A recent study shows that only 5% of companies that take the sub-contracting route reap high rewards and suffer few drawbacks. For many others, the outcome is either mediocre or a total flop. Yet the steps to successful outsourcing are fairly clear.
When British Airways' chief executive Bob Ayling introduced the airline's millennium restructuring plan last autumn he suggested that some of the £1 billion savings BA needs to make over the next three years to retain its competitive edge might come from a modest amount of outsourcing.
Activities such as baggage handling and refuelling would be scrutinised to see whether they were being done as well by BA staff as they could be by outside contractors. If they weren't, subcontracting would be considered.
Some commentators, in provocative mood, thought Ayling much too tentative.
He should go for broke, they suggested, and turn BA into a 'virtual airline', retaining its marketing function but outsourcing everything else up to and including flying the aircraft. The journalists was clearly exaggerating for effect but were nevertheless reflecting the currently popular belief that outsourcing (in which companies concentrate on the bits of their business that give them their competitive advantage and farm out the peripheral, non-core bits to others) is by and large a good thing.
Recent research suggests it may not be. The PA Consulting Group's report, Strategic Sourcing, provides, for the first time, quantitative evidence of a positive correlation between high levels of outsourcing and share price performance (demonstrating, says PA, that well-run companies, which usually perform well in the market, are likely to see effective outsourcing as part of good management practice). But it also makes very plain that the magic of outsourcing is not working for many (perhaps most) corporations. Only 5% of more than 300 companies and public sector organisations investigated by the PA researchers had found outsourcing high on benefits and low on drawbacks. For many of the rest, the outcome of such subcontracting was either mediocre or a total flop.
Taken together the two findings represent something of a conundrum for companies: 'If you take the view that outsourcing really does improve the value of your organisation,' says PA's outsourcing expert John Little, 'then there's quite a lot to shoot for, but it's only worth shooting if you're actually going to get it right. I rather tend to take the view that outsourcing is only worth doing well. If you aren't going to do it well, then don't do it at all. There are so many downsides to it.'
There are no estimates, or even guesstimates, of how much outsourcing is currently going on in the UK, but if the American experience is anything to go by (and there the Outsourcing Institute says $100 billion - or £60 billion - was spent on outsourcing last year), we are talking about very big business indeed. So getting it wrong (or even not quite right) would mean that industry, rather than having a splendid, easy-to-use new corporate restructuring tool at its disposal, could actually have quite a sizeable problem on its hands.
Research may not yet be able to put a monetary value on outsourcing in the UK, but what it does reveal is both that the practice is spreading within companies and that its nature is changing. PA says the average number of functions outsourced by organisations has risen 225% (from 1.2 to 3.9) over the past five years and will go on growing. At present the most frequently outsourced activities are property services, catering and information technology, but there is now clear evidence that outsourcing is moving from peripheral activities towards more central ones.
Traditionally, outsourcing has concentrated on activities which are remote from the heart or nerve centre of the company, but there appears now to be a growing willingness to entrust outside specialists with activities previously considered too core to the organisation's business or too complex to handle. Historically, for instance, it was thought fine to outsource payroll, a relatively repetitive and simple operation, but not such sophisticated functions as treasury management. Now, however, according to the Economist Intelligence Unit, as many as 10% of companies may soon be outsourcing treasury. Similarly, while property services have been outsourced since subcontracting began, now, according to PA, more than 10% of organisations are outsourcing property management as well, and some are even farming out their property portfolio management.
All the indications are that this particular trend may go a lot further. Classical outsourcing theory says that a company should decide which of its functions give it competitive advantage (its core competencies in management-speak) and which don't. Non-core functions can be farmed out to specialists if they conduct them more cheaply or better or both, but core functions never.
To outsource core functions, say the theorists, is to hand over the things which made the company what it is - and which make its profits.
Increasingly, however, this rule is being questioned. It is now argued that there has been a confusion between core activities (things that are central to what one does) and core competencies (the central things that one does well). Those who take this line now talk about outsourcing functions like customer care, an activity which most outsourcing theorists would consider so central to a company's success that only a lunatic would hand it over to a third party. If you cannot look after your customers, say the traditionalists, should you be in business at all? Aren't customers the raison d'etre of every business?
Mark Astbury, sales and marketing director of Ventura, a company which handles customer service management for companies like Kingfisher, Cellnet and the Co-operative Bank, understands people's surprise that organisations should be prepared to entrust such sensitive work to outsiders, but the practice is not as odd as it first seems, he says. 'Cellnet, for instance, have said to themselves, "What are out core competencies?" and they've come down firmly and said their core competency is in running a mobile phone network, that there are other things they don't regard as a core competency and one of those is customer service. Customer service is a core activity but they've decided to find a partner who can help them manage customers better than their competitors do and, crucially, better than they believe they can do themselves.'
At the level of things like customer care, says Astbury, there's a difference between outsourcing because you cannot do something yourself and outsourcing because you want to be the best in the marketplace and you need an expert to help you. 'People, I think, now understand that you're not simply outsourcing because you can't do it, you're outsourcing because there's a partner who can help you to be the best in the market.'
Mike Webb, managing director of Mondial Assistance which provides claims hotlines for a number of insurance companies, also argues for a redefinition of the concept of a core business. If you take an insurance company, he says, the instinctive thing to say is that a company which can't administer its own hotline can't be relied on to carry out its business effectively.
'But that's obviously nonsense. The company's responsibility is to assess the risk that each customer represents and provide them with the most appropriate and cost-effective package of cover. It is also the company's responsibility to ensure that its spread of risk leaves it in a position to pay out claims where necessary. Investing in these skills is a cost-effective use of resources, but staffing the claims hotline is not.'
The outsourcing of areas of the business which are close to the customer raises the issue of what to do when a service provider underperforms. The thing about outsourcing is that to the customer, the whole operation is invisible. If the service provider does something that hurts the customer, it isn't the provider who gets it in the neck, it is the company which farmed out that part of its work.
The only way to avoid such disasters is to be vigilant, both before and during the outsourcing, and to make sure you have sanctions and redress; ultimately that you have a way to dismiss the underperformer. The hard-nosed would say that the best way to keep providers up-to-scratch is to keep them on short-term contracts, constantly aware that underperformance will mean the chop. This flies in the face of more modern supply chain management advocates, however, who would argue that by involving suppliers or subcontractors closely and building up a relationship of trust, everyone can win.
As well as embracing more sensitive central functions like customer care, outsourcing is changing (perhaps evolving is a more apt description) in another way, with corporations thinking about outsourcing complete processes, rather than just discrete functions or activities. Several banks, including the Co-operative, are outsourcing cheque clearance, for example. It makes sense for the banks to outsource this particular process since the volume of cheques written is actually in steady decline, making it hard to justify spending time and money keeping the required technology up-to-date. For service providers, like Unisys, on the other hand, technology like image processing systems can be used across a range of businesses and a range of customers so it does not matter that the cheque processing business of the individual bank is declining.
The move towards process could be important for another reason, namely that it is easier to measure the inputs and the outputs of particular processes than of individual functions or activities, such as information technology. It is easier to define what is going into a process and what you expect to come out. The fact that most major companies are now re-engineering themselves around processes rather than functions would also suggest that the drift towards process outsourcing will continue.
It is not just what is being outsourced that is slowly changing, however, but also the way in which that outsourcing is conducted. Some pioneers are trying out variations, such as co-sourcing. For while traditional outsourcing may be perfectly suitable for low-risk peripheral activities such as cleaning or car fleet management, with higher risk strategic functions or processes, companies want to retain more of a say in the way in which work is done. With co-sourcing, the client company keeps responsibility for the management and strategic aspects of the outsourced activity, while the outside provider supplies consultancy services and often experienced personnel to help the business streamline the function or process.
Karen Hamilton-Smith, a partner in international executive services at chartered accountants Arthur Andersen, cites expatriate administration as one of the various functions which can lend themselves to co-sourcing. 'The company may wish to retain involvement in the selection process and in deciding the detailed terms and conditions of an overseas assignment within the context of management priorities. But outsourcing the handling of all aspects of the administration of the assignment - such as determining allowances, preparing cost projections, conducting orientation classes, co-ordinating relocation, payroll and accounting matters and providing ongoing support to the expatriate and to the management - is a sensible strategic alternative.'
The financial group Societe Generale (SG) has a co-sourcing (others might call it an in-sourcing) arrangement with Arthur Andersen, under which an Andersen tax expert spends two days a week in the group's human resources office to advise senior management and expatriates on taxation issues. Louise Barrett, SG's head of human resources, distinguishes co-sourcing from classical outsourcing.
'In outsourcing, another organisation takes responsibility for the particular function - in this case managing expats - and therefore all the liaison is with an external organisation. Co-sourcing is where responsibility is held within the organisation, so the person from Andersen is actually here in my department, part of my team and interfacing with the procedures and practices of the department.'
Even assuming a certain corporate confidence in the ability to outsource well (quite an assumption), is there an irreducible core of activities which couldn't or shouldn't ever be subcontracted? Is there a ring fence around certain activities or functions such that anything inside is sacrosanct and untouchable? The experts differ on this, and will do so even more as once-inviolable activities like treasury management and customer care are increasingly outsourced.
One attractive rule of thumb is to consider what it is that managers would absolutely have to keep in-house if they were starting the company from scratch, and outsource everything else. Hence the commentators' advice to Ayling. Several new, small airlines, after all, have been set up in precisely the way the journalists suggest. Another way is to identify which parts of the company constitute the corporate crown jewels. A pharmaceutical company, say, might well consider out-sourcing research and development on drug delivery systems and the controlled release of drugs in the body, but would never dream of farming out research into the selection of the molecules to be used in the drugs.
Even then there are dangers. The definition of crown jewels may change over time, says Dr Chris Floyd, who runs consultant Arthur D Little's technology and innovation management practice in the UK. 'In computers,' he says, 'the crown jewel element was the hardware, so IBM outsourced the software, the operating system, to the little known Microsoft because they thought the operating system was a minor, peripheral technology.
Then, over time, they found it was the operating system which became the crown jewels and what they were left with, the hardware, was the peripheral technology.'
Whatever one's choices about what to outsource and how to do it, the ultimate objective must be to avoid becoming one of PA's mediocre majority, to push oneself into the ranks of the still tiny minority who reap the benefits of the high benefit/low drawback equation. PA's Little believes it is possible, by studying the most successful outsourcers and seeing what they have in common, to isolate certain characteristics which, if emulated, might improve a company's chances of a successful outsourcing policy.
The best companies, Little says, take a strategic, top-down approach to outsourcing - he terms it strategic sourcing - and are clear and disciplined in their decision-making and process management.
Most outsourcing is done in a fairly piece-meal fashion, often for tactical reasons. Strategic sourcers, by contrast, outsource because they can see benefits for the wider organisation. 'Organisations which are more sophisticated take a strategic decision to enhance their core competencies, which might well look the same, in terms of gaining access to skills and so on, but is done with quite a different strategic intent.'
The PA researchers think that companies like Nike and Virgin (particularly in the latter's approach to the new world of finance in the shape of PEPs) are good strategic sourcers. It would be wonderfully ironic if, in considering the pros and cons of outsourcing for BA, Ayling had to ask his arch-rival, Virgin's strategic-sourcing Richard Branson, just how he does it.
Outsourcing IT - Selectivity is the source of success
The immense vulnerability of companies which outsource without thinking the decision through carefully enough is shown in Best Practices in Information Technology Sourcing by Leslie Willcocks of Oxford's Templeton College.
Willcocks found that 85% of what he describes as selective-sourcing decisions (those where only a relatively small proportion of IT was outsourced) were successful, but only 14% of total-outsourcing decisions (where more than 80% of the IT budget went to outsiders) were successful. Most of the latter, says Willcocks, were taken for reasons which had nothing to do with business strategy and everything to do with finance. The companies tended to be in financial trouble and outsourcing was a way of getting a quick infusion of cash from providers who were prepared, as part of the deal, to pay for their IT assets.
'Most total-outsourcing deals are drawn up from a position of financial weakness. It's actually then a financial package, it's not anything to do with leveraging IT to achieve business advantage,' he says.