5 Shortsighted Reasons Management Considers Outsourcing

How often have you heard a business leader state that by outsourcing non-core activity, the company can free up valuable resources to focus on brands, customers, products — the critical stuff? This is just one of the many claims made by top management as they consider moving services out of house. But while it seems to make sense on the surface, a bit of skepticism is warranted. Often, that common thinking turns out to be bogus. Here are five reasons companies frequently cite for outsourcing IT or business functions– and why they deserve extra scrutiny.

REASON #1: It’ll allow us to stick to the knitting.

Claim: As Tom Peters and Robert Waterman wrote in In Search of Excellence, successful companies “stick to their knitting.” Outsourcing leaves business managers more time to focus on the company’s primary lines of business.

Reality: This is only true if the people who used to manage the outsourced function are transferred into other business units. On the other hand, if these managers are fired or transferred to the outsourcing vendor, there will be no greater number of managers left focusing on the “knitting” than there were before outsourcing.

In other words, the business only gets more attention if line-management headcount is expanded (and costs are increased). Of course, line-management headcount can be expanded with or without outsourcing a service function.

Real cost/benefit: This is rhetoric, not a real benefit.

REASON #2: It’ll help reduce management distraction.

Claim: Outsourcing relieves top management of having to worry about managing a service function.

Reality: Managing outsourcing vendors is no easier (in fact, it may be more difficult) than managing internal staff. Contracts and legal interpretations are involved, and it’s not always easy to guide people when you don’t write their performance appraisals.

Even if outsourcing does succeed at saving management time, the result may not be desirable. Outsourcing shifts the nature of management involvement from dialogue about the function’s work to negotiations about the contract.

Meaningful collaboration is further diminished because vendors are held at arm’s length and not involved in business discussions and strategic decisions. Executives may be concerned about confidentiality. In addition, executives may be reluctant to incur the significant extra fees associated with doing anything beyond the originally-contracted workload.

Reduced executive involvement in managing the actual work of a function may actually be counterproductive.

Many service functions, such as IT and HR, have been used by clever companies to gain competitive advantages. But without management involvement, there is danger that the function will do little more than it has done in the past. That is, it may continue to produce administrative and operational products and services, but will find few breakthroughs in strategic applications of its work.

Those who understand the strategic value of internal service functions argue that management should spend more time, not less, thinking about aligning all of the firm’s activities.

Real cost/benefit: Managing outsourcing may take more time, not less. If it does save time, reduced management involvement may mean reduced strategic alignment, with untold business opportunities lost.

REASON #3: It’ll enhance management control.

Claim: Outsourcing gives top management greater control by specifying clear performance metrics in the contract.

Reality: Even seemingly indisputable quantitative metrics are of limited value.

For example, a consumer-products company became concerned when the quality of service from their vendor began slipping. Service level agreements were in place, but experience proved that they couldn’t document targets in enough detail to protect the company.

Ultimately, the company relied on simply demanding the number of labor hours they were paying for. Even labor hours proved controversial. For example, the vendor insisted on charging for time even while positions were vacant due to turnover, claiming the lost hours were covered by overtime and other efforts.

In extreme cases of non-performance, outsourcing drastically reduces management’s control. Consider the difference in the levers management can control:

Internal executives who don’t perform can be disciplined or dismissed.

Remedies for breach of an outsourcing contract, on the other hand, are difficult to enforce. If dispute resolution mechanisms don’t work, the costs and risks of arbitration or judicial proceedings can be significant. And if a company buys its way out of a long-term contract, its alternatives — switching to another outsourcing vendor or rebuilding an internal service provider — are costly, risky and time consuming.

Even if quantitative metrics could be enforced, there are dangers in managing a function this way. Many of the most important deliverables can’t be easily quantified and require subjective judgments.

For example, in IT, it’s easy to measure the cost of computer time, but nearly impossible to quantify the contribution of information technology to business strategy. Even the concept of “reasonable” response time is elusive, since what’s considered reasonable under most circumstances may be completely unacceptable in an emergency.

In general, the more interesting the concept, the less tangible the metrics.

It’s common practice to include subjective judgments in staff performance appraisals. But subjective metrics in a legal contract are extremely difficult to enforce and virtually meaningless. By limiting management control to quantitative metrics, the most important objective, strategic value, may not be delivered at all.

Real cost/benefit: Since subjective judgments are required, it’s easier to control internal staff via performance appraisals than vendors via performance metrics.

REASON #4: It’ll improve cash flow.

Claim: Outsourcing is a source of near-term liquidity, since assets may be sold to the outsourcing vendor as part of the deal, turning fixed assets into cash when the vendor takes over.

Reality: Selling a strategic resource is a drastic way to save a sinking firm. Selling a critical support function risks crippling all remaining business units and increasing long-term costs.

In such a crisis, it might be better to sell a line business unit, and leave the remaining businesses in a healthier position with the proper internal support services and cost structure.

Real cost/benefit: This is a short-term survival tactic for drastic circumstances only, and a questionable one even then.

REASON #5: We need it for “window dressing.”

Claim: Outsourcing improves the appearance of the firm’s financial statements, for example, reducing headcount, improving liquidity, and reducing assets.

Manipulating these indicators may seem advantageous if a firm is considering being acquired or floating a stock offering (especially an initial public offering), or a divestiture or sale.

Reality: In an acquisition or stock offering, due diligence uncovers long-term commitments and factors them into the cash-flow analysis. To the extent that outsourcing is more expensive, this trick will reduce the value of the firm, not increase it.

Furthermore, such “window dressing” reduces management’s credibility and damages its negotiating power.

Real cost/benefit: This is a hollow trick, not a real benefit.

Useful Links:

NDMA
http://www.ndma.com

How To Transform IT without Outsourcing: An Interview with N. Dean Meyer
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Two Vendor Claims on Cost Savings that Deserve Major Scrutiny
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Five Common Claims Vendors Make in Outsourcing Sales — and the Reasons Why You Shouldn’t Believe Them
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© 2005 NDMA Inc.