevelopment would most likely come at the expense of other income-producingendeavors.

The decision to outsource can be a difficult one, particularly when a companyhas the resources to develop the products in-house. However, not all of theproduct development effort and tasks need to be outsourced. A compromise mightbe to outsource only certain portions or tasks of the development effort thatpromise the best advantage if outsourced.

Several issues need to be addressed once a decision to outsource productdevelopment has been made. In addition to the obvious issues regarding"deliverables" and compensation, there are important issues regardingproprietary information, intellectual property and contractor status that shouldbe addressed. Professional counsel and legal assistance may be desirable andoften necessary, particularly as it pertains to contracts and agreements.

The issue of proprietary information can often be and is easily addressed byuse of a Non-Disclosure Agreement. There are many standard"boilerplate" agreements that will usually suffice. IntellectualProperty (IP), which consists mainly of patents, trademarks, service marks,trade secrets and copyrights, can be addressed by a Product DevelopmentAgreement, which explicitly incorporates ownership or assignment of any and allIP developed or discovered by all parties involved in the product developmentefforts.

Often during the outsourcing of product development, positive, lastingworking relationships develop between the company and contractor. In thesesituations, which usually evolve with time, the same contractor is chosen andused regularly as an outside, independent contractor. This is most often a verygood thing since it is derived from comfort and trust.

However, the company needs to be cognizant of the differences between theoutside contractor and what the government may potentially classify as an"employee"--temporary or permanent. The classification of a"contractor" as an employee vs. an independent contractor has verydifferent consequences as it relates to taxes (both state and federal) as wellas to how it relates to company entitlements vis--vis benefits andcompensation.

If you often hire outside contractors for product development work, you maywant to do several things. First, have all of your independent contractors signan Independent Contractor Agreement that explicitly addresses the issues andcriteria that the government uses to classify "employees". Second,amend your company benefit plans to exclude "temporary employees" fromcoverage, thereby allowing for the classification of contractors as employeeswithout having to suffer additional coverage costs. Again, you may want to seeklegal and professional counsel regarding these issues.

Finally, once outsourcing is decided--in part or in whole--two key factorswill dictate the successful outcome of all of your present and futureoutsourcing efforts: the development of mutual trust and respect amongst all theplayers, and being able to work together as a team--in other words, the"chemistry" must be right.

Louis M. Scarmoutzos, Ph.D., is president and founder of MVS SolutionsInc., a consulting firm that provides business and technical assistance tocompanies in the natural products and related industries. He can be reached at [email protected]or at (617) 283-2182.