When a company wants to focus on its core business, cut costs or exploit the expertise of specialists, outsourcing certain of its functions may be the best answer. It makes strategic sense in many cases, but there could be drawbacks.
Able to focus on the outsourced function as a core competence and benefiting from econo- mies of scale, a vendor can bring greater knowledge and expertise, and is likely to charge less than the total cost of performing the service in-house. Outsourcing replaces the fixed overhead costs of employees with variable-cost services, and tends to be cheaper. Many firms agree to such an arrangement believing that it will allow them to concentrate on strategic growth, maintain or reduce headcount, and redirect their capital budget.
Numerous large UK companies have decided to take this approach since the start of the year. Indeed, during 2002-03, Europe showed the greatest growth in business process outsourcing contracts over Eu50 million, with financial services (38%) and manufacturing (17%) accounting for the majority. And human resources showed the greatest growth of any outsourced function.
Even start-ups now consider outsourcing a key initial strategy.
Handing over responsibility for an internal business function to an outside service provider sounds tempting, especially as the vendor will often buy the assets and/or hire the staff that the customer previously employed.
So when a vendor says it can do the work for 25% less than it costs the company, management may well jump at the opportunity.
But tread carefully, or the vendor may be the one who reaps the real benefits, while the company ends up giving money away. A firm that fails to calculate its in-house costs properly can compare them falsely to the cost of outsourcing.
One manufacturing business, for example, had a small internal audit department with a staff of nine. This cost £500,000 a year to run. The firm outsourced the function, paying the vendor £350,000 a year for the job. At the vendor's rate, this was the equivalent of just three people. The company thought it was saving £150,000 and ridding itself of a problem, yet it was still paying more than the salaries of the three people it should have had doing the work in-house.
The major trap into which firms fall is failing to sort out departmental problems before outsourcing - and it is usually 'problem' depart- ments that companies outsource. So the decision to outsource should not be taken lightly. As a first step, a company should investigate any existing problems in the function, solve them and, having maximised efficiency, only then decide whether outsourcing is still the best option - having regard for the following considerations.
Outsourcing may ultimately reduce the firm's ability to control the business function. Managing the vendor may prove more difficult than managing employees.
Key business functions may also be transferred to the vendor, leaving the company dependant on the vendor for the day-to-day running of the core business. Outsourcing is generally a long-term contractual relationship and, over the contract term, the customer's business, competitive and regulatory environment may change dramatically.
Before outsourcing, the company must decide what it wants to achieve over a specific time-frame. Its in-house service needs to be reviewed thoroughly to see where improvements can be made and inefficiencies eliminated.
Outsourcing is a complex endeavour. Without clear direction, the process can become prolonged, expensive and frustrating. The firm should describe fully the functions it wants the vendor to perform, providing a matrix listing each task in detail and showing whether the firm or the vendor is responsible for completing the task. On the basis that you can gauge performance only by what you measure, performance measures need to be clarified.
Estimating the cost of performing the function using internal resources ensures a reference point for negotiations with the vendor. Anticipating the effect that outsourcing may have on other parts of the business should secure consensus across units that may not have worked together before.
Final vendor selection is crucial. Potential conflicts of interest - does the vendor serve a competitor? - and culture compatibility are important considerations in the selection process.
Our approach at Proudfoot is to prepare a division, function or site for outsourcing. By defining a company's business processes in detail and understanding all the inputs and outputs, external advisers are in a better position to plan the appropriate strategic route.
Having installed the correct process, the company immediately finds itself in a stronger position to negotiate with any vendor.
But the optimisation or enhancement process is so beneficial that in most cases the outcome is to keep the process in-house. After all, if you outsource, someone else is making money, not you. Think carefully before relinquishing the chance to make a profit.
Kevin Parry is the chairman of Proudfoot Consulting, a specialist firm that seeks to achieve measurable and sustainable performance improvements for corporate clients. He is also chief executive of Management Consulting Group Plc and a non-executive director of Schroders. He was formerly a managing partner of KPMG in the UK.