Outsourcing

We outsource a number of functions, from help-desk technical support for our employees to the physical production of our software packages. It's far more efficient for many companies, including Microsoft, to have an outside company handle installations and support for desktop machines.

Bill Gates, At the Speed of Thought

Outsourcing is the practice of using third-party resources to perform functions and/or business processes. Virtually any process can be outsourced, from sales to product delivery. Industry experts have sized the global market for outsourcing in the trillions of dollars. The industry continues to grow as businesses recognize the value potential of this strategic alternative.

Types of Outsourcing

The rapid growth of outsourcing indicates a dramatic shift in how we think about our businesses. The management mind-set has changed from control to competence. The key to competitive strategy is now based on management of core competencies and not control over functions. As an example, management used to view having the entire IT function performed by a third party as absurd. Today, many companies outsource the majority of their IT functions. The rise in the cost of implementation and operation of largescale technology initiatives has fueled tremendous growth in the outsourcing industry. The need for new technology has outstripped the capabilities of many businesses. This has created a gap in both resources and risk. The intensive demand for human capital with knowledge of new technologies has far outstripped the supply of internal resources. Yet at the same time these systems become obsolete very quickly and require major enhancement to stay current with market conditions and business needs.

This trend does not strictly apply to technology. This concept has been extended to business-sustaining functions or business services. Many companies are assessing the viability of outsource arrangements for all general and administrative processes. For example, the finance, payroll, human resource and IT functions are now on the radar screen. Customer service is being outsourced by companies like Microsoft. Many medical insurance providers are contracting out many policy administrative functions as well. Many large firms feel that these functions are no longer a core competency and can be contracted to outside firms. In order to maintain a level of control, they are structuring contracts that involve equity stakes in the outsource provider. The early-stage sales process was never considered an area that could be performed by an outside firm. Now companies have recognized that early-stage sales is an expensive, low-probability process that is best done by a service provider to reduce risk and lower cost.

There are four main reasons for a company to get involved in outsourcing: 1) to increase strategic focus, 2) to improve processes, 3) to reduce costs, and 4) to share risks. In the past many managers have focused solely on cost reduction because it is the easiest to quantify; however, the potential value of the other types of outsourcing is equally compelling.

Strategic Focus

Keeping your sights locked on improvement is an essential part of strategic planning. Identification and execution of core competencies is essential to success. A core competency is a function or process that is critical to the success of a business. Outsourcing allows companies to keep up with best practices in other functions while remaining focused on core competencies. With outsourcing, businesses have access to highly skilled personnel without having to maintain a large staff. This is relevant in information technology. Application service providers (ASPs) develop, maintain, and enhance entire systems, giving clients freedom to focus on their business. This eliminates concerns about hardware/software upgrades, staffing, and training. What is the value proposition? A company's competitive position is improved by focus on what it does best.

Process Improvement

One of the prime reasons for hiring an outsourcing firm is that it can perform processes quicker, more skillfully, and less expensively than you can. Many outsourcing companies are specialists at specific functions. They will do a better job since they are strategically focused on specific tasks. Many companies have chosen to outsource their call center function because outsourcing providers have superior technology and highly trained staff. Since these companies have numerous customers, they can attain the critical mass to twenty-four-hour-a-day service. Customer service can improve because this is the sole focus of the service provider. The value proposition here is an improvement in competitive position through access to best practices and technology.

Cost Reduction

Many companies find it dramatically less expensive to outsource than to perform a function in-house. Companies can show an immediate reduction on operating costs that can be in the double digits. Outsourcing gives businesses the ability to use their partner's economies of scale. Operating expenses are reduced because the function can be performed at lower unit costs through outsourcing versus performing the function with internal resources. Reduced expenses improve margins as shown in Exhibit 2-9, where a company reviewed its value chain, which had costs of $450 million. The company determined that product delivery was not a core competency and decided to outsource this activity. The value proposition is highlighted by the curved arrow on the lower right side of the exhibit. Value is improved by improving profits by $30 million through cost reduction. Strategically, cost structure improvements enhance your competitive position.

Exhibit 2-9: Driving value through outsourcing.

Risk Sharing

If a function is outsourced, fixed costs are generally shifted to the service provider. The outsourcing company takes on the responsibility of location, equipment, and staff. In the case of a call center, the upfront technology costs alone can be prohibitive. This does not include staffing and maintenance fees and lost productivity from ramp-up of the operation. The outsourcing provider would assume part of the risks of building the operation based on a service contract. Competitive position is improved because the required investment is minimized.

Risks of Outsourcing

Despite the tremendous growth in outsourcing, the failure rate is quite high. "Dun & Bradstreet Barometer of Global found that 25 percent of all firms … report an outsourcing relationship failure within the past two years".^[3]

Productivity Gaps

A critical thing to remember is that outsourcing is a change in the way you do business. When things change, there is an interim adjustment period that requires significant attention. If this period is not managed correctly, the initiative can fail quickly. With this in mind, the outsourcing contract will specify a learning curve and take over. For example, a company may have outsourced to improve customer service. However, service levels may get worse if the transition process is ill defined. While expense reduction may have been the goal for outsourcing of processes, transition costs would offset initial cost reductions. The risk lies in not containing costs and process burdens within budget and in forecasted time frames.

Process Fit

A business is at risk when outsourced services do not fit tightly into its business model. The looser the fit, the higher the risk. If there are gaps in processes or services, business results may suffer. In an outsourced call center, for example, the customer should not know that they are being served by a third party. The customer experience should be focused on needs and not providers. If the customer's needs are not met, the result may be loss of sales, declines in customer retention, and a loss in competitive position.

Loss of Control

Some companies are reluctant to give up what they believe to be control over some aspect of their business. When a process or piece of the business is performed by a third party, there is less input on how the work is performed. In addition, it may take longer to resolve problems if the function is being performed off-site. Companies that require tight control of the customer experience may find outsourcing too risky for certain functions.

Exit Barriers

Outsourcing leads to limited commitment of internal resources to a process, function, and or infrastructure. The risk is that the business does not have the capacity to perform the function, leaving the firm at the mercy of the service provider. If the outsourcing effort fails, then the company will be forced to find another service provider, or rebuild the competency internally. Fixing the problem then requires unraveling the outsourcing relationship. This, in turn, may cause a disturbance in day-to-day operation of the business. The result will be increased costs from productivity loss and from transitions to new providers or internal capability. Going back to our call center example, it is not simple to turn off the switch on customer service capabilities. Where will the company find the trained staff to service your customers? How would it acquire technology to enable the operation? Can it deploy the business processes to effectively service your customers? What will the impact be to customer retention and sales?

Summary: Outsourcing as a Strategic Alternative

Outsourcing creates value through increasing strategic focus, improving processes, reducing costs, and eliminating risks. Outsourcing gives firms the ability to focus on their core competencies, leaving non-value-added activities to the outsourcing provider. Processes have the potential to be improved because outsourcing providers specialize in performing these services at a lower cost. Risk can be mitigated due to reduced investment levels and elimination of operating expenses. This makes companies more productive in weaker markets as they will have a lower cost structure. The risks of outsourcing include loss of operational control, process fit, loss of productivity, and exit barriers. Outsourcing is truly a partnership. Deriving value from a partnership requires effort from both participants. Businesses that consider outsourcing must be prepared to commit significant time and effort in making the relationship successful.

^[3]Michael F. Corbett & Associates, Ltd., http://www.firmbuilder.com/articles/19/48/388/.