Outsourcing Perspectives – Part 1

by William D. Engelke
Copyright 1996, All Rights Reserved


This is the first of a three-part series on outsourcing. The first article looks at it from an employee’s view, the second from a management view, and the third discusses what to look for in an outsourcing contract.

With the continuous change now occurring in our society, it is very likely that any individual employee or manager will have to deal with his or her job being outsourced. How can one prepare? This article provides a philosophical outlook and tips on coming out on top in case of radical workplace changes.

An Employee’s View

Outsourcing has been in the news lately. The United Auto Workers’ union felt so strongly about it that they were willing to go out on a nearly three-week strike over the issue, and shut down General Motors. Even though the strike was “local,” according to union representatives who struck the brake plant in Dayton, Ohio, the lack of parts quickly led to the lay-off of over 100,000 GM workers in 23 factories across the country. There has been widespread speculation that the UAW had this in mind from the start. It is clear that they view outsourcing very seriously.

If you work in industry today, there is a good chance that you will encounter outsourcing in one way or another. It takes an understanding of this growing trend to be able to cope with the changes it brings, and, hopefully to do more than cope- to come out on top.
What is outsourcing?

Outsourcing is simply deciding to obtain selected goods and services from outside your company. Company analysts in big firms often take a “make or buy” decision, judging whether it is better for the company to build (or do) something with their own workforce, or to purchase it from outside. Traditionally, this has often been done with materials, parts, machines, and so forth. Now – in concert with the movement of much U.S. work toward services – it is being done with services and knowledge work.

It has become possible to outsource practically anything, and companies are moving to do just that in many areas which are not their “core business,” that is, those areas of special skills which define their uniqueness. It has become especially popular to outsource activities which require specialized skills, such as data processing (which for a while was called “Management Information Systems,” and is now called “Information Technology.”)

Why do companies do it?
Vertical Disintegration

In the past, it was common for companies to be highly “vertically integrated,” that is, internally handling the bulk of their production from bottom to top. It was possible to increase margins that way – profits. This was true for manufacturing firms like Ford and GM, which could often decrease their costs by making most of their parts themselves. It was true in service and high technology industries, also. With vertical integration, companies got into a great variety of different businesses. For example, GM makes most of its own wire and wiring harnesses – from scratch – for its vehicles. Drawing copper wire, putting insulation on it, making plastic electrical connectors – these activities are quite different than what we typically think of as part of the car business. The same thing holds true for Raytheon making semiconductors for its missile systems, AT&T building computers, and for a wide variety of companies making things that are peripheral to their core businesses.

Two trends have merged to put great pressure on vertical integration. First, business has become highly competitive. Every company now competes not just against its peers in its own country, but with every other company in the world which makes a similar product. Even U.S. defense industry firms are not immune, because shrinking federal budgets can force the military to consider foreign sourcing. Companies no longer have the luxury of being able to dabble in activities where they do not have world-class expertise.

The second trend is the growth of high-quality, high-speed communications and information technology. If you can do everything your company needs to do at the best possible location (even when it’s outside the company), and tie it all together with instantaneous data transfer, it means there is no longer any reason to have everything in one place.

The trend of re-engineering

Trendy ideas regularly sweep down across the country from the prestigious business and management schools in the northeast like a chilly breeze. Reengineering is one of these trends. Its central idea is a good one: model your business processes and determine exactly what must be done to accomplish the job. Eliminate everything else, especially the wasteful and work that no longer serves a purpose. Disciples of this philosophy promise enormous savings, such as having ten people do the business functions that previously took two hundred.

One problem with this approach is that opportunities for such dramatic savings are not that plentiful. Many firms are better managed than the consultants might give them credit for, and have made it a habit to winnow out useless functions on an ongoing basis. Hence, when the top boss gets the idea to “reengineer,” it sometimes evolves into merely getting rid of people, along with truly useful functions they had been doing, along with overloading the remaining staff. This is no longer cutting fat, but it is cutting muscle and bone. So, therefore, outsourcing can become a necessity because the business cannot survive any other way.
How Wall Street pressures top management to slash employment

Another business school trend in recent years has been the idea that top executives’ compensation should be linked to the company’s stock performance. This must be very carefully implemented though, so as not to be counter-productive. The reason is that Wall Street’s reaction to a firm’s real performance is valid only over a very long term – many years. If the CEO wants to get a bonus this year, however, he has to do something to pump up to stock’s price quickly. Massive layoffs often do this. The market’s reaction, though swift, is not rational; short term cost cutting does not make for a strategic vision which builds a company’s foundation. Yet it can drive a stock’s price up.
Again, outsourcing becomes necessary, because the company has laid off a number of its best people (or paid them an incentive to resign). One can see this in many high tech firms, which laid off many talented individuals in ferocious cost cutting measures, only to have to pay them more to later come back as consultants, outsourced workers, and contractors.

The explosive growth in health care costs provides yet another pressure to reduce staff. Outsourcing moves the problem of capping this cost to a point outside the company. This way, total benefits can be reduced without the company appearing Scrooge-like to its remaining staff.

So, one can see that there are good and not-so-good reasons why companies outsource. In any event, it appears to be having the desired effect, as the U.S. has recently moved back into the range of being the most competitive nation on earth. (Clearly, many factors are at work here, including interest rates, a slumping economy in Japan, and increased competitiveness of industry. Outsourcing contributes to the latter.)

What happens when outsourcing is done

There is a whole spectrum of ways outsourcing can be used. On the small and subtle side, it can be used to handle new business which comes in but can not be done internally for various reasons. In this case, the outsourcing would hardly be noticed by the staff. On the other extreme, the entire business can be restructured so as to send out everything that is not part of the core business. Significant layoffs can then be expected. In the middle, almost any combination can occur. Outsourcing well-defined, specific blocks or departments (such as data processing, auditing, or secretarial services) is often the implementation tactic. This ties in well with the current conventional wisdom that companies should “in-source” only that which is their core business.

The major justification that is used to sell an outsourcing approach is that it will reduce costs. This idea, and the connected assumption of increased profits makes the action attractive to upper management and stockholders. A second reason that can hold sway is that there is a need to implement a new business venture rapidly (where a big, fast ramp-up in staff would be otherwise required), and it can only be accomplished by contracting out major portions of the work. These justifications may or may not pan out, depending on how well the underlying business situation matches good outsourcing conditions, and how the outsourcing is implemented.

The question of cost reduction is probably the overriding consideration because of the powerful influence of economics on business policy. After all, making a profit is the number one reason for existence of virtually all private business. Managers need to be cautious about being swept up in the hype of outsourcing, especially when it is being promoted by people with a vested interest in it. We should consider why it is possible that the cost advantages are overblown. First, let’s identify the players: the “outsourcer” is the company which is going to give the work to the outside company; the outside company is the “outsourcee.”

The biggest reason that outsourcers get less cost reduction than they expect is that the outsourcee needs to make a profit doing things the outsourcer used to do for itself at cost. I learned this firsthand in a dramatic fashion, having been involved in the acquisition of Electronic Data Systems (EDS) by General Motors. Even though this was a merger, GM handled it (for reasons of stock value) as an outsourcing arrangement. EDS was owned by GM, but EDS would be permitted to earn a profit on all business done for GM. The reason was that stock options were a major source of compensation for EDS employees, and a major incentive (often given as bonuses for EDS people who went above and beyond the call of duty, which was a frequent requirement at EDS). Stock was only a valuable incentive if the stock was likely to gain in value. This had been a regular occurrence for EDS stock for years. The stock would go up in value only if the stock had a high multiple (profits to equity) buoyed by high profits. EDS marketing priced work packages being bid to GM at 42% (before tax) profit margin.

This was a shock to GM managers; it appeared as though overnight their data processing services had increased in cost by almost half. It is not entirely coincidence that, after this, GM had a year in which it lost over a billion dollars (while EDS still showed a profit) [By the way, that was not the year in which GM paid Ross Perot $750 million to leave the GM Board]. When GM’s managers instituted changes to drive the cost of their DP services down, it resulted, in some cases, in ripping out systems that had been up and running, and supporting business functions, for years.

The case of EDS and GM may be an extreme one, but it illustrates the point very well. With the type of profit margins outsourcing companies shoot for (and EDS’s 42% is not unusually high), we can see that they have to be extremely efficient to be able to do all the outsourcer’s work, at a lower cost than the outsourcer had been experiencing to do the work for themselves at cost. One must also realize that outsourcees are very competent at structuring contracts to ensure they make a profit whether the outsourcer does or not. Again, this is a factor that would not come into play in an internally controlled operation.

There are cases where outsourcing can result in significant savings: where a company’s cost to do the work is significantly higher than it should be. This needs to be determined by comparing the operation to industry benchmarks which are independent from sellers of outsourcing services. This has been the situation in GM’s recent battle with the UAW. GM’s manufacturing costs are well above those of its major competitors.

There is a big difference between this practice of outsourcing high-cost manufacturing operations and outsourcing knowledge work, however. In many instances, manufacturing can be done as well using $1.25/hour labor in Mexico as using $22/hour labor in Ohio. The difference with knowledge work is that outsourcees have to pay about the same salary to competent engineers, system analysts, accountants, and so on, as the outsourcer. To make a profit they have to make up the difference in overhead. Any claims that they may make to be able to actually do the job with less white collar labor have to be put through a reality filter. There is no way that the outsourcee’s people can know the outsourcer and its practices as well as the outsourcer’s own staff.

This is not to say that outsourcing is never a good idea for knowledge-type work. The manager must make a dispassionate analysis of whether an outside firm really could do the job better, cheaper, faster. Situations where this can happen include:

· When the outsourcer’s people are wrapped up in intracompany politics to the point that little is getting done
· When the outsourcer is trying to leapfrog a competitor and/or make a great stride quickly, especially in an area which is experiencing a high rate of change
· When the outsourcer is understaffed for upcoming business, but does not want to do much hiring because it is going through the peak workload time in a very cyclical industry

Planning for current trends in industry: Can you come out on top?

Make Change Your Friend

“Constant change is here to stay,” was a favorite saying of my friend Bob Tucker, a colleague at GM. Although he said it in a tongue-in-cheek way, he was more correct than he ever realized at the time. Once you understand how true this statement is today, and really accept it, you will adopt a whole new view of change. Further, to come out on top, you actually need to do more than just accept it- you need to embrace it.

How is the idea of embracing change related to outsourcing? Because (if you are the employee within the outsourcer) outsourcing potentially represents one of the most fundamental kinds of change that you will cope with in your life: a job change. On a stress scale, changing jobs involuntarily is right up there with death of a loved one and life-threatening illness.

However, if you constantly prepare for your next job, and set numerous, flexible goals, outsourcing may just be the trigger which prompts you to take your next step rather than a devasating cataclysm. With this philosophical approach (see sidebar) , which emphasizes flexibility, you can be prepared to make the best decisions if outsourcing (or, its angry cousin, downsizing) comes into your shop.
What happens when outsourcing appears

Let’s say your department is going to be eliminated by the use of outsourcing. What can you expect?

1. You may be moved to another department or subsidiary, or given some managerial authority over the outsourcee. [See the next two articles in this series!]

2. You may be laid off.

3. You may be offered an incentive to resign (a “buy-out”). For long-time employees, the incentive often is something like a year’s salary. [ It is often wise to take it, because the next step may be a lay off/RIF which doesn’t enrich you. But, if you take it, be sure to invest the money as soon as possible, into a non-liquid investment (such as property or long-term certificates of deposit) so that the money isn’t inadvertently frittered away.]

4. You may given the chance to continue to do your work by joining the outsourcee or becoming a contractor. In either case, you are switching employers.

In possibilities 2 through 4, you will now begin to exercise your adaptation of change philosophy. If you have prepared well, the incoming outsourcing action will act as a trigger for you to make your next career decision. You will have the option of playing the outsourcee’s game by choice, or moving swiftly and gracefully into the next step of your overall plan- something you were going to do anyway.

It is also possible that all of these options may appear as possible directions in a real situation-it happened to me in the GM-EDS merger.

The Outsourcee’s Game

Companies which receive a lot of outsourcing contracts for knowledge work have a standard set of actions they carry out when coming into a new company. Let’s say the outsourcee is contracted to assume the duties of a department being phased out. They have objectives which include the following:

· Take over the work of the existing department as quickly and effectively as possible, ensure that customer service is not impacted except in a positive way
· Minimize disruption to the department’s operations in relation to other departments
· Improve operations of the unit’s business processes to reduce costs

Often this requires cooperation from the existing staff of the department, and there may be an opportunity to hire much of that staff. If the outsourcee is in a strong growth mode, hiring much of the existing staff may be the only way to meet objectives, because experienced people are not readily available from any other source.

The existing staff will be anxious, possibly even hostile, when the outsourcee comes on board. People who know they are going to be laid off may feel they have nothing to lose, and may become uncooperative- so the outsourcee will generally hold out the possibility of hiring (whether it is true or not). Well managed outsourcee companies know that the existing staff has the best knowledge of how to make the department work, so will be interested at least in keeping the best people. They will interview the current staff.

When you interview, you are making a choice as to whether you want to work for them, just as they are making a choice as to whether to hire you. If you are in control, because you have been following a flexible philosophy, you are able to make an objective decision, because you don’t have to view them as your only chance. (Be careful not to be arrogant about this, as that will close off this choice.)

Deciding whether to join the outsourcee company is a multi-dimensional decision; it includes aspects of pay, benefits, bonuses, prospects of future opportunities, and your own compatibility with the company culture. You should be just as selective about joining this company as (a) they have been about you, and (b) as you are about taking any new job. Don’t lose sight of the fact that, even though there is a scent of familiarity about this job because it is largely a continuation of your previous duties, it is still a new job, under which you will be judged by new rules.