The advantages of working with your internal staff are pretty obvious. Assuming service levels are equivalent, internal service providers typically have significant price advantages. And even when prices are comparable, there are two key reasons why insiders have the advantage over outsourcing vendors: continuity and vested interests.
Continuity:Internal staff has a history with the firm that provides them with a better understanding of clients’ businesses, strategies, people, cultures and politics. And with the expectation of continuity, people know they’ll be around to deal with the consequences of their actions. All else being equal, this results in improved partnerships, which pay off in both greater client satisfaction and improved strategic alignment.
By contrast, outsourcing vendors may rotate their staff to other firms’ contracts more readily, tying individuals’ loyalties to the outsourcing vendor rather than to the firm.
Vested interests:Outsourcing vendors may be sincere about partnership, but ultimately they work for different shareholders and ethically must (and will) place their parochial interests first.
For example, in a needs-assessment interview with a client, what would happen if the IT professional sees an opportunity for either a $2,000,000 administrative application that could save administrative costs, or a $2,000 tool that could significantly enhance an executive’s personal effectiveness at delivering the company’s strategy? While the latter choice provides far higher payoff and more strategic value, the outsourcing vendor has a strong incentive (and ethical obligation) to recommend the more expensive (for the vendor, the more lucrative), lower-payoff administrative project.
But just as the use of internal staff has advantages, vendors and contractors also offer unique benefits when utilized and managed properly: saving money, sharing risks, accommodating peak loads, and developing internal staff.
–> Advantage #1: Outsourcing can save you money.
Economies of scale save money when unit costs go down as volumes increase. External service providers can achieve economies of scale unavailable to individual firms when they combine the volumes of multiple companies.
In manufacturing, for example, an external vendor may have a shop that specializes in a certain type of machining. The machinery represents a significant capital investment. If larger machines are more efficient, and if they can be used to produce any sort of parts for any customer, then this vendor may very well produce parts at a lower cost than a firm could by setting up such a shop internally.
Economies of scale are not limited to physical processes. Other precious assets — including money, relationships, and people — may be shared.
The pharmaceuticals industry can be used to illustrate economies of scale in relationships. Clinical trials of experimental drugs require just the right patients — healthy in most all respects but the one indication being treated, and willing to submit themselves to experimentation. It takes a significant investment of time and money to develop relationships with the hospitals and clinicians (and the triage nurses in their emergency rooms) that supply patients for the trials.
Clinical trials also require just the right medical investigators — doctors and medical researchers who are well respected in their industries. Again, it takes size to attract the best investigators. The most sought-after investigators look for organizations that can supply them with interesting and publishable research projects and with support services (such as data collection and well-managed processes) that make their jobs easier and their results more reliable.
And so a lucrative outsourcing industry has evolved to manage clinical trials of experimental drugs for pharmaceutical companies. [The author thanks Patricia Seymour, Covance Biotechnology Services, Research Triangle Park, North Carolina, for this case study.]
To be specific, there are three conditions that must be met before outsourcing saves money:
1. Economies of scale must exist. That is, there must be some economic advantage to larger size or greater numbers before outsourcing can pay off; for example, unit costs must drop as volumes increase.
2. The economies must be accessible across corporate boundaries. That is, savings only occur if outsourcers can combine the volumes of multiple clients.
For example, it’s easy for many companies to share the huge fixed costs of a telecommunications infrastructure owned by long-distance carriers. Laying one’s own fiber or leasing a private satellite channel is unlikely to be economic, so outsourcing is an obvious choice.
However, outsourcing an IT computer center may not work as well, since hardware may not offer significant economies of scale and many software licenses are corporation-specific.
There are many cases where inter-organizational sharing is possible, but each case must be examined carefully.
3. The savings must be sufficient to outweigh the additional cost of paying other shareholders a profit.
Some executives have said that at least a 20% savings (after vendor profit margins) is necessary to compensate the firm for the legal costs and the risks of long-term dependence on people you can't control.
–> Advantage #2: Outsourcing can help you share risk.
Another type of synergy that can cross corporate boundaries is the sharing of risk. In financial circles, this is called the “portfolio effect.”
In investing, it’s best to diversify your portfolio rather than put all your money in one stock. By spreading your risk, you reduce your total risk.
Why does diversification reduce risk? If the whole market goes down, you’ll lose, no matter what you do. But if the market goes up while one company makes some serious mistakes, the rest of your portfolio may still do well, and you are not as vulnerable as you would have been had you put all your money into a single stock.
In business investments, the same is generally true. Outsourcing may permit multiple companies to share risk.
To continue with manufacturing as an example, if all your work is done in one plant, an outage or a labor dispute could put you out of business. If you spread your workload across a number of plants, a labor dispute in one country may not affect the operations of other plants. Thus, you reduce your risk.
In a very large operation, it may be that the company can afford multiple plants. But in smaller companies — or in the production of small-run specialty parts — it may be cheaper to spread the work across a number of existing vendor plants via outsourcing than it is to build a number of small plants yourself.
The biotechnology industry demonstrates the concept of risk-sharing. Investors are reluctant to fund small biotechnology companies to build manufacturing plants for drugs which haven't yet been approved. But manufacturing is required to produce experimental drugs for clinical trials in order to gain approval.
Bio-tech firms often outsource manufacturing during the clinical-trials phase of development. This demonstrates both economies of scale and risk sharing: The vendor’s large plant, shared across a dozen firms at a time, is more efficient than a dozen small plants. Secondly, the risk of building infrastructure that may not be used is shared across many small pharmaceutical firms.
–> Advantage #3: Outsourcing can help accommodate peak loads.
Outsourcing can be used to minimize fluctuations in headcount that could result from peaks and valleys in demand.
To protect staff from fluctuations in demand, every entrepreneur should staff to the valleys and outsource the peaks.
The added expense per hour of contractors must be balanced against the expense of hiring enough staff to handle the peaks and then wasting time between peak periods. If peak loads are frequent and the valleys are short in duration, hiring may be more economic than outsourcing. If peaks are occasional, contractors will save money in spite of their higher costs per hour.
–> Advantage #4: Outsourcing can help develop your internal staff.
Well-managed outsourcing can enhance the development of employees. Two strategies can accomplish this:
1. Contractors can be used to off-load less interesting “commodity” or end-of-life work, or to handle peak loads. This leaves staff free to pursue new, developmental opportunities.
On the other hand, contractors should never be used to perform new, growth-oriented activities while internal staff is left with obsolescent work. This would deny staff learning opportunities, while building dependence on the vendor. Perhaps worse, it sends a message to staff that the company is not willing to invest in their professional growth.
2. Consultants and vendors can be used to bring in new ideas and to train internal staff.
It might be useful to distinguish two terms: External “consultants” transfer their skills and methods to improve employees’ effectiveness; they teach staff, often while working together on real projects. Consultants may be used by anyone whenever justifiable, since the benefits are lasting.
By contrast, “contractors” simply do work in place of employees. This is sometimes called "staff augmentation." They should be limited to the commodity work described in point 1.
There are many cases that meet these four criteria where outsourcing pays off. But each case must be examined carefully to make sure the fundamentals are there. Remember: Paying other shareholders a profit margin makes outsourcing inherently more expensive. It’s only worthwhile if these other benefits compensate the firm for its added costs.
© 2005 NDMA Inc.
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