ISIC 4 and its application rules, including the example of outsourcing 1

ISIC 4 and its application rules, including the example of outsourcing 1 Introduction This paper continues the series dedicated to extending the contents of the Handbook Essential SNA: Building the Basics 2. The aim of the series is to treat topics in the Handbook in more detail. Also, it can include topics not in the Handbook, but related to it. The choice of such topics will be based on feedback from users of the Handbook, if available. The aim of this paper is to explore the use of classifications in National Accounts (NA). The previous paper in this series 3 initiated this by looking at the international industry classification ISIC 4 in the light of the Statistical Business Register (SBR). In particular, we looked at the top-down method used for classifying enterprises by ISIC 4 activity. Here we want to continue this exploration by treating the case of outsourcing in some detail. Outsourcing involves the transfer of part of the production process from one institutional unit to another. This second unit can be located either in the same country or in another. It is the latter case that has received wide media attention in recent years. Increased outsourcing of industrial production from developed to developing countries is of growing concern to many. Although this trend has existed for many years, it seems to have accelerated and extended beyond the manufacturing sector to services and higher-value activities. The process is driven by competitive pressure on companies to enhance productivity and reduce costs. Both the specification of the top-down method and the treatment of outsourcing make use of the so called application rules of ISIC 4. In this paper we also include a brief discussion of ISIC 4 as an example of a hierarchical economic classification. The review given here builds on the material on classifications presented in the Handbook, in particular section V.1.2.3 on main classifications, the part on ISIC 4. The paper is organized in three sections. First, we look at ISIC 4 as an example of a hierarchical classification. Next, we review the application rules for ISIC 4. Finally, we treat the specific application rules for the case of outsourcing. ISIC 4 as an example of a hierarchical classification National Accounts is all about classifying data from different data sources into a common framework. This framework is determined by the system of classifications given in the SNA. Data are numbers, but numbers in isolation have little meaning. A classification labels the number along a particular dimension. For example, the number 1000 could mean anything. We have to specify what it stand for. The first step in this specification is the determination of the relevant dimensions. SNA is a 1 This paper has been prepared with the technical assistance of DevStat Servicios de Consultoría Estadística in consortium with ICON Institute. 2 Henceforth called the Handbook ; it can be found at the following link: http://epp.eurostat.ec.europa.eu/portal/page/portal/product_details/publication?p_product_code=ks-ra-11-002 3 The Statistical Business Register from the National Accounts Perspective 1

systematic treatise on transactions between institutional units, so it comes as no surprise that the first two dimensions are transactions and institutions. For each of these dimensions SNA specifies a particular classification. For transactions the classification consists of a few main categories: productive transactions (P), distributive transactions (D), capital transactions (K), financial transactions (F). Since classifications are international, they are specified in terms of coding systems, employing codes that are made out of letters (usually in combination with numbers), such as P for productive transactions. Each of the major categories is further subdivided into smaller items. Productive transactions consist of output (P1), intermediate consumption (P2), etc. Similarly, at the next level, items are further subdivided, e.g. P1 consists of P11, P12, P13 for different kinds of output. For institutions SNA specifies another classifications, consisting of two main parts: S1 for the domestic economy and S2 for the Rest-of-the-World. S1 is further subdivided into S11, S12, etc. for the main types of domestic institutional units, for a number of levels deep, a level being determined by the number of digits in the classification code. So our number 1000 along the transaction and institution dimensions can now be coded, e.g. as market output (P11) for non-financial enterprises (S11). But the number 1000 is still ambiguous. We have to further determine its meaning by investigating other relevant dimensions. Output is defined in terms of production processes. Production is defined in terms of the creation of goods and services, for which we have another international classifications, the Central Product Classification (CPC). More important here is the fact that output of goods and services for institutional units takes place in particular economic sectors, called industries, grouping units involved in similar productive activities. So, once more, we need a classification to label our number 1000 in terms of activities. Here SNA prescribes the classification that we want to focus on in this paper: the International Standard Industry Classification (ISIC), current being available in version 4. As we already explored in the previous paper, ISIC 4 is a strict hierarchical classification. The classification codes are given by numbers, consisting of four digits. The 2-digit code 21 is the parent code for 3-digit codes 211, 212 and other codes having at the first two positions the digits 21. The level is determined by the number of digits. ISIC recognizes four levels, the last three being: the 2 digit divisions, the 3 digit groups and the 4 digit classes. There are no 1-digit categories. Instead, ISIC uses letters at the first level, known as sections 4. Each item at a particular level serves as total item for all items at lower levels (such as 21 being the total for 211, 212, etc). This hierarchy is given in terms of a tree structure, with the smallest branches (4-digit classes) growing out of a bigger branches (higher levels) which ultimately go back to a small number of main trunks (letter sections) 5. The first level sections can also by totaled by one label, all activities, which is then the parent item for all sections, and which constitutes the root of the tree 6. Now that we have identified the four main classifications for NA we can specify our number 1000 as follows: output (transaction P11) on cloth of a particular make and quality (CPC code) in textile 4 Thus enabling to include 26 possibilities (A Z), instead of only 10 which a numerical digit allows (0 9) 5 There is an example in the previous paper: The Statistical Business Register from the National Accounts Perspective 6 ISIC is a true hierarchical classification in the sense that there is a single root (all activities). This is also true for CPC (all products). In both cases, the value for this root item for particular transactions (such as output) makes sense. In the institutional classification in SNA, the root item all institutions, consisting of S1 and S2 together, is not very meaningful (there are no meaningful transactions at this level). Similarly, it does not make sense to speak about a single root item for the transaction classification, consisting of all P, D, K and F transactions. 2

production (ISIC 4 code) for non-financial incorporated enterprises (institution S11). We can identify additional dimensions, such as regions (for which special regional classifications exist) and valuations (to distinguish between e.g. basic and purchaser prices). Also we want to have a temporal dimension so that we can label our number for a particular time period (the classification hare is the standard calendar, usually consisting of years and quarters). Exactly which dimensions we need to incorporate in this multi-dimensional classification coding of data depends on the particular NA analysis we are interested in, and can be different in the various parts of NA 7. The point here is that from the perspective of a particular classification such as ISIC 4 it is immaterial which other dimensions are recognized and which particular classifications are used for them. Application rules for ISIC 4 The central concept around which ISIC 4 revolves is the activity concept. In ISIC, the expression activity is used to identify productive activities. These activities are defined as the use of inputs (e.g., capital, labor, energy and materials) to produce outputs. The outputs that result from undertaking activities can be transferred or sold to other units (in market or non-market transactions), placed in inventory or used by the producing units for own final use 8. Whereas some activities are simple, taking a few inputs and converting them to single output, many activities can be complex, involving two or more outputs. Hence, we can differentiate between one main or principal output and a number of secondary outputs. These secondary outputs can of course be main outputs in other activities. The distinction between main and secondary output depends on the demarcation of the statistical units for which the outputs are measured. So in order to apply ISIC we need to be clear on the choice of statistical units. This was the subject of the previous paper in this series, where we explored the Statistical Business Register (SBR) as central repository for statistical units. The important point here is that there are two issues involved: the formulation of the ISIC coding classification around the dimension for the activity concept and the application of the coding classification to a framework for statistical units as given in a particular SBR. In the remainder of this paper we will look at this latter issue. In fact, we have already explored many of the application rules for ISIC 4 in the previous paper. We looked at the treatment of mixed activities: since a unit can carry out several activities, rules are necessary to identify the primary activity of a given unit. The application and impact of these rules depends strongly on the selection of units. In particular, we looked the top-down method and the cases of horizontal and vertical integration in the previous paper. Here we want to explore another application rule for ISIC: how to assign the correct activity codes for the case of outsourcing. Outsourcing Statistical units may sell goods or services under their own name but the actual production, such as the physical transformation process in the case of manufacturing, may be carried out fully or in part 7 For Supply-Use Tables we do not usually need institutions; for Integrated Economic Accounts we do not need products; in Regional Accounts we do need the regional breakdown, etc. 8 UN Statistical Papers, Series M No. 4/Rev.4 (2008), para 55 3

by others through specific contractual arrangements. This section describes how units involved in such arrangements should be classified in ISIC 4 9. First let us introduce some terminology. The principal is a unit that enters in a contractual relationship with another unit (here called contractor ) to carry out some part (or all) of the production process; the contractor is a unit that carries out a specific production process based on a contractual relationship with a principal. The activities performed by the contractor are denominated on a fee or contract basis. Outsourcing is a contractual agreement according to which the principal requires the contractor to carry out a specific production process 10. In this context, the production process may also include supporting activities 11. The principal and the contractor may be located in the same economic territory or in different economic territories. The actual location does not affect the classification of either one of these units. Outsourcing can take many forms. First, there is outsourcing of labor, where companies provide only the labor force to their clients, which in turn may have little or no employment of their own. Next, the principal may carry out the core production process, but may outsource certain support functions, such as cleaning or computer services, to the contractor. These support functions are not part of the core production process, but support the general functioning of the principal as a production unit. Next, the principal may outsource a part of the production process, but not the whole process, to the contractor. The principal owns the (material) inputs to be transformed by the contractor and thereby has ownership over the final outputs. Finally, the principal may outsource the complete production process, either by the outsourcing of service producing activities (including construction) or by outsourcing of manufacturing activities. Which criteria should be applied to classify a principal that markets goods under its own name, but has the manufacturing process of these goods outsourced to another unit (either within or outside the economic territory)? There are different approaches possible. One possibility is to take ownership of the physical input materials as determining factor. If these are owned by the contractor then this is the unit to which the classification rules should be applied. Other possibilities are to look at the production process or the output. The ISIC 4 application rules state the first criterion as the determining one, i.e. ownership of input materials. The motivation for this is usually stated in terms of risk. To take the risk of manufacturing, you need to have a liability in this process, which is the case if you have bought the input materials. Just having the knowledge to produce something is not sufficient. Contractors, i.e. units carrying out an activity on a fee or contract basis, are usually classified with units producing the same goods or services for their own account. The classification of principals is a bit more complex. Let us first look at manufacturing. The principal provides the contractor the technical specifications of the manufacturing activity to be carried out on the input material. The input material (raw or intermediate good) can either be provided (owned) by the principal or not. According to the ISIC 4 application rules a principal who outsources only part of the transformation process is to be classified into manufacturing, whereas the activity of a principal who completely outsources the transformation process should be classified into manufacturing only if he owns the 9 Ibid. para 136 145 10 The terms subcontracting and offshoring are sometimes used as well. 11 These are the ancillary activities as discussed in the previous paper on the SBR 4

raw material used as input to the production process (and therefore owns the final output). In this case the manufactured good is the output of the principal and the contractor provides a manufacturing service. In all other cases the manufacturing is done by the contractor and the activity of the principal should be classified in Section G "Wholesale and retail trade" (according to the type of operation and the specific good sold). In this case the principal buys the good from the contractor and re-sells it without transformation. For services, there is no corresponding separation of production and trade. Hence, if the whole process involved in service provision is outsourced, both the principal and the contractor are classified to the same ISIC class. If only a portion of the process is outsourced, the principal remains classified as if it were carrying out the complete process. If a separate class exists for the outsourced portion, the contractor is classified to that portion, otherwise to the same class as the principal. In the case of wholesale trade, there is a special class 4610 for the contractor (Wholesale on a fee or contract basis). For the outsourcing of support functions like cleaning and computer services, the principal is classified as if it were carrying out the complete core process. In other words, support functions do not influence the classification of a unit. The contractor is classified to the specific support function it is carrying out. For the outsourcing of employment the principal is classified as if it were operating with own employees. The contractor is classified to ISIC 7820 (Temporary employment agency activities) or 7830 (Other human resources provision), depending on the type of contract. We can summarize the above application rules in the following diagram: 5

Outsourcing Principal Contractor Services Classify as if carrying out the complete process itself Manufacturing If Wholesale trade: Classify in ISIC 4610 Completely outsourced Owns inputs Remains classified in manufacturing (ISIC Section C) Does not own inputs Classified as wholesale/retail trade (ISIC Section G) Partially outsourced Remains classified in manufacturing (ISIC Section C) Other Classify as if contracted activity was carried out for own account Employment Classify in ISIC 7820 or 7830 Figure 1 ISIC 4 application rules for outsourcing Concluding remarks In this paper we explored in some detail the ISIC 4 classification. This classification is important in NA because it classifies statistical units according to their main activity. In the previous paper on the SBR we approached ISIC 4 from the perspective of statistical units; in this paper we did so directly from the core concepts involved in ISIC itself. Either way, the key point is that applying ISIC 4 to practical cases involves making certain choices, there being more than one course of action possible. To ensure uniformity in making these classification choices, ISIC 4 has a number of application rules. We looked at the top-down method in the previous paper, and at outsourcing in the current paper. Having devoted individual papers to statistical units and to classifications, we have explored some of the foundations on which NA compilation rests. In the next paper in this series, we will start investigating in some detail the NA compilation processes themselves. To find out more Essential SNA: Building the Basics (2010 edition), International Standard Industrial Classification of All Economic Activities Revision 4, UN Statistical Papers, Series M No. 4/Rev.4 (2008) 6