Planning
7. Outsourcing and risk management
Program
Outsourcing as a business concept
Definitions
Rationales for outsourcing
Success of outsourcing as a business strategy
The outsourcing process
Risk assessment
Critical success factors of outsourcing
Outsourcing as a business concept
Organizations turn to outsourcing to enhance their competitiveness
Drivers behind outsourcing are:
Changes in the business environment
New management concepts (e.g. BPR)
Organizational restructuring
Benchmarking
Alliance management
Lean management
The Outsourcing Institute reports that outsourcing in the USA has
grown dramatically from 1996 onwards. Outsourcing expenditures in
2000 were around $340 billion and were expected to grow 15%
annually.
Also in Europe and Asia the market for outsourcing is expected to
grow double digits (Corbett, 2002)
Outsourcing as a business concept
The types of activities that are outsourced have evolved over time.
Starting out with activities, more and more entire business functions
are being outsourced.
Transportation 5%
Real estate 10%
ICT 20%
Manufacturing 7%
Marketing and Sales 6%
HRM 9%
Distribution & Logistics 10%
Finance 7%
Management 4%
Customer services 7%
Administration 15%
Source: The Outsourcing Institute,
Dun & Bradstreet, 2000
Definitions
Outsourcing is the transfer of activities, that were previously
conducted in-house, to a third party
Outsourcing means that the company divests itself of the resources
to fullfil a particular activity to another company to focus more
effectively on its own competence (NEVI, 2000)
Outsourcing is the decision and subsequent transfer process by
which activities that constitute a function, that earlier have been
carried out within the company, are instead purchased from an
external supplier (Axelsson and Wynstra, 2002)
Definitions
Major characteristics of outsourcing are…
1. that activities that initially were performed in-house
are transferred to an external party
2. that assets and people go over to that external party
3. that there will be an extended relationship between
the parties involved over a longer period of time
4. that in transferring the activity to the external party
the buyer is exposed to both a cost- and risk profile,
both of which are new to the companies involved
Definitions
Two different types of outsourcing:
Turnkey (integral) outsourcing: responsibility for the
execution and the coordination of the entire function (or
activities) lies with the external supplier.
Partial outsourcing: Only a part of an integrated function
is outsourced. The coordination of the function still lies
with the outsourcer.
Definitions
Partial versus turnkey outsourcing
Advantages Disadvantages
Turnkey Buyer has minimal responsibility for The buyer has limited influence on the
outsourcing outsourced processes determination of the price and little insight in cost
structure of provider
Buyer doesn’t need to have experience with
similar projects Buyer has limited influence on the staff, technology
and materials used and their quality
The project generally goes smooth for the
buyer Large dependence of buyer on provider resulting in
high commercial, technical and performance risks
Partial The buyer has more influence on prices, rates Buyer is required to have knowledge of the
outsourcing and costs seperate parts of the outsourced function/ activities
The buyer has more influence on the staff, The buyer is required to have the organizational
technology and materials used and their capabilities to coordinate and integrate the
quality outsourced function / activities
Specific advantages can result in cost Communication and coordination problems
reductions between parties involved can be a cause of delay
and disappointment
Definitions
Outsourcing consists of two important dimensions
Outsourcing
Transfer of the function
Decision to outsource and/or activities to an
external supplier
Rationales for outsourcing
Strategic reasons 1. Improve company focus
for outsourcing 2. Gain access to world class capabilities
3. Get access to resources that are not available internally
4. Accelerate reengineering benefits
5. Improve customer satisfaction
6. Increase flexibility
7. Sharing risks
Tactical reasons 1. Reduce control costs and operating costs
for outsourcing 2. Free up internal resources
3. Receive an important cash infusion
4. Improve performance
5. Ability to manage functions that are out of control
All these reasons underlie one overall objective: to improve the
overall performance of the outsourcing firm
Rationales for outsourcing
Advantages and disadvantages of outsourcing
Advantages Disadvantages
Freeing up of cash: investments can be Increased dependence on suppliers
concentated on core activities
Optimal usage of knowledge, equipment and Continuous follow-up and monitoring of the
experience of third party supplier relationship necessary
Increased flexibility: fluctuations in the workload Risks of communication and organizational
can more easily be absorbed problems during the transfer of activities to a third
party
Outsourcing leads to easier and more focussed Risks of leakage of confidential information
primary processes in the organization
Input through an independent party’s point of view Performance incentives and penalties
which reduces the risks of introvert short-
sightedness in the organization
Risk of losing essential strategic knowledge
Success of outsourcing as a business
strategy
Determining the success of outsourcing is very difficult
External factors in the before and after situation may have
changed
Often impossible to determine the costs of the function before it
was outsourced
Outsourcing is often poorly evaluated as data is just not
available
The success of outsourcing as reported by various reports
varies enormously. However, most reports conclude that
outsourcing projects in more than half of the cases do not seem
to produce the results that were expected from them.
The outsourcing process
Strategic phase Transition phase Operational phase
Competence Assessment Contract Project execution Managing Contract
analysis & approval negotiation & transfer relationship termination
Adapted from Momme, 2002
The Strategic phase
Three main questions in the Strategic phase
What is the motive to outsource?
Focus on core competence?
Focus on efficiency / effectiveness?
Focus on service?
What activities are candidates for outsourcing?
Transaction cost approach (Williamson, 1983; Arnold, 2000)
Core competence approach (Quinn and Himler, 1994)
What qualifications should a supplier require?
Supplier selection process (Momme, 2002; Wynstra, 2002)
Monitoring practices in supplier partnership
The Transition phase Different outsourcing contracts
Lump-sum turnkey Contract is based upon a fixed price (per period) for executing the project or a certain
activity
Reimbursable turn-key The provider is compensated for all costs that he incurs for executing the project or a
certain activity
Semi lumpsum turn-key Part of the work is compensated on a fixed price basis; the other part is compensated
on a reimbursable basis
Lumpsum fixed price The supplier agrees to complete the work against a fixed price based upon a
predefined, detailed scope of work. Everything that is not included in the scope of
work is settled between parties on an ad-hoc basis
Cost reimbursable The supplier agrees to complete the work on open book, open cost basis based upon
a general scope of work. There is no sharing of savings
Guaranteed maximum The same as a cost reimbursable contract, only the outsourcer pays to a certain
contract agreed maximum. The extra costs are for the supplier
Share the savings / loss The services are paid for on a reimbursable basis. When the contract costs are higher
(target price contract) or lower than the original budget (target price), the difference is shared between
parties on a pre-agreed basis
Unit rate Rates are agreed for regular, routine activities, the size of which cannot be
anticipated. Rates are defined per m2 of paint, meter of cable to be installed, etc.
Payments are made based upon actual use.
The Transition phase
The type of contract is just one of many issues to be
discussed. Other ‘ingredients’ in an outsourcing
agreement are:
Scope of services
Term of agreement
Service level agreement (SLA)
Rates, fees, incentives, penalties
Termination plan
Conflict resolution
Communication
Management and control
Other (e.g. warranty, confidentiality, audit rights, etc.)
The Transition phase
Outsourcing transition can be very complex
The transfer should be conducted using project management
principles
Assignment of a dedicated project manager by
Sound transition plan
Project timeline with milestones
Test phase before going ‘live’
Outsourcer should provide training and support to provider if
necessary
The Operational phase
It is in the operational phase that the outsourcing will deliver its
expected results
Successful outsourcing depends heavily on close cooperation with
the supplier
McQuiston (2000) identifies six core values as being critical to a
successful outsourcing relationship
Core values Supporting factors
Shared goals and objectives
Mutual dependence Developing a personal relationship
Open lines for communication Having professional respect
Concern for the other’s profitability Investment of effort by top management
Mutual commitment to customer Commitment to continuous improvement
satisfaction
Trust
McQuiston (2000)
The operational phase – Risk assessment
In cases where trust and interpersonal relationships are not present,
parties try to arrange for dealing with these risks and uncertainties
by detailed outsourcing contracts
These contracts are associated with the following kinds of risks:
Technical risks: related to the extent to which the supplier is able to
provide the desired functionality and performance
Commercial risk: related to the uncertainty with regard to the price we
will pay and the costs that we will incur when having outsourced our
activities to the supplier
Contractual risks: e.g. does the contract in sufficient detail describe
the performance that is expected from the supplier?
Performance risks: related to the chance that the supplier is not
capable of doing the job he was hired for.
Many authors have pointed out that in dealing with these risks,
detailed contracts will not solve the problem. Trust and partnership
are more important.
Critical success factors of outsourcing
The Outsourcing Institute and others considers the following factors as
critical for success in outsourcing:
Understanding company goals and objectives
A strategic vision and plan
Selecting the right vendor
A properly structured contract
Open communication with the individual groups involved
Ongoing management of the relationship
Senior executive support and involvement
Careful attention to personnel issues
The way the company is strategically positioned vis-à-vis its
supplier. Can it still exert some control over its supplier, or not?
