Outsourcing – A Management Technique
Outsourcing – A Management Technique
Outsourcing is a usual practice among different organizations and is a one of the element of the organizational strategy. Most of the organizations these days outsource some of the functions they used to perform themselves.
Outsourcing is when any operation or process that could be (or would usually be) performed in-house by the organizational employees is sub-contracted to another organization for a substantial period. The outsourced tasks can be performed on-site or off-site. By outsourcing, the organization uses third parties to perform noncore activities of the organization. Contracting third parties enables the organization to focus its efforts on its core competencies. Third parties that specialize in an activity are likely to be lower cost and more effective, given their focus and scale. Through outsourcing, the organization can access the state of the art in all of its operational activities without having to master each one internally.
The concept of outsourcing came from the American terminology ‘outside resourcing’, meaning to get resources from the outside. The term was later used in the economic terminology to indicate the use of external sources by an organization for some of the activities in its functioning.
As per James Brian Quinn of The Outsourcing Institute, outsourcing started with organizations outsourcing physical parts. Now the big shift has been to outsource intellectually based service activities like research, product development, logistics, human relations, accounting, legal work, marketing, logistics, and market research. If an organization is not best-in- world in doing something and is doing it in-house, then it is giving up the competitive edge. In such a case the organization can outsource to the best in the world, up the value, and lower the cost.
There are three major categories of motivations for outsourcing namely (i) cost, (ii) strategy, and (iii) political. The first two normally drive outsourcing. While there may be three categories, outsourcing activities are likely to be initiated for more than one reason and in fact, may be driven by elements from all three categories.
The phenomenon of outsourcing generally refers to procurement of materials and services inputs by an organization from a source outside. In this context, outsourcing can be both internal and international.
Internal outsourcing is the purchase by an organization of services or material inputs from a source located in another organization within the same country. International outsourcing is defined as the purchase by an organization of services or material inputs from a source located in another country. This term includes both intra-organization international outsourcing (by which foreign supplier of inputs is still held by the organization), and distance international outsourcing (by which foreign supplier of inputs is independent of the organization that uses inputs). International outsourcing is part of imports of goods and services of the country. Another term often used for international outsourcing is ‘off shoring’. International outsourcing is mostly used by organization in advanced economies, which offloads part of their work to the organizations located in developing countries in particular to reduce costs.
In some places where the process of outsourcing is a relatively new phenomenon, it is viewed with skepticism and considered to be one with full of risks. In highly developed countries, things are better understood, and outsourcing, in some cases, is considered a natural and necessary process in improving the performance of the organization.
Outsourcing is sometimes defined as ‘the process of contracting with the most suitable expert third party service provider’. It can take a multiplicity of forms which includes designing, constructing, managing, financing, administering, and providing the service in question. It can also involve the transfer of assets (including human resources). Outsourcing also involves ensuring that all linkages to internal operational departments and customers are seamlessly implemented.
Outsourcing can also be defined as ‘the provision over the longer term of non-core organizational activities by an external provider of such processes to an organization which heeds them but does not wish to do them any longer itself’.
Outsourcing is often defined as ‘The placing of contracts with third party service providers to deliver essential support services to an organisation which is normally dependent on such services to be able to achieve its own core organizational objectives. The aim of outsourcing is to ensure that expert service providers are used to optimize the cost effective delivery of those services. Outsourcing is always to be approached with a view to improving value for money rather than simply to save money without regard to the effectiveness and quality of service’.
Quelin and Duhamel have defined outsourcing as ‘the operation of shifting a transaction previously governed internally to an external supplier through a long-term contract, and involving the transfer of staff to the vendor for the firm’. According to their definition, the following five elements characterize strategic outsourcing (Fig 1).
- A close link between outsourcing processes and the key success factors of the organization in the industry.
- The transfer of ownership of an organizational function previously internalized, often including a transfer of personnel and physical assets to the service provider.
- A global contract, longer and denser than a classical subcontracting agreement.
- A long-term commitment between the organization and the service provider.
- A contractual definition of service levels and of each partners obligations.
Fig 1 five elements of outsourcing
Common outsourcing applications
The first myth about outsourcing is that it is new. Actually, the term dates to the 1970s, when manufacturing organizations seeking efficiency began hiring outside organizations to manage less than essential processes. Outsourcing worked. Today many manufacturing organizations outsource 70 % to 80 % of the content of their finished products. Large organizations normally outsource half of their IT (information technology) operations. Organizations outsource their entire back office operations, including human resources, payroll and accounting. Organizations may soon be more outsourced than ‘in-sourced’, signifying a fundamental reorganization that affects their employees and customers. With outsourcing consumer choices increase, product costs drop and employees’ roles in the organization change.
Outsourcing is not a new phenomenon in the organizational practice. It rapidly develops and establishes the beginning of a new stage of division of work between the organization and the outsourcing organization. Although there is no common agreement on the term, outsourcing generally refers to the procuring of material inputs or services by an organization from ‘sources’ outside the organization.
Outsourcing becomes an operational practice through which the organization provides itself the possibility to mobilize its scarce time and financial resources and direct them to the development of its core competitive characteristics, in the same time achieving better results from its outsourced secondary operational processes.
Outsourcing is promoted as one of the most powerful trends in modern management. The rationale for outsourcing some functions and/or processes includes substantial financial economies, increased ability to focus on strategic issues, access to technology and specialized expertise, and an ability to demand measurable and improved service levels. Outsourcing differs from alliances, partnerships or joint ventures in that the flow of resources is one-way, from the outsourced organization to the outsourcer organization with profit sharing or mutual contribution being not a typical common practice.
There is no doubt that the main reason for the outsourcing decision is costs reduction. The organization finds that costs can be cut down by outsourcing of one or more operational processes. An additional motive is to provide for a more flexible cost control.
Outsourcing helps the organization to concentrate on its strategic tasks and goals by concentrating on the core activity. As a result of minimizing expenses on activities that are necessary but unrelated to the basic functions and goals of the organization, the prime cost can be reduced.
The top drivers that most often cause an outsourcing are namely (i) the need to reduce cost or internal manpower, (ii) internal capacity constrained by increasing market demand, (iii) internal manufacturing or service performance is insufficient or does not meet requirements, (iv) strategic sourcing process, (v) for meeting the regulatory, legal or environmental requirements, and (vi) Internal capacity is underutilized.
The organization which wants to outsource some of its activities is to determine the following.
- The tasks which can be accomplished in-house.
- The tasks which are to be accomplished through strategic partnerships.
- The tasks which are to be contracted out (outsourced) to third-party specialists.
The decision to commission some processes to an external provider is strategic in nature, and it can largely determine the future of the organization. Therefore it is to be a well thought out and informed decision.
Keeping the views usually connected with the outsourcing and considering the multiple criteria of its classification the following options are available for outsourcing.
- The proportion of outsourcing that is total, selective, or partial.
- Outsourcing can be applied in the areas of human resources, project development management, and service management etc.
- The outsourcing contract can be general, transitional or of an economic process.
- The type of outsourcing relationships can be described as (i) one supplier – one customer, (ii) one supplier- several customers, (iii) several suppliers – one customer, or (iv) several suppliers – several customers.
- The period of outsourcing can be either long term or short term.
- Location of the supplier can be local, regional – closer to the customer or international (offshore).
When outsourcing certain activities, the organization is to take the certain steps as given below.
- To determine whether the activity to outsource is a ‘core competency’ – In most cases, it is unwise to outsource something that creates a unique competitive advantage.
- To evaluate the financial impact of outsourcing – Outsourcing likely offers cost advantages if an outsourcing provider can realize economies of scale. A complete financial analysis is to include the impact of increased flexibility and productivity or decreased time to market.
- To assess the nonfinancial costs and advantages of outsourcing – It is necessary also to qualitatively assess the benefits and risks of outsourcing. Benefits include the ability to leverage the outside expertise of a specialized outsourcer and the freeing up of resources devoted to non-core organizational activities. A key risk is the growing dependence the organization might place on an outsourcer, thus limiting future flexibility.
- To choose an outsourcing partner and contract the relationship – Candidates are to be qualified and selected according to both their demonstrated effectiveness and their ability to work collaboratively. The contract is to include clearly established performance guidelines and measures.
Advantages of outsourcing
The Outsourcing Institute, a strong voice in the field of outsourcing, has built a top 10 reasons for organization to go for outsourcing. These ten reasons are as follows.
- Cost reduction and operations control
- Improving organizational focus
- Gaining access to the various possibilities
- Free internal resources for other purposes
- Resources are not available within the organization
- Accelerate the benefits of reengineering
- Driving is expensive for some time
- Employment equity becomes available
- Sharing of risks
- Capital injection.
Besides there are also additional benefits such as specialized, complete, and professional solutions, ease of installation and configuration, integrated applications, powerful, flexible and secure activities, increase accuracy, productivity and efficiency, and reduction or even elimination of the storage needs.
The main advantages of outsourcing in an organization are given below.
- It allows the organization to focus on its core and value adding activities without the distraction of having to run support services. Support services can soak up both management time and financial resources and these would usually be better spent concentrating on where the organization can use its resources and competences to gain competitive advantages.
- It results into cost savings. Usually the organizations to which activities are outsourced specialize in those activities and, therefore, are likely to enjoy economies of scale, whether from the use of machinery or the employment of expertise.
- It helps in the achievement of cost certainty. An outsourcing contract at a fixed, or closely defined price, shifts much of the financial risk on to the provider. Costs become more predictable.
- It assists in the restructuring of cost. For example, in some types of outsourcing such as component manufacturing, it results into lower fixed costs and higher variable costs. If all components are bought in, then these costs are all variable. In case the components have been made in-house then there would inevitably have been associated substantial fixed overheads.
- It leads to access to cutting edge expertise and talent. In technically advanced, fast moving industries, it can be difficult for small organizations to develop or make use of new processes. Outsourcing to a specialist organization can give access to the latest technologies.
- It results into better quality. There can be an immediate improvement in quality if a process is outsourced to a top class organization where the quality is carefully defined in a service level agreement.
- It assists in the transference of risk. If the organization perceives that one of its processes has high risks, then this can be transferred by outsourcing to that organization for which this process is a regular process and does not constitutes a risk.
- It helps in the management of the capacities. For example, it can be difficult for organizations to deal with variable demand that is either they run out of capacity (unhappy customers), or have (expensive) unused capacity. Outsourcing assists in mitigating this problem.
Other advantages of outsourcing are given below.
- Reduced overheads and operational costs
- Price competitiveness
- Lower involvement (freezing) of capital
- Higher flexibility, the ability to meet fluctuations in demand
- Easier and more economic access to the latest technologies
- Improvement of measurability of costs
- Better control of internal departments
- Availability of new service options, and reduced capital commitment
- Access to external competencies
- Acquisition of specialist expertise
Disadvantages of outsourcing
There are also several disadvantages of outsourcing since in any association one of the basic conditions is a compromise. The main disadvantages of outsourcing are given below.
- There is dependence of the organization on the supplier
- On-time delivery performance and end customer satisfaction levels can decline because of delays at third parties. This risk can be severely aggravated since the product/service is outsourced. Delays can be caused by many factors that are outside the control of the outsourcing organization. As lead-time and variability increase, so does the need for higher stock levels and other costly buffers, while overall supply chain confidence deteriorates.
- Product or service quality can also suffer in outsourcing, affecting customer satisfaction. Organizations are to carefully select, qualify, contract with, and manage their outsourcing partners to ensure that quality does not deteriorate. This often requires adequate transition periods and/or parallel production as well as effective cross-training between the organizations. These aspects are often neglected because of cost saving efforts.
- The outsourcing transition phase may also fail if schedules and budgets are not achieved because of insufficient planning and/or resources. An outsourcing project is to be run with the same discipline and planning as a well-run large-scale systems implementation. Outsourcing is a replacement of production or service functions, and these functions have a direct bearing on the organization’s ability to meet its commitments to customers and shareholders.
- There are hidden costs or unexpected costs. Although many costs become more predictable, the supplier is usually very careful to define exactly what these costs cover. There are likely to be substantial additional charges for anything extra. Additionally, it is to be remembered that almost certainly the supplier knows that part of the operations better than the outsourcer and usually ensures that the contract is carefully (and advantageously) worded.
- There is a loss of know-how within the organization. The employees start losing touch with new technological breakthroughs that offer opportunities for product and process innovations.
- There is loss of long-run research and development (R&D) competitiveness.
- There is the risk of co-operating with a dishonest supplier which, having gained access to knowledge concerning the organization and its products may use it against the organization in the future.
- There can be issues related to the confidentiality/security. Outsourcing some processes can give the supplier information that could be valuable or sensitive. Keeping a process in-house always increase security.
- The service provider can lack necessary capabilities. It may not be financially viable, thereby exposing the organization to supply interruption risk.
- Communication and coordination difficulties can be there.
- The process of outsourcing is difficult to reverse. Once an activity is outsourced and internal knowhow gone, it can be very difficult to bring a process in-house again. This is particularly relevant when a contract comes up for renewal and the price increase might be higher than expected but it can be difficult to abandon the supplier.
- There is a possibility of damage to reputation. If the outsource supplier does not perform properly (for example, not manufacturing to the required quality standards and not supplying goods on time) then great damage can be done to the reputation of the organization.
- There are issues related to non-congruent objectives and loss of managerial control. The supplier organization makes money doing things efficiently. The organization outsourcing might make money by innovation. To some extent, despite the contract, there can therefore be a difference in the objectives and core values between the two organizations.
- Outsourcing success depends on the performance of another organization. Though there is always a dependency between buyers and sellers, outsourcing shifts more responsibility for success to the performance of the outsourcing organization. If an important outsourcing organization goes bankrupt, there can be serious consequences.
Outsourcing generally continues to be a key part of many organizations’ supply and cost management strategy. The strategy has proven to be effective but brings with it significant risks which is to be recognized and managed. In outsourcing, an organization is relying on someone else to run certain organizational functions. If not properly managed, organizations may negatively affect their operations and customers. The product or service can be outsourced, but the risk cannot.
Today, outsourcing is at a crossroads. Organizations no longer outsource only vertical business units. The new cross-functional approach follows a process horizontally throughout an organization known as business process outsourcing (BPO). Now more organizations are seeking strategic advantages based on outsource alliances. While the relentless push to operate more efficiently remains the driving force behind outsourcing, it has also become a competitive, strategic marketplace tool, allowing organizations to improve response times and develop new products faster than ever. Once focused just on reducing expenses, today’s outsourcing initiatives are likely to help organizations to do things which they previously could not do.
One of the impediments for outsourcing is that the outsourced organization is lacking the knowledge of the outsourcing organization’s environment, both internally and externally. Of course, with good collaboration, communication and patience, this impediment can be easily removed. A second impediment can be an incorrect definition of the objective of outsourcing an activity, after a serious analysis of the outsourcing decision. Decision need to be made taking into account both benefits and other considerations. Other considerations can be poor alignment of objectives, response time and control of quality by various means, and the difference in mentality between ‘the organizational employees’ and ‘outsource colleagues’ level of personal pride to compensation packages.
Outsourcing results are not immediate. Most organizations had a 20 % decline in labour productivity in the first year of an outsourcing contract, mainly because of time spent on knowledge transfer to the outsourcing provider. After bringing their customer and supplier knowledge and goals to the required level, they can work together more effectively, thereby generating cost savings.