The Dimensions of Outsourcing

By Desmond Doran and Stephanie Morgan of the Kingston Business School Kingston University Kingston upon Thames

Contents [hide] 1 The Dimensions of Outsourcing 2 Introduction 3 Why do organisations outsource? 4 What activities are typically outsourced? 5 What is the Process of Outsourcing? 6 What are the difficulties associated with Outsourcing? 7 Trends in outsourcing 8 Current debates and future issues 9 Resources 10 References 11 Bibliography

Introduction

This paper will explore the various dimensions of outsourcing and the processes and difficulties associated with the transfer of in-house activities to external third parties. In essence, outsourcing involves an organisation handing over control of a function to another organisation that then takes responsibility for the provision of that function. Outsourcing as a viable alternative to in-house provision became popular in the 1990s as organisations experienced increased competition and began exploring ways to reduce their costs (Mullin, 1989)^[1]. This led to the development of an outsourcing industry capable of providing cohesive and attractive options for organisations seeking cost reductions for peripheral services and products. Whilst traditionally associated with back-office or support activities, outsourcing is now increasingly seen as a viable alternative for activities that could be regarded as core to an organisation’s operations and is now utilised extensively in both the public and private sectors.

What is Outsourcing? Outsourcing has been defined by the National Outsourcing Association (NOA) as: 'The provision by a third party organisation of services or a bundle of business processes that historically have been performed in-house by the service receiving customer.'

Bravard and Morgan (2006)^[2] break down the key elements of outsourcing as:

• The contracted use and leverage of third-party resources, assets and skills,
• with guaranteed levels of quality, resilience and value to cost criteria and measurement,
• to deliver services previously provided in-house,
• possibly involving the transfer of existing staff to the service provider,
• and/or transformation/rejuvenation of the business support processes and technology.

Outsourcing is often confused with sub-contracting. Sub-contracting is a situation where an organisation uses the resources of a third party to provide services that it has not previously provided in-house. For example, the completion of year-end accounts is traditionally sub-contracted by small businesses that do not have their own internal resource for such activities. Similarly, a building firm will often sub-contract trade activities and focus its own resources on the building itself. Outsourcing therefore refers to the transfer of activities previously provided in-house.

Why do organisations outsource?

The motivation for outsourcing has been explored by a number of authors in a number of sectors. The catalyst for change was work undertaken by Skinner (1969)^[3] who developed the concept of organisational 'focus' (concentrating on activities that were small, manageable and which the operation can become excellent) whilst Prahalad and Hamel (1990)^[4] developed the distinction between “core” and “non-core” activities which now form the initial assessment of most outsourcing decisions. Moving beyond the boundaries of the firm, Teece (1986)^[5] developed the notion of “complementary assets” which revealed the potential benefits of partnering with external organisations in order to improve overall organisational performance. In essence, each of the above developments were step changes toward creating an environment in which outsourcing became a natural consideration for organisations seeking to improve their operations.
There are now many reasons why organisations choose to outsource activities previously provided in-house:

• To focus upon core business activities – outsourcing non-core activities can free up internal resources to concentrate on more critical activities.
• To Reduce and control operating costs - this is perhaps the primary reason why many organisations do turn to outsourcing. Outsourcing converts fixed costs into variable costs, releases capital for investment elsewhere in your business, and allows organisations to avoid large expenditures in the early stages of their business development. Outsourcing can also make your business more attractive to investors, since you're able to inject more capital directly into revenue-producing activities.
• To improve focus – outsourcing can allow an organisation to focus upon what it regards as the most important issues relating to their long-term viability. For example, a retail operation might regard selling goods or services as its primary focus and providing customer support services (for warranty claims, delivery arrangements, spare parts enquiries etc) as a non-core activity that could be outsourced.
• Gain access to world-class capabilities - this is particularly the case in Customer support services and Logistics where global capabilities have improved as a result of advances in technology and the development of cohesive solutions by global players.
• Free internal resources for other purposes - this reason for outsourcing has grown as organisations focus upon what they regard as their core competencies.
• A function is time-consuming or difficult to manage – typically examples of such activities include payroll (as a business expands its operations), website management, health and safety training (to comply with changes to legislation).
• Insufficient resources – leading to the need to utilize the capital resources of specialist service or product suppliers.
• To reduce risk - Every business investment carries a certain amount of risk in terms of markets, competition, government regulations, financial conditions, and technologies. Outsourcing providers assume and manage this risk for you, and they generally are much more proficient at deciding how to avoid risk in their areas of expertise.

Similarly, McCarthy (1996)^[6] notes that firms consider outsourcing in order to provide the opportunity to refocus their operations and to provide time to improve processes associated with their core activities. Taking a more strategic view, Lankford and Parsa (1999)^[7] view outsourcing as an opportunity to completely re-engineer the organisation. They argue that re-engineering provides the opportunity to examine who is best suited to performing a task, who can do the task with the greatest efficiency and the highest quality

What activities are typically outsourced?

Typical outsourced activities include:

• IT functions – including the transfer of payroll, the management of IT systems, website management and application/order processing activities.
• Customer support services – stock ordering, claim handling, delivery queries.
• Business processes – including recruitment, payroll and secretarial services.
• Logistics – whilst essentially focussed upon moving goods this service now extends to warehouse management, procurement and stock control and supply chain management activities.
• Training services – taking on responsibility for customer service training, health and safety compliance training.
• Maintenance – buildings, lifts, grounds etc.
• Accounting – typically involving the maintenance of book-keeping systems, tax management and invoicing.

What is the Process of Outsourcing?

Dornier et al (1998) developed an outsourcing decision matrix which assesses the strategic value and criticality of activities being considered for outsourcing (Figure I). The strategic value is the extent to which the activity contributes to the achievement of competitive advantage whilst criticality relates to the contribution that it makes to the performance of the final product of service to which it contributes. The matrix consists of four key areas – Novelty, Proprietary, Commodity and Utility. The novelty dimension is not essential to the functioning of the final product but may reflect specialized or restricted technology. Proprietary items are likely to be based upon core competencies of the organization and are unlikely to be considered for outsourcing. Commodity items are likely to be based upon standardised and commonly available technology and make minimal contribution to product or service functionality – such items are often considered appropriate for outsourcing. Finally, Utility items are regarded as critical to the final product but are based on readily available technology. Outsourcing of such items should only be considered when a supplier offers an adequate level of cooperation and service to ensure product/service availability.
Figure I – The Outsourcing Decision Matrix

The process of outsourcing has also been considered by McIvor (2000) who proposes a logical framework for evaluating the outsourcing decision consisting of a number of key stages (Fig II)
Figure II – Framework for evaluating the outsourcing decision

Source: Adapted from McIvor, 2000
Stage 1 of the process is, perhaps, the most critical. At this stage you must identify the ‘core’ activities of your business and what activities might be regarded as ‘non-core.’ Core activities are those activities that the organisation does particularly well and that from the basis of a competitive advantage whilst non-core activities are those activities that could be outsourced to a third party without negatively impacting the nature or scope of your operations.
Once you have performed this stage you can move onto...
...Stage 2, which involves evaluating relevant value chain activities. Value chain activities include in and outbound logistics, operations, marketing & sales, and services . The idea behind this stage is that you compare your ability to perform these activities with those of potential outside suppliers. This will enable the company to identify its relative performance for each core activity along a number of selected measures.
Stage 3 attempts to identify and measure the costs associated with either retaining the activity in-house or outsourcing the activity. This stage needs to be undertaken as accurately as possible and should reflect prudent accounting practices that accommodate overhead, management, capital and transition costs, loss of business or utility during the changeover period, and managing the supplier during the initial stages of the activity. If the cost analysis indicates that outsourcing is still viable then management should consider selecting a suitable supplier to perform the relevant activity.

The type of relationship formed will depend, to a large degree, upon the nature and scope of the outsourced activity. If the activity is regarded as critical to the organisation’s future then steps need to be taken to ensure that the supplier delivers according to the contractual specification and that penalties are in place for situations where the supplier fails to deliver contracted obligations.

What are the difficulties associated with Outsourcing?

Whilst outsourcing has been heralded as a way of controlling costs and improving services levels there are a number of difficulties associated with outsourcing which need to be considered before embarking upon such an option. The key difficulties associated with outsourcing are:

• The potential for loss of control of the process. Once a contract has been agreed it is then that the real impact upon everyday operations is felt. New staff, new uniforms, new approaches make real the feeling that the outsourced process is no longer under your control. Additionally, you may lose the flexibility that you had when the activity was performed by your own staff.
• Other companies may also be using the service provider. Therefore in some cases, the best interests of the service provider may be diluted with other users; this may lead to a loss of competitive advantage.
• Employees may react negatively to outsourcing and consequently their quality of work may suffer. This has often been the case where the outsourced activity has been performed in-house for a number of years. Within the public sector, particularly the National Health Service, outsourcing has often been regarded negatively as a way of reducing headcount rather than a way of improving services. As a consequence there may be a great deal of tension between the service provider and other staff within the organisation.
• Creates potential redundancies – a natural consequence of many outsourcing decisions is the reduction in employee numbers. The impact of such reductions needs to be accommodated by the outsourcing organisation when planning the outsourcing process.
• The fear of the service provider ceasing to trade (bankruptcy, etc). It is incumbent upon the outsourcer to undertake a financial assessment of the outsourcing organisation to determine its long term viability. This is particularly important where the outsourcing contract is for a long period.
• Potential for price rises – once the service is outsourced the service provider is in a position of power, particularly where the service user has few options to seek an alternative provider or where the costs associated with changing the service supplier are prohibitive.
• Managing the outsourced operation – Whilst outsourcing can often lead to immediate reductions in outgoings the cost of managing the outsourced activity is often overlooked and can be considerable. Such costs include monitoring, management and administration costs.

Harland et al (2005) suggest that there are a number of risks associated with outsourcing which include:

• Failure to differentiate between core and non-core activities
• Difficulties in Insourcing the activity if the outsourcing activity fails to effectively deliver desired outputs
• Lack of skills and competence to manage outsource relationships
• Lack of understanding, skills and competence to design appropriate service level agreements with the outsource supplier

Such risks are often overlooked and may impede or negate the expected benefits of outsourcing. However, it is often difficult to determine in advance what skills and competencies are required for managing outsource relationships.

Trends in outsourcing

Predicted trends in outsourcing have been modified somewhat due to the global recession. There are opposing views about whether outsourcing will increase even faster or reduce under current circumstances (Allen, 2009, Flinders, 2008). There is also debate regarding whether multi-sourcing will become more popular, or whether clients will tend to stick to one supplier to increase discounts (Tholons, 2009). However the general view is that the complexity of outsourcing, the range of activities being outsourced, and that the number of countries developing their outsourcing offer to the West will all increase. In terms of locations, China is likely to become a major player, particularly in offering to South Korea, Japan and Taiwan. China is targeting the IT Industry and basic finance and accounting processes in the West, although language difficulties still hold it back (Bhatnagar, 2008). Russia is attempting to move into the knowledge market (Swabey, 2008) and Egypt is considered a particularly strong future contender for a range of offshoring due to a low cost base and cultural compatibility with the West, however infrastructure and perceived terrorist risks are still considered problematic (Willcocks, Griffiths & Kotlarsky, 2009). Tunisia and Morocco are becoming attractive to French speaking nations and South America for the Spanish. Language and culture remains a key concern for offshoring, along with the issues of managing at a distance, making nearshoring more popular (Carmel & Abbott, 2007).
In terms of forms of outsourcing, some suggest that organisations will turn more to insourcing or use a smaller range of suppliers as they become more expert at managing outsourcing contracts, with larger organisations developing internal strategic sourcing capabilities (Lucas, 2008). The financial services sector is viewed as particularly suitable for insourcing due to legislative and high rate of change in markets (Kortmann, 2007). As awareness increases of the risks of offshoring a broader range of organisations are likely to consider insourcing as a strategic option. Industry sectors likely to increase their outsourcing spend include healthcare, education, retail and telecom (Tholons, 2009). In the UK service sector the largest increase is considered to be in the public sector, (Health Service Executive, 2008). The occupations most likely to attract increased offshoring include, computer and mathematical sciences, back-office and administrative support, architecture and engineering (Moncarz, Wolf & Wright, 2008, see also Manning, Massini & Lewin, 2008). A recent report by Nelson Hall (Wilmott, 2009) indicates that the global business process outsourcing market will reach 450 billion US dollars by 2012, with a key driver being the need to gain entry into emerging markets. Outsourcing in all its forms remains an important business strategy.

Current debates and future issues

Outsourcing and offshoring in particular, have been criticised in a number of ways, and there is still substantial debate regarding when it is best to outsource and how to ensure the strategy achieves its aims. Some research suggests that 30% of outsourcing contracts do not achieve their goals (with approximately 25% back-sourcing - bringing back in-house) and that up to 60% are not fully satisfied with their supplier (Deloitte, 2005; Logan, 2000), and a number referring to their relationships as ‘difficult and uncomfortable’ (Harris, Parker, Le Quoc & Takahashi, 2005). Core issues are around contract development, measurement and the need for clear service-level agreements, alongside the development of a strong and trust-worthy relationship (Beaumont, 2006; Poppo & Zenger, 2002). Service level agreements must be detailed enough to allow clear evaluation of compliance but flexible enough to allow for future changes.
Issues such as these will also depend upon which timescales are considered and although in the past short term contracts have been popular, there is a view that longer term contracts are more suitable, giving both parties time to learn, and reducing disruption, as long as the contract and all involved take the full life-cycle into account (see Dueck, 1999; Morgan & Morgan, 2007). Legal, moral and ethical regimes and enforcement of these vary by country, and this is increasingly viewed as problematic (see Daugherty, & Dickins, 2009) - and linked to this are concerns about security. Horror stories of credit card details being sold in coffee shops has made the public more aware of these issues, and the recent accounting fraud at Indian outsourcing giant Satyam has raised the profile of risk in outsourcing. Companies cannot hand over the risk or their regulatory responsibilities when they outsource a process or activity, indeed the risks are further complicated.
The human aspects will also need increased consideration, in particular the issue of ‘retained competencies’. Having the right people with the required skills to negotiate, manage and evaluate the outsourcing contracts is crucial, yet our understanding of what these skills are remains weak. These skills are likely to include contractual and commercial understanding, co-ordination and control of suppliers, change management and strategic planning – such skills take time to develop. Issues that are starting to emerge in the literature include concerns regarding the loss of intellectual capital, reduced organizational learning and lack of knowledge transfer (e.g. Willcocks, Hindle, Feeny & Lacity, 2004)). Cultural aspects particularly in offshoring will remain of concern (Swabey, 2008) with research indicating that misunderstandings occur due to cultural differences, increasing the risk in outsourcing (e.g. Metters, 2008).
The development of organisational interfaces and understanding of how to manage virtual organisations will become more important (Useem & Harder, 2000) again this is linked to how well people can communicate and negotiate ongoing contracts. Employee engagement has been shown to be problematic, particularly in transfer situations (Morgan, 2007). Even though staff are often protected (for example, TUPE arrangements in the UK) a poorly managed transfer can lead to a great deal of ill-feeling which can impact upon your business. Coyle-Shapiro, Morrow & Kesler (2006) demonstrated that the level of organizational support from both the original employer (client) and the receiving company are important in ensuring commitment and service oriented citizenship behaviour.
Theories and concepts linked to, for example; the psychological contract, exchange theory, organizational justice, trust, and knowledge management are increasingly being used to understand outsourcing and insourcing (see Coyle-Shapiro & Morrow, 2006; Logan Faught & Ganster, 2004). Trust has been shown to be a vital element in outsourcing contracts (Lander et al. 2004), although developing trust can be problematic over distances (Handy, 1995). Other research linked to these theories but not specific to outsourcing can inform. For example Chiu & Peng (2008) demonstrate a clear link between employee deviance and perceptions of psychological contract breach. This suggests that deviance may be a problem after outsourcing transfers; however, research specific to outsourcing is needed in many of these areas to understand in depth how outsourcing may influence staff behaviours and best practice in managing transfers and ongoing relationships (see Morgan, 2008). Psychological aspects, including emotions, have been shown to influence seemingly rational, economic decisions, including choice of supplier (Donada & Nogatchewsky, 2008). Clearly there is a need to understand how outsourcing affects the people involved to better understand how it will affect your organisation and your customers.
Questions have been raised regarding how long companies can continue to move around the globe finding cheaper labour. The cost of graduate employment in India is already increasing and this wage inflation is a trend seen in the past as work is moved to other countries. The recession is also likely to lead to an increased backlash from the public as protection of jobs becomes a deeper issue. The recent announcements that IBM is to move thousands of jobs to India and China from the US has led to much public interest, although Earle, Madek & Madek (2007) emphasise that state and federal law will not be sufficient to stem the tide of outsourcing. In terms of future staffing organisations also need to consider that for the higher end (e.g. BPO and KPO) we are reliant on a regular supply of graduates willing to work in low level jobs. Of crucial concern to the service sector is the customer experience. Should the outsourcing contract impact on just one of the ‘critical points’ for the end-customer serious repercussions arise, Offshoring in particular has been shown to have a significantly negative impact on customer service (Poppo & Zenger, 1999), although some studies suggest this can also be a problem if customer service itself is outsourced domestically (Whitaker, Krishnan & Fornell, 2008).
Moncarz et al. (2008) suggest that service organisations should only consider offshoring when:

• The level of contact with the customer is low.
• Social networking demands are low (no need to discuss with other staff).
• Need to understand local cultural or social situation is low.
• Inputs and outputs can be transmitted electronically with ease.
• The work can be easily routinized or scripted.

To summarise, outsourcing has many benefits but also many hidden costs (Barthelemy, 2001). Organisations should analyse in detail why they wish to outsource, what they hope to achieve, and use the many tools available to evaluate which activities are likely to benefit from outsourcing. Development of in-house skills to negotiate and manage contracts will be vital. Those organisations already experienced in outsourcing should continue to learn from the process and ensure benefits are quantified, something still rare even in the mature IT outsourcing market (KPMG, 2007). Service level agreements are vital components in successful outsourcing contracts, do not believe the rhetoric around relationships being more important than contracts, research supports the view that the two are complementary (Poppo & Zenger, 2002).

Resources

Outsourcing organisations
National Outsourcing Association (NOA) http://www.noa.co.uk/
The US Outsourcing Centre http://www.outsourcing-center.com/
The Outsourcing Institute: http://www.outsourcing.com/
Global service directory and forum: http://www.outsourcing.org/
The Outsourcing Project (journal) http://www.cxoeurope.com/
Shared Services: http://www.ssonetwork.com/