OUTSOURCING

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Photo by: Ben Chams

A company is outsourcing when it purchases products or services from an outside supplier, rather than performing the same work within its own facilities, in order to cut costs. The decision to outsource is a major strategic one for most companies, since it involves weighing the potential cost savings against the consequences of a loss in control over the product or service. Some common examples of outsourcing include manufacturing of components, computer programming services, tax compliance and other accounting functions, and payroll and other human resource functions. A relatively new trend in outsourcing is employee leasing, in which specialized vendors recruit, hire, train, and pay their clients' employees, as well as arrange health care coverage and other benefits. A study quoted in Industrial Management indicated that the global outsourcing market was growing at a rate of 10 percent per year, and was expected to reach $121 billion by the year 2000.

The growth in outsourcing is partly the result of a general shift in business philosophy. Prior to the mid1980s, many companies sought to acquire other companies and diversify their business interests in order to reduce risk. As more companies discovered that there were limited advantages to running a large group of unrelated businesses, however, many began to divest subsidiaries and refocus their efforts on one or a few closely related areas of business. Companies tried to identify or develop a "core competence," a unique combination of experience and expertise that would provide a source of competitive advantage in a given industry. All aspects of the company's operations were aligned around the core competence, and any activities or functions that were not considered necessary to preserve it were then outsourced.

Successful outsourcing thus requires a strong understanding of the organization's capabilities and future direction. As William R. King explained in Information Systems Management, "Decisions regarding outsourcing significant functions are among the most strategic that can be made by an organization, because they address the basic organizational choice of the functions for which internal expertise is developed and nurtured and those for which such expertise is purchased. These are basic decisions regarding organizational design." Outsourcing based only upon a comparison of costs can lead companies to miss opportunities to gain knowledge that might lead to the development of new products or technologies. Business Week called companies that had outsourced too many of their core functions "hollow corporations," and claimed that they had relinquished their reason for existence.

Outsourcing can be undertaken to varying degrees, ranging from total outsourcing to selective outsourcing. Total outsourcing may involve dismantling entire departments or divisions and transferring the employees, facilities, equipment, and complete responsibility for a product or function to an outside vendor. In contrast, selective outsourcing may target a single, time-consuming task within a department, such as preparing the payroll or manufacturing a minor component, that can be handled more efficiently by an outside specialist. The opposite of outsourcing is insourcing, when a staff function within a company markets its product or service to external as well as internal customers.

By the late 1990s, 93 percent of executives in North America and Europe reported outsourcing at least one business function. Some business leaders took outsourcing further than ever before, forming intricate partnerships with other companies and outsourcing more than just mundane tasks. "Today, outsourcing relationships have evolved from one-dimensional contracts based on cost savings to multidimensional partnerships that support the core business of client corporations," CEO Bill Concannon stated in Industrial Management. "The trend is for outsourcing relationships to function more and more like partnerships. Outsourcing providers are taking increasing responsibility in realms that have traditionally remained in-house, such as corporate strategy, information management, business investment, and internal quality initiatives."

ADVANTAGES AND DISADVANTAGES
OF OUTSOURCING

Companies that decide to outsource do so for a number of reasons. The primary reason is to achieve cost savings or better cost control over the outsourced function. Companies usually outsource to a vendor that specializes in a given function and performs that function more efficiently than the company could. On average, outsourcing companies realize a 9 percent cost savings and a 15 percent increase in capacity and quality, according to the Outsourcing Institute. Anticipated cost savings sometimes fail to materialize, however, because the vendor must make a profit and because the company incurs additional transaction costs when interacting with the vendor. Another common reason for outsourcing is to achieve headcount reductions or minimize the fluctuations in staffing that may occur because of to changes in demand for a product or service. Companies also outsource in order to reduce the workload on their employees, or to provide more development opportunities for their employees by freeing them from tedious tasks.

Some companies outsource in order to eliminate distractions and force themselves to concentrate on their core competencies. Still others outsource to achieve greater financial flexibility, since the sale of assets that formerly supported an outsourced function can improve a company's cash flow. A possible pitfall in this reasoning is that many vendors demand long-term contracts, which may reduce flexibility. A common reason for outsourcing computer programming and other information technology functions is to gain access to new technology and outside expertise. Some experts claim, however, that companies are exposed to new technology by vendors anyway, and that they could simply hire people with the expertise they seek. But this is not true for small businesses, which often cannot afford to hire computer experts or develop the in-house expertise to maintain high-level technology. When such tasks are outsourced, the small business gains access to new technology that may help it compete with larger companies.

Company politics is another common reason for outsourcing. For example, some companies might begin outsourcing initiatives after observing the successful efforts of a competitor. Others might be pushed toward outsourcing by managers seeking personal gain or by a desire to eliminate troublesome departments. Finally, outsourcing provides an attractive option for start up firms as they grow. In these instances, outsourcing can free the entrepreneur from tedious and time-consuming tasks, such as payroll, so that he or she can concentrate on the marketing and sales activities that will enable the firm to make money.

Some of the major potential disadvantages to outsourcing include poor quality control, decreased company loyalty, a lengthy bid process, and a loss of strategic alignment. There may also be inherent advantages in maintaining certain functions internally. For example, company employees may have a better understanding of the industry, and their vested interests may mean they are more likely to make decisions in accordance with the company's goals. A general rule of thumb is that companies should never outsource any function that directly affects quality or service.

STEPS IN SUCCESSFUL OUTSOURCING

Once a company has made the decision to outsource, there are still a number of factors it must consider in making a successful transition and in forming a partner relationship with the vendor. In National Underwriter Life and Health, Ethel Scully recommended a series of steps for companies to follow. First, the company should determine what sort of outsourcing relationship will best meet its needs. Some businesses share strategic decision making with their vendors, while others outsource only on a limited, as-needed basis.

Next, the company needs to obtain the support of key personnel for the decision to outsource. Many companies encounter resistance from employees who feel that their jobs are threatened by outsourcing. This is particularly important in businesses where workers are represented by labor unions. In the mid-1990s, the issue of outsourcing was key in several strikes by the United Auto Workers against American automobile manufacturers. Scully suggested forming a team consisting of an outsourcing expert, representatives from senior management and human resources, and the managers of all affected areas of the company to help address employee concerns about the decision. To maintain the loyalty and productivity of remaining workers, it may also be helpful to design programs to assist any workers that may be displaced due to outsourcing.

After people issues have been addressed, the company can begin contacting potential vendors, either formally or informally, and asking specific questions about the services provided and the terms of the contract. Ideally, the vendor will have experience in handling similar business and will be able to give the client's needs the priority they deserve." Consider the service company's knowledge of the entirety of your business, its willingness to customize service, and its compatibility with your firm's business culture, as well as the long-run cost of its services and its financial strength," said service provider Carl Schwenker in Money.

Finally, the company should select a vendor it trusts in order to develop a mutually beneficial partner relationship. It is important for the company to develop tangible measures of job performance before entering into an agreement, as well as financial incentives to encourage the vendor to meet deadlines and control costs. The contract should clearly define responsibilities and performance criteria, outline confidentiality rules and ownership rights to new ideas or technology, and include a means of severing the relationship if necessary. Since the vendor is likely to have more experience in preparing outsourcing agreements than a small client company, it may also be helpful to consult with an attorney during contract negotiations.