Labor Arbitrage and the Cost Differentials of Outsourcing

Labor Cost Differentials to Consider When Outsourcing and Offshoring

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Labor arbitrage is often associated with outsourcing or offshoring. The idea is that a certain set of skills (e.g., a mathematician with five years of experience) could be hired in a different market, such as another city, region, or country for less. The difference in labor costs is an incentive to reevaluate the position's geographic location, whether in the same country or to a global market.

The term labor arbitrage comes from a financial concept that refers to identifying the cost differential between two similar or identical products or services in two or more markets and capitalizing on the difference in cost. For example, financial traders will buy the rights to a million tons of wheat in one state where the price is slightly low and sell it in another state where the price is slightly high.

Likewise, if an employer has $10,000 to spend on labor cost, the decision to outsource the labor for $5,000 is far more appealing than keeping up with the rising cost of wages that may require the employer to pay $12,000 for an employee with identical or similar capabilities.

Using Labor Costs to Justify Outsourcing

Labor cost differentials also may affect an employer's decision to hire an employee with less or even more expertise for the role in that particular region. The cost to employ a New York-based mathematician with 10 years of experience for an entry-level or mid-range position is likely more than the cost to hire a recent college graduate in Oklahoma City, who has the basic skills and aptitude necessary to perform the job duties.

However, in the real world, the arbitrage of labor is not the same as the arbitrage of agricultural or manufactured goods. For example, each of a batch of 1,000,000 ball bearings might be essentially identical. However, each member of a team of financial analysts in Paris will have their strengths and weaknesses.

If their work were given to a team in Berlin, even if that team had similar qualifications, the results would probably be somewhat different. If the work were instead given to a team in India with good (but different) qualifications, the results would differ even more.

Factors That Affect Outsourcing Decisions

The lack of certainty in labor arbitrage can be mitigated a number of ways. If the outsourced labor is less expensive, you can hire some or all of the teams with individuals with higher credentials than the team they replace. Alternatively, you may be able to hire additional team members or managers. Each option has a cost that must be part of the calculation for labor arbitrage benefits.

The benefits and disadvantages of labor arbitrage should take into account indirect costs associated with outsourcing, such as expenses related to managing the outsourced positions, and employee benefits cost in the newly selected region or market.

For example, labor costs might be lower in a particular region due to labor market availability, skills, and expertise of workers. On the other hand, the cost to insure workers, products, and equipment might be higher, thus offsetting the benefit an employer stands to gain from outsourcing work or sending jobs offshore.