By: Nima Heirati

 

Many companies who have tried outsourcing view it as a difficult process that does not often end as initially planned. Indeed, the failure rate for outsourcing relationships remains incredibly high. In a recent Deloitte Consulting survey, One-quarter of the companies had brought business functions back in house after realizing that they could do the work themselves more successfully and at lower costs. Forty-four percent of the companies surveyed reported that outsourcing didn’t save any money, and nearly half identified hidden costs as the most common problem when managing outsourcing projects.

Hence, though initially motivated to outsource in order to cut costs, simplify projects, and tap expertise not found in-house, many companies learned that unexpected complexity, lack of flexibility among outsource providers, and other unforeseen problems added costs as well as friction, ultimately translating into higher total costs than originally anticipated.

 

Outsourcing Problems

In May of 2006, InformationWeek surveyed 420 business technology professionals. In that survey, participants were asked to rate services provided by their outsourced vendors in a number of categories on a scale of 1 to 10. Respondents were only reasonably satisfied with their vendors’ performance and generally disappointed with the cost-for-value of the service. When referring to failed outcomes, %45 attributed failures to poor service and lack of flexibility, and %39 pointed to hidden costs as a serious problem.

What are the “hidden costs” of outsourcing? The costs of identifying and specifying the functions in a business that ought to be outsourced can be expensive, especially if a company relies on the services of outside consultants to do the evaluation. The real hidden costs that most often adversely affect the bottom line, however, are in the transfer of knowledge and scope of work along with the costs of ongoing management of the outsourcing relationship.

The customer is seeking to procure a good or service at lower costs than it would incur with in-house production. However, the vendor wants to make a profit. This tension between the buyer’s wish to buy at a low price and the seller’s wish to sell at a high profit margin means that the relationship must be designed carefully in order to ensure a successful outcome for both customer and vendor. As a consequence, if the activity outsourced is difficult to scope, define, bound or monitor, then what the buyer may seek and what the vendor delivers are neither aligned nor easily described, leading to an imperfect contract for which neither party’s expectations are adequately accounted.

The decision to outsource an activity should begin with a straightforward cost-benefit analysis that quantifies all the relevant costs associated with the prospect of outsourcing a function and weighs them against the projected benefits from having that function produced outside of the company’s control.

 

Systematic View

Once such a sound business analysis is completed, an operational framework for analyzing strategic sourcing decisions can be made on an informed basis, exploiting the opportunities from outsourcing and off shoring by using a systematic method.

The framework proposed here argues that any activity can be viewed either by considering the function that it performs or by considering what inputs are used to create it and how these inputs need to be managed. A company has to decide between buying the function, or output, versus buying and managing the inputs, the latter including capital and labor. Hence, the celebrated “make-or-buy” question can be thought of as a “buy-or-buy” question, where the refined question is what to buy, function or inputs, and how to manage the deal.

The relative advantage of outsourcing as compared to in-house production is cost-savings associated with the procurement of well-defined functions and enforcing adequate delivery by the outsource vendor using a well-defined contract. This means that both the complexity of the function and the need to adapt the function over time will put a strain on the ability of a company to outsource an activity. Thus, the framework offers an operational method for evaluating the hidden costs by which so many companies have fallen prey to disappointment. The framework further provides a method for evaluating the costs and projecting the benefits of employing external markets to procure needed goods and services.

 

Tips for Success

Outsourcing is broadly applicable across industries. Realizing that every activity (or transaction) serves a function is the first step towards effective procurement. Realizing that the ease of contracting for the delivery of the function will affect the effectiveness of outsourcing is the second step needed to identify activities that are good candidates for outsourcing. The key driver is determining how difficult it is to develop terms in a contract that adequately cover the function-activities required to fulfill the function over time. The more difficult to prescribe, then the less likely outsourcing will be the right choice.

In brief, here are several “tips for success” to assist a company’s executives in making informed outsourcing decisions, optimally leveraging use of the global market economy to a company’s advantage:

Reasons-Good reasons for outsourcing are looking for cost-effective deals, reducing distractions for non-core activities thus increasing core activity focus, and keeping fluctuating capacity outside the company.

Timing-Analysis of the company’s direction over time provides a basis to distinguish core from contextual activities. Using outsourcing to drive the innovation of the company’s procurement structure means that it is important to recognize the need to outsource early ahead of the competition.

Contract-Having a well-defined contract is paramount. Clearly define expectations, responsibilities, and activities on both sides up front, and make sure to have good evaluation systems to measure outcomes.

 Accountability-Ensure that every contractible action has an accountable entity, and define the relationship clearly-who’s responsible for what, and what gets done cooperatively. When possible, build penalty and performance clauses into contracts, and share both risk and rewards to provide ample and aligned incentives to do the job effectively and efficiently.

Life Cycle-Be mindful of the project’s life cycle. If up-front transition costs are very high, a longer contract is needed to benefit from reduced long-run costs. However, longer-term contracts are more likely to require changes and adaptation, which often increase costs dramatically. It is therefore necessary to fine-tune the scope and the length of the contract to maintain balance between the contract length and the potential needs for flexibility.

Selection-If you know what you want, and have a solid contract in hand, using the market mechanism (competitive or invited bidders) will be best. Use a network of other companies who have experience in outsourcing similar activities to help identify qualified vendors.

 

To sum up, sourcing can prove to be a valuable tool in the arsenal of innovative business leaders who wish to create value and, in the case of public companies, increase shareholder wealth. It is important to acknowledge, however, that the bottom line will be compromised if the so-called hidden costs of outsourcing are not uncovered and quantified, and the need for flexibility is not adequately considered and accounted for in advance. Following the framework and guidelines prescribed here will result in better business decisions for strategic sourcing.