Overview of reasons for outsourcing, pitfalls, outsourcer
selection, contracts, and numerous links. Part 2 of a series examining outsourcing.
By William D. Engelke
Copyright 1996, All rights reserved. All opinions presented herein are the author’s personal views.
This article discusses the major reasons for outsourcing, and how it can help your firm; possible pitfalls and disadvantages; selecting an outsourcing partner; tips on setting up a contract; issues of working with your outsourcer; and the problem of transitioning staff.
Is Outsourcing Right for You?
Companies typically outsource for the following reasons:
1. To concentrate their efforts (especially management attention) on their core business areas, and would like to outsource some unrelated ancillary functions.
2. Major new business is coming in, or new facilities are rapidly coming on line, and they wish to respond quickly without taking the time to build up a staff.
3. To reduce costs and/or risks.
4. They are a small company and have difficulty attracting and compensating professionals in specialty areas.
5. To jump quickly into a new technology to support a product or business function, or to develop a major new integrated system.
6. To reduce head count/downsize but still need to accomplish certain functions.
7. To gain control of an area that seems out of control.
8. To free capital for other purposes (by selling assets to the outsourcing firm).
Outsourcing can be done in a wholesale manner, jobbing out an entire department, or it can be done for specific tasks. Outsourcing portions of your core business is generally frowned upon- one reason for this is that effective outsourcing requires sharing information which in the case of your core competency is likely to be highly proprietary.
Economics lies at the root of most outsourcing decisions. (decision support book, software ) Thus, it is vital that you analyze your decision honestly: don’t fool yourself that outsourcing is a good business decision if you are really trying to deal with issues of company politics or personal career.
How outsourcing can help
Revealing hidden costs.
Especially true when it comes to information technology, companies tend to have a lot of hidden costs in certain areas. If this area is outsourced, and it is enforced that all acquisitions of this type must come through the outsourcer, the hidden costs will be revealed. (That doesn’t necessarily mean that the expenditures are any less vital!)
Free up company to concentrate on coreactivities.
If specialty areas outside the core business have been monopolizing management attention, this is a way to get a respite from these issues. (They will still have to be dealt with, but less frequently, if the project is done right).
If the company needs money more than it needs certain assets, these can be transferred to the outsourcer in return for capital. The assets transfer to the outsource company’s books and are leased back.
Small companies and companies in a rapid growth mode may not be able to respond to changing market demands or the need to
quickly establish new facilities. Outsourcers can provide a rapid influx of talent which can remain in place if needed, be phased out,
or be replaced with the original company’s staff.
Re-engineering and downsizing.
Bringing in a outsourcing company can be an opportunity to do things differently (and, hopefully better) than the original company was doing, instituting re-engineering and new, streamlined processes.
Revamping of corporate culture.
If the outsourcing company has a corporate culture which is highly compatible with the original company’s culture, the outsourcing can be done more smoothly. However, it may be intentional to create a certain amount of upheaval to jolt the client firm into some positive changes.
In many cases, upper management compensation is tied to the company’s stock performance. Head count reduction combined with outsourcing can lead to actual or perceived cost reductions, increasing stock prices. (This can be illusory, though, as a growing school of thought believes that downsizing also cuts the company’s muscle, rendering it able to do less).
Potential problems of outsourcing
When you outsource, you will necessarily cede a good deal of control to the outsourcer, at least in their specialty area. If you have retained
them to remake a certain area of the business, they will do it in their own way. If you have strong preferences on how you want the project done, you will have to use a very firm hand. (article
Costs now versus later.
You may be able to get a very good price on an initial outsourcing contract, especially if you play several outsourcing firms off against each other. However, beware; they have to make a profit to stay in business, and will tend to demand high fees for (the inevitable) changes to the contract later. At that point, it is very difficult to develop competitive options.
Morale & public image.
Severe cutbacks in staff can damage a company’s public image and hurt the morale of the remaining workers. Social responsibility would suggest extreme care in this area, especially when actions would have a dramatic effect on a local community.
The human aspect of outsourcing is often overlooked when planning, as number crunching and dreams of higher profits dominate managers’ thoughts. If the outsourcing plan puts excessive pressure on the staff (fear of job loss, loss of control, forced transfer to a different company, etc.), it will be the most talented, marketable people who will jump ship first.
Outsourcers have to make a profit on work your company used to do for itself at cost. Since pre-tax profit margins on outsourced work can range up into the 40% area, the outsourcer must be extremely efficient to give you the value you want at a truly reduced cost.
Selecting an outsourcing partner
Match outsourcer’s capabilities to your requirements.
Outsourcers range widely in their capabilities. Ensure that their strengths play to your needs. Small companies tend to be hungrier, more flexible, and more willing to bend to your desires because your business forms a larger part of their total business than a mega-firm. Big firms can pick from a wider range of talent and gear up for larger projects.
A phased approach.
Hire the outsourcer to do a small project first to demonstrate its talents. If the initial project is to plan the bigger one, insist on making one of the prime deliverables a good scope of work which can be bid out to anybody.
Powerful decision support systems are available to help select the best outsourcer. Be sure to use these and document the decision well, because no matter who you pick, it will be questioned later. It’s best if you can get all affected executives to sign off in writing that they buy in to the decision.
It often pays to hire a consultant to help with the outsourcing decision. Work hard to make sure the consultant does not have a conflict of interest in the selection.
Setting up a contract
Legal help a law firm specializing in outsourcing contracts can be very helpful. Such contracts are large and complex; unless your legal department has deep experience in this area, encourage them to enlist outside help.
If you wish, you should have the option to spread the work out to more than one firm, even if this comes after or during the initial outsourcing contract. This helps keep your outsourcing partner honest and competitive.
How much risk is your outsourcing partner willing to assume- and how much profit? For a real partnership, they must share the risk and have profits which are tied to the original company’s profits.
Write your own.
Don’t work with a contract draft supplied by your outsourcer. Write the contract yourself, and then insist that it be used as the base. This puts you in control. If they refuse to consider your draft, be prepared to go to another outsourcer.
Get control over subcontractors.
The outsourcer may want to subcontract work out, especially for big projects. This is OK, as long as you insist they get your permission for this and any such important decisions.
A strong confidentiality clause is important to protect you from loss of proprietary information, and also from claims by the outsourcer that you have released their secrets. Each party should treat the other’s internal information with the same level of care as its own.
Outsourcers often would like to be paid proportionally to the amount of work they do. Excellent idea, especially if it can be tied to your revenue and they take a cut if they do less or miss their objectives.
It is very stressful to discuss (like discussing a pre-nuptial agreement with a fiancee)- but you must do it. Agree on all the costs, payments, etc., in case of early termination of the contract, and be prepared to carry them out if need be. You need to retain control over your business.
Remember than control over your account is one of the objectives of any good outsourcing company – they want to ensure they keep your business forever, if possible! Always work to retain enough control to control your own destiny
Working with your outsourcer
The trade-off between fixed price & time-material.
You may be tempted to set up a fixed price contract where the outsourcer provides all services within the scope of work for a single fee. Be careful – you would have to have infinite wisdom to foresee and correctly negotiate every possible service, item, and option you could need over a lengthy contract. On the other hand, time-and-material contracts are well known, especially in government
contracting, for leading to an out-of-control cost spiral. A better approach is a hybrid contract, where you specify and set pricing for all the things you can foresee, and then put aside a specific “kitty” for handling changes, corrections, and additions. Access to the kitty should be controlled by a change management process. Small changes should be at the discretion of project managers. The outsourcer should provide firm prices for added resources (possibly inflation-adjusted).
Always remember that, despite what the marketing people say, the outsourcer’s interests differ from their customers’. It is in the outsourcer’s interest to control the account. Always retain sufficient staff whose priority it is to monitor and steer the outsourcer so their actions are on concert with the company’s directions. Don’t let the outsourcer’s account manager become your company’s de facto CIO (or “VP-in-charge-of the-specialty”) unless you do it by choice.
Planning is as important for the area managed by the outsourcer as it is for any other major department. Demand real, measurable, specific
plans from your outsourcer on how they will accomplish the challenges of the account. Tie these to payments to create a real incentive. This means the outsourcer needs sufficient information, even if proprietary, on your company’s forward direction, to produce a good plan. Use organizational structure to optimize your results.
If your one of your outsourcer’s major selling points is that they will put certain highly talented individuals on your account, put it in the contract, and get them to guarantee what percentage of the genius’ time will be available for your account. This is not to encourage indentured servitude, but remember that without such guarantees the outsourcer can pull these hotshots at any time and replace them with trainees who will learn their trade at your expense.
Transfers from the company to the outsourcer should be made optional if possible. Nobody likes to be forced to change employers, especially if they perceive (whether true or not) the outsourcer’s benefits are less. Provide an option to transfer within the company or be out-placed if possible.
Pensions and benefits
are a sensitive area. Try to make sure that the outsourcer’s plan is at least as good as the base company’s, that it is well-funded, and that people can take seniority with them if transferred involuntarily, including vacation days.
Be prepared for the fact that transitioning to an outsourcer and all the changes that go with it is stressful and traumatic and you will probably lose some good employees no matter how careful you are. Have an open door policy to encourage people to ventilate; you want to minimize loss of corporate knowledge and expertise.
Have your legal house in order.
You need a well-trained, sensitive human resources staff to minimize trauma to workers which then can result in lawsuits. Ensure coordination between HR and legal, do things right, and keep good records; if lawsuits occur, you can minimize costs and morale-busting litigation.