Outsourcing is taking a function or activity previously or typically done in-house and farming it out to a supplier. Imagine that your are a small business selling home made muffins to independent coffee shops. You get to the point where you need someone to handle payroll, but you don’t have enough work to justify a full time accountant, and so you “outsource” by hiring an accounting firm that handles payroll and taxes for you. You might also grow to the point where you really needed a second delivery van, and didn’t want to invest in one, and might “outsource” delivery to a courier service to focus your business just on making the product. Imagine your muffins became really popular and your business went national. Would you want to develop staff and facilities to handle processing orders by phone or would you want to save money by hiring a company in India (offshore outsourcing or “offshoring”) to do it for you?
Outsourcing is when a firm buys some of the products or services that it needs to make its own product from other firms instead of producing them within the company. (Please note that people often confuse outsourcing with offshoring, which is the practice of outsourcing to companies in other countries. Offshoring is one kind of outsourcing, but a firm can outsource within its own country.)
For example, an auto manufacturer obviously needs glass windows and windshields for the cars it produces. The company could have a department that makes these kinds of glass. Alternatively, it could buy the glass from another company. If it buys from another company, it is outsourcing.
Outsourcing is typically seen as a good way to cut costs, but it can also come at the expense of efficiency. The firm has to rely on an outside firm to provide it what it wants. This may not be as easy to do as it was when the firm was making its own (in the example above) glass.