Outsourcing - A Strategy Whose Time Has Arrived
Michael G. Patton
Michael G. Patton, President & CEO, Corporate Strategic Services, Inc. Columbus, OH 43235, 614-760-9280, Pattonmg@aol.com.
83rd Annual International Conference Proceedings - 1998
Outsourcing has been with us for years in one form or another. A common form of outsourcing that has existed in manufacturing since Henry Ford's days has been whether a company should make vs. buy components of products they are building and selling. There are many myths, distortions and exaggerations which surround outsourcing both in the positive and negative. The one indisputable fact is that the use of outsourcing for acquiring non-core products and services is growing rapidly in both the manufacturing and service sectors. Additionally, outsourcing is now moving into many non-traditional areas that in the past would never have been outsourced as companies are striving to be more competitive in both the domestic and international market.
Issues cover by this paper include:
- Status of outsourcing today
- Products and services commonly outsourced
- Risks vs. Benefits to outsourcing
- Factors in selecting an outsourcing vendor
- Key elements to consider when implementing an outsourcing program
- Common problems to avoid when establishing an outsourcing program
- How to Implement and sustain an outsourcing program
Outsourcing Today. The outsourcing phenomenon that is currently occurring today is transforming many managers from providers, to brokers and facilitators of required services, products and functions. In the purchasing profession, we are evolving from buyers and contract administrators to sourcing managers and administrators. Today every commodity, service and function that has been traditionally purchased or provided by an internal function could be and is being outsourced. A 1996 survey conducted by Arthur Andersen and The Economist Intelligence Unit found the following:
- 93% of the companies surveyed plan to outsource in the next 3 years
- 90% of the companies currently outsourcing work are satisfied with the results
- Outsourcing is not just a process for large companies, companies with sales of less than $100 million to more than 5 billion responded the same
- 85% of the companies surveyed outsourced all or part of at least one business function.
Outsourcing is being used in a variety of ways by different industries. In the service sector, such as banking and insurance there is push to focus on their core competetcies and use outsourcing for many functions from outsourcing the entire IT function, couriers, mail services, security and many more. Other companies are outsourcing functions to alliance partners, where both companies eliminate non-core functions, but gain additional volume by performing work for their alliance partners. The common reasons companies are using outsourcing in addition to cutting costs is that they wish to focus more of their energy, resources and capital on their core competencies and by turning fixed costs into variable costs.
Benefits Achieved by Outsourcing. What are the perceived benefits provided to any organization that decides to initiate an outsourcing program? Listed below are just a few of the benefits to outsourcing which are offered as justification and rationalization to outsource:
- Improve efficiencyFocus on core business
- Improved cost flexibilityImproved quality of services delivered
- Accelerate reengineering benefitsIncrease service levels
- Function difficult to manageIncrease productivity
- Free resources for other purposesReduce staffing levels
- Reduce and control operating costs Use assets more effectively
- Access to world-class capabilitiesResources not available internally
- Cost savings over existingReduction in acquisition costs expense structures
- Ability to respond quickly to changing market conditions and technology
Risks in Outsourcing. There are risks to using outsourcing as a tool that should be considered prior to making a decision to outsource. Many outsourcing contracts are so complex that companies have hired consultants to evaluate proposals. Another problem is that some companies are now locked into long-term contracts with outside suppliers that are no longer competitive. Some of the more common and relevant issues to consider are listed below:
- Long term & inflexible contractsLoss of Control
- Transfer of assets and personnelTax liability
- Default RiskCost risk
- Difficult to disengage
Checklist of Supplier Selection Issues. In establishing an outsourcing program the single most key element is obviously the selection of the outsourcing company that will be providing those services, products or functions to your company. It is a very critical decision as once you have entered an outsourcing agreement and implemented the process, it can be extremely difficult and painful to extricate yourself from an outsourcing contract that fails. Listed below are several of the factors you should consider when selecting a supplier to bid on outsourcing, but the three most important factors in choosing potential outsourcers are reputation, existing relationships, and references.
- Supplier capabilities
- Cultural match between companies
- Additional value-added capability
- Scope of resources
- Flexible contract terms and conditions
- Company size
- Financial stability and staying power
- Industry knowledge
- Percentage of their overall business
- Has this company been involved in outsourcing in the past?
- Geographical compatibility
- References/reputation of outsource supplier
- Price of services
- Commitment to quality
- Past and current relationships
- Percentage of work commonly subcontracted
- Is outsourcing their core business
- Insurance and litigation history
- Commitment to outsourcing
Skills and Tools Required. When evaluating how, why, and when you should consider using outsourcing as a strategic tool, first inventory the skills you need to effectively develop, manage, implement, and sustain this type of program. What skills are necessary? The following list represents the "typical" skills required for most outsourcing programs:
- Contract development. In order to be successful in any formal program, one must have the ability to develop sound, competent, comprehensive contracts that fully protect the organization while being fair to the outsource provider.
- Contract administration. This is the most commonly overlooked and underestimated area when setting up an outsourcing program. To reach their maximum potential benefit, all contracts should be administered in a consistent and professional manner. In outsourcing, the significance of contract administration takes on a whole new meaning ( it will not be successful if the purchaser assumes a passive posture.
- Experience in cross-functional teams. When outsourcing, it's extremely beneficial if you possess the ability to form, participate, and lead a group of individuals with diverse backgrounds that are not as familiar with many of the strategies and processes commonly used in contract development and negotiations.
- The ability to manage relationships. The ability to effectively manage relationships requires the individual to suppress egos and give credit to others rather than themselves for providing a service more effectively or efficiently than they had been able to do in the past.
- Financial analysis. To determine the potential savings or additional or transferred costs and to develop an effective contract, you must first perform a financial analysis of all costs associated with the product being outsourced. This should be done in conjunction with a process flow analysis to ensure all costs related to the outsourced product/service are accounted for.
- Process flow analysis. Process flow analysis will ensure that all processes which are included in the acquisition of these products and services are accounted for and included in the development of the cost structure for outsourcing.
Tools. As important as the skills which are required to effectively make outsourcing decisions, the tools that purchasers can use when making these decisions are equally important and readily available. There are many tools one can use to help in this process which range from NAPM videos, satellite seminars, and publications to articles published in journals, Web sites, expenditure analysis, consultants, third-party training programs, and sourcing companies. However, the most beneficial tool to use is Expenditure Analysis.
Expenditure analysis will help you determine what potential opportunities exist for achieving cost savings by outsourcing. Use of this tool in conjunction with process mapping will provide you with the information you need to obtain prior to launching your outsourcing program. The process of considering all costs, tasks and functions associated directly with the outsourcing of a product and/or service is critical, as knowing this information will allow you to accurately structure your RFP, contract and any service level agreements (SLA) to ensure your success. Use of expenditure and process flow analysis will detail the following:
- How much you spend in total for any product or service
- What types of products you purchase and in what volume (detail)
- How many companies you currently purchase from
- Who is spending it (what departments, etc.)
Development and Implementation of Outsourcing Programs. Laying the groundwork for any outsourcing program begins long before any supplier is ever contacted. Success in outsourcing depends on having a clear vision, a defined corporate strategy, knowledge of what it currently takes to deliver the outsourced commodity, what service levels must be met and what it costs to meet them. Once you have identified the commodity or process to be outsourced, take the following actions:
1. Select your team. If you are outsourcing a complex product or service you should form a cross-functional team. The team leader is the key to the success of the project and normally this individual would come from the purchasing function. The other members of the team would be individuals that represent the product/service being outsourced and/or those affected by the product/service being outsourced.
2. Understand your cost structure. Using some of the tools mentioned previously, such as expenditure analysis and process mapping, will detail the costs involved in providing this product/service. Make a complete and detailed inventory of the various personnel, licenses, equipment, leases, facilities, and any other resources, assets, and contracts that are currently required to produce the item or perform the function which is going to be outsourced. Use metrics, benchmarks, and other tools to evaluate existing capabilities and costs of the function being outsourced. Be certain to include all conversion costs that will be associated with this function being outsourced.
3. Develop Service Level Agreements. The service level agreement (SLA) defines the level or amount of service to be performed. Meet with the internal clients that had provided this function and develop SLA's that define the nature of the services as well as performance measurements, quality levels, and other relevant metrics or key performance indicators (KPIs) and any transfer pricing. These results, when completed, will be incorporated into the Statement of Work. Include baseline performance measures and the formula for measurement.
4. Determine the length of the outsourcing contract. It's in the interest of the purchaser to negotiate a shorter-term contract that provides ample flexibility. Whatever the length of the contract, you should provide a reasonable exit of convenience in case the relationship becomes unmanageable.
5. Develop a Statement of Work. This is the most critical portion of any outsourcing agreement as it defines how the program will work, required SLAs, quality levels, hours of operation and performance, working conditions, services to be provided, performance measurements, and budgets. This document should specify exactly what, when, where, how, why, and by whom this function will be performed and the manner in which this performance will be measured.
6. Identify potential suppliers. Identify and conduct preliminary due diligence on all prospective suppliers before determining if you are going to outsource. Determine how many companies can provide the function you are planning to outsource, where they are located, and the geographic area they can support.
7. Identify internal resources. Identify all critical internal resources that will stay with your company after the function has been outsourced and who will help manage and administer the outsourced function.
8. Develop a strategic plan. Identify the long-term needs of your company for the function being outsourced and incorporate these projected needs into any outsourcing agreement. The need for developing a detailed strategic plan will vary based upon the spend and the critical nature of the products and services which are involved.
9. Determine which outsourcing strategy fits best. There exists a multitude of strategies and options, which range from "out-tasking" a single function such as PC Maintenance to turning multiple functions over to a sourcing company. It is important to review and consider which option(s) fit best for your current environment and will meet your long-range goals.
10. Develop a pre-qualification process. During this time, develop a pre-qualification form and have all potential suppliers complete it prior to determining your candidate list. This form should provide relevant information regarding the capabilities of any potential company to provide outsourcing services to your organization.
11. Facility inspections. Facility inspections of potential providers of outsourcing services should occur after your analysis of the pre-qualification forms has been completed. On-site inspections of their clients where the outsourcing company is providing functions should also occur, if allowed.
Upon completing all steps involved in the pre-selection and pre-qualification process, begin developing the request for proposal (RFP) for outsourcing this function. Your goal should be to create an RFP that is well structured and clearly defines what you wish to achieve. Developing a detailed, thorough, and formatted RFP will result in supplier responses that allow for comparisons from multiple suppliers.
Receive, Analyze, and Rank the Proposals. Your team should review and rank the proposals from the suppliers. The importance or weight of these issues will vary based upon the contract and your company's position. However the order of these items listed below are ranked based upon "typical" issues for these types of contracts. Construct a comparison chart or table to evaluate and compare responses on these key issues:
- The total cost of providing outsourcing for this function
- Escalation and de-escalation
- Performance requirements and response
- Asset valuation and disposition cost
- Hiring existing personnel
- Return of assets
- Change management
- Escape clauses and exit strategies
- Disposition of existing personnel
- Reference checks from existing customers
- License fees and transfers
- Ability to extend or renegotiate the agreement
- Transition planning and cost
- Damage limitations
- Dispute resolution process
- Ownership of assets
- Learning curve applications
- Return of files, data and proprietary information
- Non-competitive wage and benefit requirements
- Insurance and/or bonding of the outsourcer
Upon completion of the evaluation of the aforementioned items and subsequent ranking, develop and determine your negotiating plan and strategy for each potential supplier.
Negotiating. In negotiations, be sure to address the worst-case scenario: terminating the contract prior to its scheduled completion. Terminating a contract is the worst condition that can occur and is never easy, regardless of the product, service, or function involved. Your contract must define intermediate consequences for both parties so that terminating the contract is not an issue when minor problems occur in the relationship and in the supplier's performance of their responsibilities. To ensure this relationship is mutually beneficial when consummated, focus on the key issues detailed in the previous section, as these will impact the success of your program.
Measurement and Enforcement. What are the factors involved in successfully managing and sustaining your outsourcing program? The contract and statement of work specify the required service levels, performance expectations, penalties for non-performance, and termination clauses. Listed below are tips for success commonly suggested by organizations and trade groups such as the Outsourcing Institute.
- Objective performance criteria are negotiated, measured, and reviewed
- Formal relationship management structure exists
- Performance-based pricing is applied
- Internal combinations and training on business goals and relationship management are regularly conducted
- Provide training regularly on customer's business environment
- Cultural differences between organizations are understood and bridged
- Continuous exchange of knowledge and expertise occurs
Possible Pitfalls. As you progress into the relationship, this will be a question that is commonly asked by yourself and others who have been involved with or affected by the decision to outsource. Depending on how well you have or have not structured your outsourcing program, you may be suffering any one of the following problems:
- Nickel-and-dime syndrome - You are charged "extra" for every request or change you suggest to the outsourcing provider. These typically can be one-time charges or change orders, which permanently change the scope of the program.
- Inflexible conditions - These limit your ability to accomplish and support your changing business strategies and objectives
- Loss of control over your key information resources - You are no longer receiving the information you require to effectively and successfully manage your business or plan for future growth.
- Ineffective management of the outsourced function - You determine that the outsourcing provider is performing no better than you did in managing the outsourced function.
- Conflict of interest - The outsource provider is performing similar functions at multiple organizations and key resources are continually removed from your company to support and start-up new accounts, thus impacting the timely and successful performance of the function.
How can you minimize these problems? There are many things you can do to successfully manage the outsourced relationship. Some of these suggestions are detailed below:
Coordination. Coordination often determines the value of the relationship and needs to be done early on. To ensure successful coordination between your organization and the outsource provider, both parties should coordinate standards such as software, network protocols, and business processes such as procurement and customer service, shipping schedules, warehousing processes, inventory, and lead-times.
Single point of contact. Although the cross-functional team will move on to other projects, this does not mean that they are done managing the outsourced process. The contract administrator should become the point of contact that is responsible for coordinating with the supplier throughout the course of this agreement. It's essential that the contract administrator be available to manage this long-term commitment and should have adequate resources provided.
Accountability. Detailed Service Level Agreements and other performance measurements and indicators are critical to the success of the relationship. Outsourcing relationships should be dynamic in nature, allowing for the addition of performance indicators during the course of the contract, which reflect changing business requirements and therefore changing service levels. The documentation of the lines of accountability involved in the managing and coordination of the outsourced function are rarely done before the contracts are signed.
Continuous process improvement. At a minimum, you should have the same flexibility when a function is outsourced as you had when you performed this function internally. It's essential to have a continuous process improvement model included in your agreement to ensure the function's continued flexibility to respond to changes. One way to address the continuous improvement issue is to start benchmarking where you are today with respect to cost, performance, productivity, utilization of resources and other key metrics.
Post contract management. Issues range from holding someone on the staff accountable for overseeing contracts with outside suppliers, to integrating into the outsourcing company employees who may have lost their jobs because of the transition. Stated and included in this agreement are provisions for some sort of escalation process that clearly defines how problems will be handled and the process that will be used to resolve these issues.
Double outsourcing. One common event that should be understood and addressed with your outsourcing supplier is the practice of "double sourcing." This is common in some functions that are typically outsourced such as the IT function. Double outsourcing is when subcontractors are employed by companies providing outsourcing to you.
Evaluation and Measurement. The need for post-outsourcing contract evaluation and measurement is imperative. Some commonly used methods of evaluation and measurement are:
- Benchmarking ( The first benchmarking should occur prior to contract award, as the organization that is prepared to outsource an existing function should benchmark all relevant metrics against all responses from the suppliers. This will provide a starting point from which the purchaser will be able to effectively measure future performance and progress. Companies such as Dun and Bradstreet and The Outsourcing Institute can provide some information to use in benchmarking outsourced functions.
- Service Level Agreements (Use of SLAs is critical to the success of most outsourcing contracts. This normally has been negotiated and agreed upon by both parties and the metrics have been acknowledged as valid. Review of these indicators should occur on a monthly basis and should be a critical part of any supplier evaluation program.
- Surveys - Surveys of internal and sometimes external customers can be informative and beneficial. This is a simple but effective way to gain feedback from those individuals that are directly and indirectly impacted by the outsourcer's performance.
- Supplier Performance Evaluations ( Quarterly and annually, the contract administrator should conduct a performance review of the outsource provider. Contingent upon the result of the evaluation and the structure of the contract, the outsourcer could either be penalized or rewarded.
Outsourcing Relationships: Why are they Difficult to Manage? Any purchasing professional who has been responsible for managing and administering long-term contracts will tell you that it can be very difficult at times. Experience shows that the following are common contributing factors to problems involving outsourcing relationships:
- Pricing and SLAs that were established at the start of the contract do not provide nor contain mechanisms for recognizing, supporting and rewarding continuous process improvement.
- The differences in purchaser and supplier cultures often cause misunderstanding and distrust as they have fundamentally different goals and objectives that are frequently difficult to harmonize.
- All outsourcing contracts are based on assumptions regarding technology, business conditions, personnel, and other relevant issues. These premises and assumptions begin to change sometimes before the ink is dry on the contract, due to rapidly changing business and economic conditions. Any long-term contract that lacks flexibility will tend to increase the likelihood of dissatisfaction from the purchaser and their internal clients.
- Once the contract has been finalized and implemented, there is a great temptation for both parties to improve their cost/profit position at the expense of the other party.
- Organizations that have not outsourced functions previously frequently underestimate the time, effort, and attention required managing an outsourcing relationship.
- Lack of management oversight is usually due to the fact that the team that negotiated the contract often does not participate in any facets of contract administration. Therefore, the new players that assume control may not understand the contract's intentions, but are made responsible for managing the relationship.
SUMMARY. What conclusions can one draw from the information contained in this article on Outsourcing? First, its obvious those companies are more frequently making the decision to outsource functions that were traditionally performed internally. The reasons for outsourcing are strategic in nature and outsourcing is viewed by companies as one more solution for gaining a competitive edge. Finally, understanding where, when and how to successfully outsource will be one of the most important business skills needed for the future not only for purchasing professionals but for all managers that are challenged to do more with less.
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