Outsourcing Will Become a Source of Strategic Advantage In todays unforgiving global marketplace, no firm can afford to be "second-rate" in any business activity. Every business must find some way to get their cost and quality in line with world-class standards.
Of course, every company has always insisted it needed to be the best in these areas. What is new is the approach that CEOs are taking. Instead of controlling every activity and every link in the value chain, chief executives are now giving up control to gain the benefits of outsourcing.
To illustrate how radical a shift this is, lets contrast the mindset of todays business leaders to those of 100 years ago.
Early in the 20th century, Henry Ford and other leading innovators imagined an enterprise turning out millions of identical units from organizations that directly controlled all of the work that delivered value to the end-user. From iron ore to finished automobiles, the vision was to have every raw material and every twist of a wrench directly under the control of the enterprise.
Early in the 21st century, one of the strongest trends in management thinking is to own only those few business activities that are crucial to competitive advantage and to let others control those that are peripheral to the core. This new mindset has been the driving force behind the multi-billion dollar outsourcing industry.
Today, Henry Ford would be horrified to learn that about two-thirds of the North American auto industrys $750 billion in value now resides with suppliers. But the reality is that outsourcing is a logical, cost-effective solution to the problem of doing business in an increasingly complex world.
Manufacturers were really the first companies to outsource elements of their business. They did so as far back as the 1950s, well before firms outsourced their IT needs or their call centers. It wasnt until the 1990s that outsourcing entered the common business lexicon, as executives became increasingly focused on performing only those activities core to their respective businesses. The core competency movement was intertwined with the reengineering movement sweeping the nation.
Reengineering teams examined all the activities performed by their companies, with the goal of eliminating all work that didnt create value for the ultimate customer. As part of this process, companies formally identified those activities that were core to their business ? those activities which they could perform better than anyone else. Non-core activities were candidates for divestiture ? the company wouldnt perform them but would source them outside the firms walls through a supplier. Hence the term outsourcing.
If a company is uniquely skilled at an activity, it may choose to become the outsourcer of that activity to others for a fee. For example, the basis of IBM’s strong growth in outsourcing has been the strong competence it gained from managing its own data centers and networks.
Executives have embraced business process outsourcing over the past decade as a way to increase value to customers and shareholders. Gartner reports that the worldwide market for business process outsourcing services was $110 billion in 2002.
The most popular function to outsource in 2003 was information technology, according to the Outsourcing Institute. Two of every three companies surveyed outsourced some or all of their IT function as part of what the investment firm Robert W. Baird & Company estimates to be a $115 billion industry.
Among the other commonly outsourced activities are administration, human resources, logistics and distribution, real estate and facilities management, and finance and accounting.
Many of the world’s largest corporations, such as British Petroleum, American Express, J.P. Morgan and Lockheed Martin, embraced outsourcing in a major way because the benefits are huge. These corporations are slashing overhead, reducing overall costs for many processes by 10 percent to 40 percent. This translates into hundreds of millions of dollars in saved expenses at each company.
“Outsourcing has the potential to save companies in the region of 20 to 30 percent,” says Brian Hurley, a business manager with Hewlett Packard’s outsourcing unit.
One of the key reasons that many companies choose outsourcing is that it really improves the balance sheet and return on assets, while improving cash flow in some cases.
When a firm outsources a capitalintensive business process like IT or manufacturing, it transfers all those process-related capital assets to the outsourcing provider. At the same time, it gets rid of the asset-based liabilities, like leases and mortgages. So the debt/equity ratio looks better, and the return on assets looks better.
If a company needs to make a big systems upgrade in the near future, it helps cash flow as well, because the outsourcing firm makes the necessary cash outlays for the upgrade. The client firm simply pays usage fees that are fixed or based on transaction volume, as specified in the contract.
These financial savings are luring one Fortune 500 Company after another into outsourcing agreements with firms such as Accenture, IBM, EDS, Computer Sciences Corporation, Mellon HR, and Hewitt Associates.
However, the market for outsourcing services does not consist only of large customers. Middle-market companies and smaller firms are also looking to outsourcing. Although the chosen areas to outsource differ by company size, the Outsourcing Institute’s annual Outsourcing Index1 reveals that the underlying motivations of companies really don’t differ all that much.
Executives realize that outsourcing some or all of their non-core activities can reduce costs and increase efficiency, while maintaining or even improving the level of service provided to customers.
Those same motivations extend to the public sphere. Last May, the Office of Management and Budget, or OMB, shortened and simplified the process by which private sector companies compete to provide public services, the first major overhaul in 20 years.
The U.S. government currently spends hundreds of billions of dollars each year on commercial services provided by 850,000 government employees. The new policy championed by the Bush Administration will open up 425,000 federal jobs to competition from private companies to do the work that federal employees now perform.
According to the OMB, independent studies by the General Accounting Office and the Center for Naval Analyses show that holding these competitions saves taxpayers an average of 30 percent ? cost savings comparable to those achieved by Fortune 500 companies.
Even the Army has considered outsourcing, although it has indefinitely suspended plans to contract out as many as 214,000 military and civilian positions.2 Under consideration were the jobs of 58,727 military personnel and 154,910 civilian employees who perform such support functions as accounting, legal counsel, maintenance, and communications.
The plan, known as the “Third Wave” within the Pentagon, could have affected about one in six of the 1.3 million Army jobs around the world. In an October 4, 2002 internal memo explaining the initiative, former Army Secretary Thomas E. White wrote that the Army needed to direct as many resources as it could to anti-terrorism efforts and let support jobs go to the private sector.
This is in keeping with the main reasons companies consider outsourcing. While cost reduction was the primary motivation for outsourcing, half of the companies the Outsourcing Institute surveyed placed “improving company focus” in second place.
Outsourcing lets an organization focus on its core business by letting an outside expert take over operational functions. Freed from devoting energy to areas that are not in its expertise, the company can focus its resources on meeting customers’ needs.
In third place, 39 percent of surveyed executives cited “attaining world-class capabilities.” Worldclass providers make extensive investments in technology, methodologies, and people. They gain expertise by working with many clients facing similar challenges.
This combination of specialization and expertise gives customers a competitive advantage, and helps them avoid the cost of chasing technology and training. In addition, better career opportunities are available to personnel who transition to the outsourcing provider.
“Freeing up resources for other purposes,” came in fourth place, mentioned by 37 percent of executives. Every organization has limits on the resources available to it. Outsourcing permits a company to redirect its resources ? most often people whose energies are focused on non-core activities ? onto activities that add value to customers.
A recent study by Accenture suggests another reason why outsourcing is becoming so popular: It gives executives control and flexibility over their businesses. The survey of more than 800 executives found 55 percent believed outsourcing lets their companies implement change at a faster and more controlled rate. Also, 86 percent said outsourcing gives them more control over business results in a variety of areas.
This does not mean that outsourcing will work for every company; that it will be successful in every part of a business; or that all executives will use it properly. Fortunately, there are some guidelines that you can follow. In a survey by The Outsourcing Institute,3 executives identified the following 10 factors as contributing to the success of an outsourcing arrangement:
1. Understanding the company’s goals and objectives.2. Having a strategic vision and plan.3. Selecting the right vendor.4. Managing the relationship on an ongoing basis.5. Structuring the contract properly.6. Communicating openly with affected individuals and groups.7. Securing senior executive support and involvement.8. Paying careful attention to personnel issues.9. Providing a near-term financial justification.10. Using outside expertise in developing outsourcing programs.
The top two reasons ? “understanding the company’s goals and objectives” and “having a strategic vision and plan” ? support our earlier statement that outsourcing is part of the larger strategic process. Companies that don’t approach outsourcing strategically, do so at their own peril.
For example, “Mid-tier firms are often tactical in their outsourcing, but not strategic,” says Robert Brown, a Gartner Group analyst of the outsourcing industry. “They’ll outsource payroll and 401(k) administration, but not HR benefits administration entirely. Taxes will be outsourced, but not all the general accounting and financial reporting. Big companies are outsourcing processes end to end in order to gain the efficiencies of simplified processes and single systems. Small and medium-sized companies have been far more reluctant to hand over entire processes or departments, and don’t get the same efficiencies as a result.”4
One result of this is that some mid-tier firms’ outsourcing costs haven’t declined, and in fact, have started to rise. Payroll services, for instance, have been increasing in price, says Brown, spurring some firms to think about bringing payroll back in-house.
What companies need, but often don’t have available, is better information about their real internal and long-term costs. They also need benchmarking data for the cost of various processes when performed internally and by outsourcers for companies their size and in their industry.
Acquiring this kind of information, however, is expensive ? whether paying large sums for reports generated by consultants like Gartner or IDC Corp., for example, or ample employee time researching the topic.
Another factor cited by executives as leading to a successful outsourcing relationship ? “managing the relationship on an ongoing basis” ? is also frequently ignored. A Gartner survey found that half of this year’s IT outsourcing projects will be labeled as losers by senior decision makers for failing to deliver on bottom-line promises.
The study found that less than one-third of companies have formal plans for managing relationships with their chosen outsourcers, contributing to the perceived failure rate by executives.
An international survey in 2002 by London technology consultant PA Consulting, found that two-thirds of companies were disappointed with their outsourcing contracts.5 Only 39 percent of the companies said they would renew contracts with their existing outsourcing suppliers, and 15 percent said they planned to bring services back in-house.
In an article titled “Has Outsourcing Gone Too Far?”6 McKinsey consultants also noted that one-fifth of executives said that they were dissatisfied with the results of their outsourcing arrangements, while another fifth said that they were neither satisfied nor dissatisfied ? which suggested that they were not seeing clear benefits. The authors also cited the following Dun & Bradstreet research findings:
About 25 percent of all outsourcing relationships fail within two years, and 50 percent fail within five years.
Nearly 70 percent of the companies asserted that suppliers “didn’t understand what they were supposed to do” and that “the cost was too high and they provide poor service.”
And it is not just companies that might be unhappy with outsourcing. Speak to the swelling crowd of customers dissatisfied with the service they are getting from banks, airlines, and utilities and listen to their anger at having to deal with call centers run by outside contractors.
In the pursuit of lower costs, many companies are turning over customer service activities to organizations that may not be qualified to provide great service.
For example, one prison in Oregon, the Snake River Correctional Institute, is now offering “inmate outsourcing.” Convicted felons work in prison call centers for several companies, and customers have no clue that the person on the other end of the phone is behind bars.
This leads to a critical point that many companies seem to miss about outsourcing: It does not mark the end of managing an activity, but the beginning of managing it in different, and often more difficult, ways. Instead of ensuring that your own employees are doing their jobs properly, you have to ensure someone else’s employees ? or inmates ? are. And you have to do that without the familiar tools of hiring, firing, promoting, and rewarding.
You can argue with a contractor and threaten to replace them, but once they have intruded themselves into your organization and systems, that is often not easily done. By that stage, the bargaining power has shifted. The companies that outsourced their business processes have often lost the ability to do the job themselves. The provider of the service is in a strong position to demand a higher price.
Based upon the preceding discussion, we forecast the following developments:
First, executives are just beginning to exploit the potential of outsourcing. While it may seem that so many companies are outsourcing activities that the approach has reached its peak, that is far from the case. In fact, we expect to see worldwide revenues from business process outsourcing soar in line with an estimate from Gartner, which projects revenues to rise from $110 in 2002 to $173 billion by 2007.
Second, we expect the average workforce size of Fortune 1000 companies to continue to shrink drastically over the next decade, as companies continue to outsource more and more of their non-core activities. This development will help to compensate for the shortage of skilled workers we discussed earlier in this program. However, it will make an impact on the economy in numerous ways. For example, the insurance industry will be affected as corporations lay off unnecessary workers ? and subtract the cost of their benefits from their books ? in favor of outsourcing their work to outside firms. Also, the prices of commercial and residential real estate may plunge in some small and medium-sized cities that host the headquarters of major corporations that embrace outsourcing.
Third, the U.S. prison population will be used to fill many outsourcing jobs at low cost. There are now a staggering number of people in American jails and prisons: over 2 million. The U.S. has surpassed Russia as the country with the highest percentage of imprisoned citizens in the world, according to a report in The Baltimore Sun.7 To offset the cost of housing, feeding, and guarding these inmates, we expect the government to tap this labor pool to provide a cheap way to answer calls, enter data, and do other routine, non-sensitive work for companies that are striving to save money.
Fourth, companies will make more outsourcing deals based solely on business strategy, rather than on cutting costs. Although cost savings will remain the top reason for outsourcing business processes, anticipate outsourcing to be increasingly driven by the Chief Purchasing Officer or by a new position, the Chief Resource Officer, who will emphasize the strategic and competitive aspects of outsourcing rather than solely the financial benefits.
Fifth, several large, global financial institutions will emerge as major outsourcing players over the next five years. These firms will insource the complete end-to-end accounts receivable and accounts payable processes from other companies, building on their reputation for secure and confidential transaction processing.
Sixth, we predict that nearly one-quarter of all transcription services, stock market research, customer service centers, on-line database legal research, payroll, and other “back-office” activities will be outsourced. With the globalization of the economy and increasingly large wage differential between the developed and developing worlds, expect that many of these jobs will be moved out of the country.
This brings us to the topic of offshoring business activities, which is often confused with outsourcing. We’ll discuss that important topic in the next part of our program.
References List :
1. Outsourcing Essentials, Vol. 1, No. 1, 2004, "Mid-market Firms Face a Host of Challenges in Business Process Outsourcing," by Ian Springsteel. ⓒ Copyright 2004 by The Outsourcing Institute. All rights reserved. 2. The Washington Post, January 5, 2004, "Army Outsourcing Put On Hold," by Christopher Lee. ⓒ Copyright 2004 by The Washington Post Co. All rights reserved. 3. For more outsourcing "intelligence," visit The Outsourcing Institute website at: www.outsourcing.com/content.asp?page=01i/articles/intelligence/index.html 4. Outsourcing Essentials, Vol. 1, No. 1, 2004, "Mid-market Firms Face a Host of Challenges in Business Process Outsourcing," by Ian Springsteel. ⓒ Copyright 2004 by The Outsourcing Institute. All rights reserved. 5. Forbes Online, October 31, 2003, "Outsourcing Overseas Has Downsides, U.S. Execs Say," by Wei Gu. ⓒ Copyright 2003 by Forbes Publishing, Inc. All rights reserved. 6. The McKinsey Quarterly, 2001 Number 4, "Has Outsourcing Gone Too Far?" by Stephen J. Doig, Ronald C. Ritter, Kurt Speckhals, and Daniel Woolson. ⓒ Copyright 2001 by McKinsey and Company. All rights reserved. 7. The Baltimore Sun, June 1, 2003, "US: Locked Up in Land of the Free," by Scott Shane. ⓒ Copyright 2003 by The Baltimore Sun, a Times Mirror Newspaper. All rights reserved.
