Outsourcing can be a powerful tool to cut costs, improve performance, and refocus on the core business, however outsourcing initiatives often fall short of management’s expectations.
Research suggests (Jerome Barthelemy) there are seven “deadly sins” underlining failed outsourcing initiatives.
(1) Outsourcing activities that should not be outsourced:
(2) selecting the wrong vendor:
(3) writing a poor contract:
(4) overlooking personnel issues:
(5) losing control over vendor:
(6) losing control over plan an exit strategy (i.e. vendor switch or reintegration of an outsourced activity).
First Deadly Sin:
Determine which activities can be best performed by outside vendors requires a good understanding of where the firm’s competitive advantage comes from. For example a car rental company outsources IT application development and maintenance. The car rental industry is a highly IT-intensive industry a good reservations system is the key to competitive advantage. IT applications that underpin reservation systems is a core business activity and shouldn’t be outsourced.
Second Deadly Sin
Selecting the Wrong Vendor. Firms shouldn’t necessarily outsource to cut costs. Hard qualifications are tangible and can be easily verified by due diligence. They refer to the ability of vendors to provide low-cost and state-of-the-art solutions. Important criteria also include business experience and financial strength.
Soft qualifications are attitudinal. They may be non-verifiable and may change depending on circumstances. Important soft criteria include a good cultural fit, a commitment to continuous improvement, flexibility, and a commitment to develop long-term relationships. Trustworthiness is an important soft criterion.
High levels of trust are often associated with outsourcing success. In most cases, the client and the vendor have different business objectives that can result in conflicts of interest. For instance, the beginning of the contract is generally more beneficial for the client than for the vendor. As time goes by, the contract becomes subject to negotiation and misunderstanding. As one vendor bluntly put it: “Outsourcing is a profitable operation in the short run. It must remain profitable in the long run.
Third Deadly Sin: Writing a Poor Contract
The best contracts have the following components.
- Precise. Ill-defined contracts often result in high costs and poor service levels. Cost and performance requirements should be established from the outset and clearly specified in the contract.
- Complete. Writing a contract that is as complete as possible has two important benefits. First, the more complete the contract, the smaller the risk of potential opportunism of the vendor. Second, the more complete the contract, the smaller the probability that it will involve costly renegotiations.
- Incentive based. The contract should be written to encourage the right behaviour from the vendor. For instance, the vendor may get a bonus when its performance boosts indicators business value. This incentive could help align the goals of vendors with the business objectives of their clients. The contract should also address how the relationship will change over its life cycle. For example, unit-based pricing may be used at the beginning of the relationship. The pricing could switch to cost-plus as the relationship develops. The contract could eventually call for a change to a gain-sharing arrangement so that the client and the vendor have a joint stake in the outcome.
- Balanced. In general, one-sided contracts do not last long. Even a contract that is weighted against the vendor is not necessarily beneficial for the client: service levels quickly drop, and the vendor tries to win back some value by imposing extra fees.
- Flexible. Due to evolving technology and changing business conditions, medium and long-term outsourcing contracts should not be written in an inflexible way. Flexibility clauses can help both parties accommodate to environmental changes.
Fourth Deadly Sin: Overlooking Personnel Issues
The efficient management of personnel issues is crucial because employees generally view outsourcing as an underestimation of their skills.
Fifth Deadly Sin: Losing Control Over the Outsourced Activity
When an activity is outsourced, it is crucial to retain a small group of managers to handle the vendor.
Sixth Deadly Sin: Overlooking the Hidden Costs of Outsourcing
The hidden costs of outsourcing are an important topic for managers because they can challenge the rationale for outsourcing.
- Outsourcing vendor search and contracting costs. Search costs are the costs of gathering information to identify and assess suitable vendors. Contracting costs are the costs of negotiating and writing the outsourcing contract. Both search and contracting costs are incurred before the outsourcing operation actually takes place;
- Outsourcing vendor management costs. These costs have three different dimensions: monitoring the agreement to ensure that vendors fulfil their contractual obligations, bargaining with vendors and sanctioning them when they do not perform according to the contract, and negotiating changes to the contract when unforeseen circumstances arise. Outsourcing vendor management costs are incurred while the outsourcing operation actually takes place.
Seventh Deadly Sin: Failing to Plan an Exit Strategy
‘Writing a poor contract” and “losing control over the outsourced activity” has the largest impact on the outcome of outsourcing efforts. One retail company outsourced several IT activities that senior management considered to be commodities (data centres, applications maintenance, and user support). However, outsourcing failed due to high costs and low performance. The vice president of information services wanted to get out of the contract, he was reluctant to cancel it as he knew that a vendor switch would take over six months while reintegrating the activities would require as much as ten months. All he could do was to renegotiate the contract, implementing a 15 per cent reduction in services due to poor performance.
The Seven Deadly Sins of Outsourcing and Lessons Learned
|Original idea to outsource||Outsourcing activities that should not be outsourced||Only activities that do not belong to the core business can be safely outsourced. The core vs. non-core approach can be implemented both at the firm and activity level.|
|Selecting the wrong vendor||Outsourcing clients should look for vendors that are able to provide state-of-the-art|
|Writing a poor contract||The contract is the main tool to establish a balance of power in outsourcing relationships. Good contracts have four characteristics. They must be precise, complete. Balanced, and flexible.|
|Beginning of the relationship||Overlooking personnel issues||Loss of key employees and lack of commitment can seriously threaten the viability of outsourcing efforts. However, good communication and ethical behaviour towards employees can help avoid such problems.|
|Losing control over the outsourced activity||In order to keep control over outsourced activities, clients must retain a small group of qualified managers. An active management of the vendor is also crucial.|
|Overlooking the hidden costs of outsourcing||The hidden costs (i.e., search, contracting, and managing costs) can threaten the viability of outsourcing efforts, Hidden costs are likely to be lower when commodities are outsourced.|
|Vendor switch or reintegration of the outsourced activity||Failing to plan an exit strategy||The end of the outsourcing contract must be planned from the outset. Building reversibility clauses into the contract is crucial.|