The ABC of Outsourcing
Typical questions about outsourcing
Last week, I spoke in the webinar on outsourcing. Some questions there sounded somewhat basic, i.e.,
- What to outsource and what not to do?
- How do you explain the benefits of outsourcing to an arrogant CEO?
- What are the possible pricing models, etc.?
I realized that everyone knows of outsourcing, as with many other topics. However, the Internet throws tons of raw data you must cleanse, arrange, and digest regarding technical details.
This post should help those who want a 360-degree brief yet informative view of all dimensions and flavors of outsourcing.
The definition of outsourcing
Economic exchange is a transaction where goods or services are transferred from the provider for a return of relative value (compensation) from the receiver that advances the financial interests of both parties.A contract projects an economic exchange into the future.
The transfer of goods happens under trade contracts.
The transfer of services is called outsourcing, which involves transferring some tasks to an outside company and generally uses an appropriate service contract.
So, outsourcing is contracting services and working with an external party.
Outsourcing is a cost-cutting mechanism and a critical business enabler, as it provides access to the business partner's resources, skills, knowledge, and technologies.
The notion of outsourcing is well-known and widely utilized. You may read this post from a public cloud in an office managed by a third-party FM provider and guarded by an external security company. Yet, there's a certain ambiguity in standard definitions.
Many years ago, our telecom operator outsourced subscriber bill printing.
That was an example of essential outsourcing. The business process remained fragmented between the external provider of print service, our company operating customer data and managing billing cycles, and the government post service collecting and dispatching envelopes.
Of course, no SLAs, service credits, or else. Our benefit was not to acquire and maintain the expensive printing and enveloping machine.
Then we outsourced the spare part management process – sold our existing inventories, let providers manage stock levels and trigger replenishment, and took care of out- and inbound logistics. That was an example of business process outsourcing (BPO.)
Later on, we outsourced the mobile network support to a global OEM. That was a genuine managed service - driven by quality and availability SLAs and orchestrated by the provider's onshore team.
Naturally, all of us are now using various models of as-a-Service outsourcing – cloud-based and subscription-charged IT Infrastructure (IaaS), software development platforms (PaaS), and the software itself (SaaS).
As there is a certain ambiguity in definitions of various types of outsourcing, one can refer to the ISG Index - the well-known source of data on the outsourcing services market.
They divide the market into two segments – Managed Services with IT Outsourcing (ITO) and Business Process Outsourcing (BPO) subsets and As-a-Service divided into Infrastructure-as-a-Service (IaaS) and Software-as-a-Service (SaaS). Essentially, they differentiate the outsourcing of physical business processes or their fragments from cloud-based models.
Whichever definition you like, we are exposed to different shapes of outsourcing services, especially during COVID-19.
Our remote work (WFH) extensively resides on As-a-Service solutions; hence, this market is growing by double digits.
Traditional BPO providers suffer as the crisis severely affects physical supply chains and legacy business models. ISG Index provides excellent insights into these tendencies.
The advantages of outsourcing
Under the ever-increasing pressure of global crises and competitive rivalry, you would need more resources to attend to all tasks equally. Therefore, you need to prioritize and dedicate your best people and most efforts to value-generating activities.
Outsourcing will let your team focus on core areas. Simultaneously, some specialist providers would take on the routine - usually with equal or better quality and at a lesser cost to the company.
Therefore, four typical reasons to outsource are
- to focus on core business,
- to solve capacity issues,
- to cut costs,
- to acquire missing skills or technologies.
Forward-looking companies will bridge gaps in skills, competencies, and technologies by accessing the capabilities of an outsourcing partner.
Outsourcing disadvantages
Just as with any other business concept, outsourcing provides various benefits and efficiencies at the cost of potential risks and deficiencies:
- suboptimal service quality vs. in-house;
- compromised security and confidentiality;
- loss of control over the outsourced activities;
- lack of service flexibility and hidden costs due to poorly constructed contracts.
A more detailed view of the pros and cons of outsourcing follows.
Outsourcing in economics
The economics of outsourcing is explained by two dominating theories - transaction cost theory and the resource-based view of the firm.
Transaction cost theory explains outsourcing decisions from the efficiency perspective, while the resource-based view looks into capabilities.
Transaction cost economics (TCE)
Focusing on firm boundaries - the borders between the firm and its environment - TCE aims to answer when activities would occur within the market and the firm.
TCE describes governance frameworks based on the net effects of internal and external transactions.
More specifically, the central question of TCE is whether a transaction is more efficiently performed inside a firm (hierarchical governance), outside it (market governance), or by forming an alliance (relational governance.)
The dominant view of TCE is that firms make outsourcing decisions driven by efficiency through the lowest possible combination of production and transaction costs.
The transaction cost is impacted by bounded rationality (limited resources and capabilities to understand the situation) and opportunism of vendors.
The degree of impact on cost relates to the frequency of transactions, the uncertainty of the business environment, and asset specificity (being tailored to the specific transactions and not easy to redeploy.)
Outsourcing governance models
The combination of all of the above factors leads to the choice of the outsourcing governance model, e.g.,
- increased asset specificity leads to relational governance, i.e., partners decide to jointly invest in assets to mitigate risks;
- volume uncertainty favors hierarchical governance as the market perceives such a relationship as risky due to unexpected production costs;
- technological uncertainty leads to market governance as a firm retains the flexibility to switch between partners with more appropriate technical capabilities.
A resource-based view of outsourcing
The resource-based view considers resources and capabilities as skills, competencies, and know-how, which are at the heart of boundary-related decisions.
Mainly, collaboration with external parties allows firms to access resources and capabilities unavailable within the firm. Thus, firms seek collaboration with partners that
possess valuable resources that are difficult to obtain, imitate, or substitute to complement their resource base.
Outsourcing vs. outstaffing: types of outsourcing services
When people think of outsourcing, they may imagine shut-down offices and laid-off employees carrying their boxes with personal belongings. They may think of outstaffing, offshoring, or both.
In fact, outsourcing has many flavors, and not all assume the transition of jobs offshore and cutthroat staff optimization.
Staff Augmentation
Staff augmentation assumes filling in occasional skill gaps and improving the quality of the workforce. The IT jargon calls this "body shopping."
- It is the fastest way to mobilize resources. Primarily if you work with the outstaffing provider.
- Rates are not cheap but still reasonable - way lower than the consultant's.
- The customer retains complete control over resources.
- Another benefit is trying new, highly proficient experts without long-term social commitments. Then you may convert them into full-time employees.
Business process outsourcing (BPO)
BPO is contracting a standard, narrowly defined business process to a third party.
- One of the BPO subsets is project outsourcing. Customers are used to this type of outsourcing as part of a complete solution implementation contract.
- Another distinctive subset of BPO is Knowledge Process Outsourcing (KPO.) As the name suggests, KPO assumes outsourcing knowledge-intensive activities to a provider of highly skilled and educated resources. KPO is paramount to all BPO variations in terms of added value. KPO has its own subsets
- Business consulting,
- Data Analytics and Insight,
- Market Research/ Business Research,
- Global Reporting and Performance Management,
- Data Management.
Managed Services
Managed services are driven by quality and availability SLAs and orchestrated by the provider's onshore team in close cooperation with the customer's personnel.- Usually, the scope is related to outsourcing technology services and covers the operation of business-critical infrastructure. However, some of these services, e.g., Managed Print, went commoditized.
- Managed services provide excellence across various domains, including technical enhancements, business optimization, and cost-cutting.
As-a-service
Typically, as-a-service outsourcing means the cloud-based and subscription-charged provision of IT Infrastructure (IaaS), software development platforms (PaaS), and the software itself (SaaS).Characteristics of an as-a-service offering are:
- remote service provision over the Internet (cloud)
- standardized offering,
- no customer's ownership of assets or resources related to the provision of services,
- a standard all-inclusive recurring charge (subscription fee.)
With the ever-increasing use of cloud technologies, a notion of XaaS - Everything-as-a-Service appeared. E.g., desktop-as-a-service (a virtual machine,) IT security-as-a-service, or even network-as-a-service.
The new generation has become increasingly reluctant to invest in the ownership of assets and prefers the speed and flexibility of leasing. Therefore, the as-a-service model began replicating traditional commodity services, e.g., coffee or laundry - no ownership of equipment, online sales and customer care, and contactless service provision.
Managed as-a-service (MaaS)
The critical deficiency of the as-s-service model is the need for more customization for the needs of a particular customer. This can be solved by the MaaS provider, who tailors their standard product to the client's specific requirements and provides more significant support.
Naturally, the MaaS offering comes at a premium but unlocks the opportunities to fine-tune the commercial off-the-shelf product into the value differentiator.
What to outsource and what not to do?
Despite the growing popularity of outsourcing, some functions or products should be kept from being outsourced at any time. The list of exclusions is much longer than the core business we all know.
The following matrix represents typical considerations on whether or not to outsource a business function.
Core business competencies
This exclusion is well understood. As indicated above, companies exercise outsourcing to focus on their core business.
Such competencies are only sometimes as straightforward as essential products or services. For example, if a company is recognized for customer service, everything should stay in-house. For, airlines could train their pilots on third-party simulators, but the cabin crew training will be retained due to the customer-facing nature of service.
The subset of this exclusion is the critical quality enabler. Therefore, famous product companies, e.g., Apple, don't outsource the R&D, design, and operating system due to their strategic role in the corporate quality system.
Distinct source of value
Obviously, core competencies create a constant inflow of value. However, there will be other emerging sources of value that should be nurtured and supported in-house.
The value management cycle has three stages:
- Value generation.
- Value delivery.
- Value maintenance.
Indeed, product and service development is the distinct source of value generation, just like supplier partnership for innovation.
A company may recognize the importance of value delivery and retain customer order fulfillment, which is not necessarily their core business competence.
Similarly, the highest product maintenance and support standards will ensure customer retention, i.e., value maintenance. So, a company may decide not to outsource it.
Knowledge-based functions dependent on proprietary company information
This one is also simple because it's not permitted by law. No one would outsource the management of company financial statements, intellectual property, or customer records.
Highly volatile business functions
Wherever the business requirements are fluid, and their delivery cannot be expressed in clear KPIs and measured to track performance, it is better not to outsource such functions.
Otherwise, the nature of outsourcing - the predictability and repeatability of the service delivery - would be defeated.
Multi-disciplinary and/or multi-departmental activities shouldn't become the first objects for outsourcing. At least until a company is mature enough to manage the delivery of complicated cross-functional services.
Management controls
There's an essential distinction between the operation of a function and its management. You should refrain from outsourcing management decisions and overall responsibilities for a function's effectiveness and business success.
The same applies to the management of outsourced projects. This is obvious for many readers of this post, but I took part in projects where main contractors have been given the master project management responsibilities. So it was no surprise they blamed all eventual delays on subcontractors and tirelessly protected their own holiness.
The outsourcing process steps
The process of outsourcing consists of 5 steps.
Outsourcing Step 1: Preparation.
The preparation phase defines the firm's general philosophy of being involved in the outsourcing process.
The most important aspect of this phase is that the firm should explore alternative strategies regarding outsourcing using specialized analysis and decision-making models.
The questions to be answered by the organization about outsourcing at this stage are: "If?", "What?" and "How?".
Outsourcing Step 2: Vendor Selection.
In the preparation stage, the organization must announce its intention to run a competitive selection process for the outsourcing provider. Essential selection criteria could be:
- scope,
- price,
- timing,
- efficiency,
- flexibility in contract and resource management,
- provider's experience and skillset,
- management control,
- impact on SLAs (quality of service)
- risks and returns sharing,
- hidden costs,
- strategic partnership,
- access to innovation.
The firm's question to be answered at this phase is: "To whom?"
Outsourcing Step 3: Transition.
Upon completing the competitive process and awarding the contracts, the organization enters the next phase of the outsourcing process, namely Transition.
It guarantees a smooth, productive, and functional transition to the scheduled operations.
Essential considerations at this stage are:
- to maintain contact between internal and external operations,
- the redeployment and adjustment of human resources,
- the reorganization of the overall productive activity.
Outsourcing step 4: Relationship Management.
This stage provides the relational approach to outsourcing instead of contract management.
The relationship between the organization and the provider is primarily determined by how this relationship is managed at the business level.
Outsourcing step 5: Reconsideration.
Reconsideration takes place when the outsourcing process is nearing its end.
Apart from its scheduled time of expiry, a contract may also be terminated earlier for reasons such as:
- changes in the ownership structure of the organization or of the vendor,
- mutual interest,
- insolvency of a party,
- breach or violation of specific contract terms by at least one of the two parties.
Key options upon outsourcing contract termination
The organization's key options are:
- repeating the outsourcing process with the same vendor,
- repeating the process with another vendor,
- transferring these operations into the enterprise's internal structure.
Outsourcing business models
The following information is instrumental in understanding the business model of your to-be outsourcing partner.
They can be horizontal - industry-agnostic or vertical - industry-specific businesses.
Some start from low-value transactional services and fight for the most lucrative KPO offering.
Others grow from a particular horizontal domain, e.g., IT consulting, towards broader business opportunities and development in selected industries.
Some providers start from the narrow industry niche and expand from there.
Such scenarios provide critical input to your outsourcing strategy overall and a choice of partner, in particular, e.g.,
- the business strategy of your provider,
- their core competency area,
- their appetite to fight for emerging business opportunities outside the "home zone,"
- possibility to bundle different types of outsourcing services with the same provider,
- opportunities to de-risk a "bottleneck" vertical provider with the new offering from its horizontal rivals.
Outsourcing pricing models
Cost-plus model
Traditionally, the price of outsourcing services is based on the "cost plus margin" basis. At least, this method applies in the initial stage of cooperation on a small footprint.
The cost-based model is relatively simple and includes direct costs, overheads, and finance costs.
Transaction-based pricing
However, providers may offer transaction-based pricing and expand the scope of services and the geographical footprint.
This pricing model works fine for uniform transactional services, i.e., raising Purchase Orders, paying invoices, processing calls in contact centers, etc. - whatever fits the "factory" model.
Market-based pricing
Once the cooperation extends onto the mix of different services (e.g., finance, procurement, and HR) and covers multiple global locations, your provider may offer market-based pricing with or without the distinction of different types of services.
Effort-based pricing
So-called effort-based pricing acknowledges the different nature of outsourcing services. For example, some are routine and low-skilled, while others require educated personnel operating complex tasks, i.e., a PO clerk and a cost accountant. Obviously, there should be some respective rate differentiation.
Risk-and-reward sharing pricing
When the partnership reaches true maturity, parties may apply the risk-and-reward sharing pricing. It assumes the incentive increment to the base fee payable upon reaching or over-achieving contract performance metrics. Similarly, the under-achievement leads to the base fee deduction.
Providers can be additionally incentivized to deliver savings and efficiencies, or their remuneration could be expressed as a share of measurable benefits.
Outcome-based pricing (vested contracts)
Vested contracts assume the cultural shift from performance to outcome-based pricing. I.e., a facility management contract remuneration could be based on the customer's personnel satisfaction and non-business interruption metrics.
Vested contracts assume constant cooperation between the customer and provider to optimize the service-related business processes, resources, costs, etc. Therefore, these contracts involve both parties' delivery and process excellence teams, i.e., the ongoing investment in dedicated resources.
Success factors of the outsourcing relationship.
This research may seem intuitive, but it is still helpful to understand the capabilities a firm needs to possess to successfully manage the outsourcing relationship.
- Management capabilities
- contract management capabilities - the ability to operationalize requirements in the form of detailed service descriptions and SLAs and negotiate the price of the outsourcing services;
- relationship management capabilities - relational governance attributes, such as partnership quality, trust, commitment, solidarity, role integrity, cooperation, and mutual understanding.
- Dynamic capabilities
- sensing capabilities - the extent to which a company can scan the environment to identify new outsourcing opportunities and become alert to changing outsourcing market conditions and offerings;
- seizing capabilities - the ability to identify capable outsourcing providers (either among current vendors or new ones,) establish criteria for assessing vendor proposals, and select the most appropriate proposal;
- orchestrating capabilities - the extent to which a company can coordinate the work of outsourcing providers and integrate their activities with their own resources and activities.
Management capabilities are traditional ones expected from a firm that establishes outsourcing relationships. They directly affect the successful delivery of outsourcing services.
However, the dynamic ones affect the delivery and reconfiguration of outsourcing services and represent the soft skills that a firm needs to possess. These are to be noticed.
The current state of outsourcing global market
The ISG Index indicated the global outsourcing services market increased by 7.5% YoY to 17.6 Bn USD in Q1 2021. The expansion is predominantly driven by the as-a-service segment (17%,) which is the natural consequence of the pandemic.
There's no sense in discussing the benefits of outsourcing - it is to stay for many years ahead. But, perhaps outsourcing is one of the most efficient tools for supporting and enabling value delivery under constant crises and scarce resources.
Like any other complex multifunctional instrument, it must be applied topically and managed consciously.
Most importantly, it requires high-level trust in outsourcing providers. Only then would the occasional capacity overhaul become the vested relationship.
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