8
Outsourcing
Let External Providers Generate Value for You

Outsourcing is an important tool for companies seeking to transform cost structures. It can reduce costs, improve service levels, and guarantee annual productivity gains by enabling a company to hand off necessary but nondifferentiating business processes to external service providers with specialized expertise in a wide range of processes. Providers offer services for back-office functions such as the IT help desk, accounts payable, and payroll; operational activities including transportation and warehousing; and customer-facing processes like sales and call center operations. They deliver value through leveraging their technical platforms, process expertise and standardization, continuous improvement, economies of scale, and labor-cost arbitrage by moving work to lower-cost locations. Outsourcing also serves the primary objective of a Fit for Growth cost transformation: freeing up time and resources so that companies can focus on capabilities that support their unique way to play.

What Is Outsourcing?

What comes to mind when you think of outsourcing? Vast call centers in southern India where customer service agents earning a fraction of Western wages field inquiries from consumers in North America and Europe? Massive contract-manufacturing complexes in China churning out gadgets for multinational consumer electronics companies? Both impressions are accurate examples of outsourcing, but neither captures the full picture.

Before going deeper, let's define outsourcing and clarify the difference between outsourcing and offshoring. Outsourcing is a contractual relationship in which a company pays an external service provider to perform activities it would otherwise handle in house. The provider could be anywhere—a remote offshore locale, a neighboring country, or even right next door. Offshoring , on the other hand, moves work overseas, usually in search of lower labor costs, either managing it internally through a global in-house center or using an outsourcing provider with facilities overseas. The discussion in this chapter will focus on outsourcing, regardless of location.

The power of outsourcing stems in part from its broad scope. You can outsource just about any link in the corporate value chain, from research and development to manufacturing, supply chain, sales, and back-office activities (see Figure 8.1 ). Major targets for outsourcing are processes that contain many rule-based, repetitive tasks that can be performed remotely and that also have a very mature, sophisticated external provider base. Examples include selling, general, and administrative (SG&A) functions (which can include accounting, benefits administration, and IT) to take advantage of labor arbitrage and best practices; manufacturing and warehousing operations, where specialized providers have advantaged scale and low-cost labor; or even sales force organizations for nonstrategic customers, with which brokers are able to achieve a lower cost to serve without compromising customer service.

Figure depicting the functional areas and processes of the companies. — **Figure 8.1**

Outsourcing creates value in three primary ways:

Turning fixed labor costs into variable expenses that rise and fall with fluctuating business volumes;
Driving efficiencies through the provider's highly competitive labor costs, expertise, scale, and platforms; and
Transforming processes through the provider's investments in automation and other technologies that spur continuous improvement and year-over-year productivity gains.

Over the typical five-year life of an outsourcing contract, external service providers can generate savings of 30 to 35 percent on sales and marketing costs; 5 to 10 percent on manufacturing, transportation, and warehousing costs; 35 to 45 percent on information technology costs; and 30 to 50 percent for back-office business processes such as accounts payable and receivable (see Figure 8.2 ).

Outsourcing Myths Debunked

Despite the proven benefits, some companies still hesitate to outsource. Resistance often stems from a few common misconceptions:

Nobody can do it better than we can . Executives sometimes believe their own people are best qualified to handle their company's processes. But an external service provider that specializes in a particular process will always do it better than nonspecialists.
We'll lose control of outsourced processes. Companies worry about what will happen if they lose direct control of essential business operations. Well-designed outsourcing arrangements are centered around service-level agreements, performance measures, and issue resolution and escalation processes. Together these safeguards ensure the company still retains control over the outcomes of a process while handing execution to a provider.
People won't want to work here if we outsource jobs. Some fret that talented employees will avoid companies that outsource noncore processes. On the contrary, the best employees prefer companies that allow them to focus on key strategic activities.
Employee morale and community relations will suffer. While anti-outsourcing backlash can't be ignored, it can be mitigated through strong communication and assistance for displaced employees.
Outsourcing is only a labor-arbitrage play. Some still doubt outsourcing generates meaningful benefits beyond labor-cost savings. But the largest benefits of outsourcing are from productivity gains and process transformation, along with functional, operational, and technology benefits.

When to Outsource

Companies outsource for many different reasons. Large companies tend to view outsourcing as a way to maximize efficiency in high-volume, commoditized business activities such as order entry or travel and expense processing. Smaller companies, however, may not have sufficient transaction volumes to benefit from incremental savings on commoditized activities. But they can nevertheless use outsourcing as a tool for growth as well as cost savings. External service providers offer capabilities a small company may lack, such as advanced R&D, product design, or data analytics. And the emergence of cloud-based, “as a service” external service providers has enabled small companies to tap some of the benefits larger organizations get from outsourcing, such as process standardization, market-leading capabilities, and application support.

In our experience, companies often turn to outsourcing when they face one of these common business challenges:

They need the scalability and flexibility of resources an external vendor can provide;
They perform important but nondifferentiating work that bogs down senior management, or need differentiated capabilities that the company does not have yet;
They need quick access to an external provider's expertise and diverse talent pool;
They are unable to invest in capital and talent required to generate efficiencies in their nonstrategic operations; or
Outsourcing vendors can perform the same work at lower cost.

The best candidates for outsourcing are standardized, well-documented processes with clearly defined inputs and measurable outputs. Stable technology is also important—don't ask an outsourcer to manage processes scattered across myriad IT systems riddled with bugs and other shortcomings that compromise data accuracy and undermine service quality. You should also avoid the temptation to outsource overly complex, nonstandardized processes involving customized activities and variable outputs, or those requiring frequent judgment calls by front-line workers with deep understanding of the business. Broken or flawed processes should not be outsourced unless you have a clear plan to fix them with an external provider that has the expertise and a reputation for operational excellence in the specific process. Last, outsource only when viable external providers with relevant experience are available and willing to take on your processes in a way that will serve your transformation objectives. In cases where you have to rely on a third party to deliver a differentiated capability, make sure that you either have a plan to build the capability internally or lock in the vendor into a long-term agreement.

The Outsourcing Process: How It Works

Ready to outsource? Fortunately for you, two-plus decades of predecessors have marked a clear path to follow (see Figure 8.3 ). While this approach is designed for back-office and information technology, it can also work, with some tailoring, for manufacturing, supply chain, R&D, and other parts of the value chain that may benefit from outsourcing. First, you need a sourcing strategy that establishes a framework, rationale, and processes for deciding what to outsource, picking service providers, identifying risks, estimating costs, and defining the benefits you expect from outsourcing. Next comes supplier selection, with requests for proposals circulated to prospective candidates, and an evaluation process based on their responses. After narrowing the field to a few contenders, conduct financial and operational due diligence and choose a finalist. Contract development and negotiations proceed in parallel with transition planning, leading to a final agreement with a service provider. The process requires a wide array of expertise, including subject-matter experts who understand the scope of the project, procurement experts familiar with vendors, pricing benchmarks and other marketplace factors, and lawyers who know how to negotiate outsourcing contracts.

Step 1: Develop Sourcing Strategy

A well-developed sourcing strategy is the cornerstone of smart outsourcing. It lays out screening criteria and other guidelines for critical decisions about which processes to outsource and how. Your strategy should articulate the specifics of what you are trying to accomplish, the geographies, functions, and processes to be sourced, insource-outsource scenarios, associated economics and risks, and transition strategies. From this you can find the best partners, know what market pricing and terms are required to implement the solution, and define a plan for execution against the business case. You are also well positioned to articulate and undertake the necessary change management within your organization. These decisions require a thorough understanding of your company's requirements for each business activity, and a willingness to at least consider outsourcing every process.

You forfeit potential value when you don't question preconceptions about which processes an outside provider can or cannot perform. No process should be exempt from outsourcing unless a rigorous, objective analysis reveals compelling reasons to keep it in house. Nor should any process be outsourced unless such an analysis shows the move would create more value than handling it internally. To ensure a meaningful comparison, the outsourcing scenario should not be compared to the “as-is,” in-house process performance, but to the “to-be” process performance, where identified improvements are factored into the performance of the in-house process.

The best outsourcing candidates are uniform, well-documented processes that produce standardized outputs in a repeatable, measurable way and require little or no interpretation by staff. Maximize potential cost savings by focusing on processes that employ significant numbers of employees—at least 20 to 30 full-time-equivalent employees (FTEs). Assess the supplier base to ensure that large, proven service providers are available to ramp up quickly and meet your needs. Also assess the risks before pulling the trigger. Outsource only processes that can be handed off without jeopardizing intellectual property, customer relationships, or regulatory compliance.

Don't let departmental boundaries confine your outsourcing program. Many end-to-end business processes span several groups within a company. The spectrum of activities involved in receiving and processing customer sales, for example, covers various sales and finance processes, while the “hire to retire” HR lifecycle encompasses human resources and finance. You can't hold an external provider accountable for end-to-end performance if half the process stays in house. Bundle all interrelated activities in a single, comprehensive outsourcing contract.

After “what” comes “how.” For each process you intend to outsource, choose a service model that serves your objectives and fits the requirements and operational characteristics of the process. The primary models are offshore, onshore, and nearshore outsourcing. When choosing, weigh factors such as savings, security, regional stability, cultural compatibility, language proficiency, and ease of access to outsourcing centers.

Offshore outsourcing offers the most potential savings. It's a good choice for companies seeking maximum cost benefits on highly standardized processes that tap widely available skill sets. Drawbacks include cultural challenges and shortages of specialized talent, and potential negative publicity and even government scrutiny in some industries.

Companies often choose onshore outsourcing when regulatory barriers restrict overseas knowledge transfers, or when they need easy access, time zone compatibility, and home-market language skills. Onshore outsourcing centers also may offer more-sophisticated talent, but yield less cost savings. Nearshore outsourcing sits somewhere between the two, offering greater savings than onshoring, along with synchronous time zones, relatively easy access, and a degree of cultural affinity with customers.

Step 2: Down-Select Suppliers

When you have determined scope and delivery model, it is time to assess potential suppliers. Use sourcing experts and analysts' reports to identify potential candidates with relevant experience and capabilities, capacity to meet your volume requirements, and stable businesses. Then engage three to five of the most promising providers in a rigorous competitive-bidding process to secure the best possible pricing and service commitments.

We discourage sending broad requests for information (RFIs) to a large number of providers. These time-consuming “open auditions” produce little information that isn't available from industry reports. Even worse, a scattershot RFI signals that you don't understand the market and lack clear objectives, which may lead providers to steer you toward solutions that serve their needs better than yours. We recommend having a clear perspective on your scope and moving straight to a request for proposal (RFP) with three to five top providers.

Your RFP should be prescriptive, requiring vendors to answer specific questions directly related to your needs. Their answers will allow a team of internal stakeholders to review RFP responses side by side and evaluate bidders on objective criteria across five dimensions:

Basic qualifications. These include an external service provider's experience and capabilities, financial strength, and capacity to handle the work you plan to outsource, including future growth.
Proposed solution. Compare the bidders' plans for performing the work, service level and productivity commitments, and track records with outsourcing transitions. Also assess how well each provider understands your specific process needs, the challenges and objectives of the assignment, and its role in your broader transformation agenda.
The team. Size up each bidder's team. Is senior management committed to your work? How many staffers would they dedicate to your account? How good are their workers? Look past sales teams and their polished presentations to scrutinize staffing models, and insist on meeting the operational experts who would oversee your work daily.
Fit. Pay attention to “soft” factors such as a provider's culture and alignment with your organizational values. Preexisting relationships between key players at your company and the external service provider may provide comfort in this area. Look for flexibility and the creativity needed to devise innovative solutions to unique challenges that may arise during the assignment.
Pricing. Understand the cost assumptions underlying each bidder's price estimates, including the estimated number of FTEs assigned to your work, the mix between offshore and onshore FTEs, and projected increases in worker productivity.

Step 3: Execute Due Diligence and Contract Negotiations

After scoring bidders, invite the top two or three contenders to intensive joint-solution design sessions, where you will clarify the solution and sources of value you expect to tap. Define the respective roles, responsibilities, and decision rights of each party to the relationship, and lay out a clear timeline and cost-allocation regime for the transition phase. These daylong sessions with the subject-matter experts who would work on your account are your best opportunity to gauge a vendor's ability to deliver on its promises and drive buy-in from your organization for the outsourcing initiative. Spending a day with them also allows you to evaluate their expertise and assess how well they fit with your company culture. By the end, you should secure agreement from all finalists on key deal terms, building in contractual incentives for the supplier to achieve your goals (see Figure 8.4 ).

A tabular representation of the technology service provider assessment, where to discuss, example, and relative perception of vendor (1, 2) are represented in the column heads. Meets minimal requirements, meets partial requirements, and meets all requirements are denoted by quarter-filled, half-filled, and completely filled circles. — **Figure 8.4**

While a clear favorite may emerge from these discussions, don't limit your options until contracts are finalized. Companies that commit to a favorite vendor too early may tip their hands, sacrificing negotiating leverage they might have retained if the vendor thought they were still negotiating with a competitor, and possibly missing out on favorable contract terms they otherwise might have secured.

Contract negotiations are critical to the long-term value of the outsourcing relationship. Negotiate in parallel with at least two of the strongest candidates until scope, price, and other major terms are nailed down. Take a balanced approach: to avoid prolonging negotiations unnecessarily, acquiesce quickly on terms that are less important to you, but don't let time pressures force you into unfavorable concessions on terms that really matter.

Step 4: Launch Transition

When a contract has been signed, the delicate work of shifting internal processes to an external provider begins. This transition phase is critical, setting in motion relationships, expectations, and patterns of behavior that can make or break the outsourcing initiative's ultimate success. Transitions are managed by a joint transition team with members from the client and external service provider. Each side appoints an overall transition leader and joint managers for every process to be outsourced. The team establishes a timeline and key milestones for the transition. Team leaders monitor progress, identify potential obstacles, and resolve issues escalated by the process managers.

With a team in place, the outsourcer staffs up to handle the work, either by hiring and training new workers, or by reassigning and retraining existing employees. After staffing is complete, process-knowledge transfer begins. The external service provider learns the process by sending representatives to shadow incumbent company workers. Then the work shifts to the outsourcer in a controlled transfer, under the supervision of company representatives who “reverse shadow” the external service provider's workers as they perform the process.

Last, the transition moves into the pilot phase, in which the external service provider handles a limited amount of work without direct client supervision. If the external service provider meets required service levels during the pilot phase, full-scale implementation of the contract can begin.

Step 5: Design Communications and Retained Organization

Outsourcing frequently triggers anxiety within an organization. Setting realistic expectations among those affected is essential to success. Yet too many companies neglect to define updated organizational roles and responsibilities or communicate them properly, leaving important stakeholders uninformed and wary. Successful outsourcing programs proactively address the fact that an outsourced organization operates and manages very differently than one that is not. Remaining employees will have to focus on managing the vendor instead of executing the services themselves. That means they will have new responsibilities and need new skills. These changes in how and where work is done must be engrained in the organization through continuous, targeted communication.

Case Study: Outsourcing Drives Savings, Performance, and Competitive Advantage at P&G

Consumer products giant Procter & Gamble (P&G) consolidated many processes in the late 1990s, creating a global business services organization that supported business units under a shared services model. But by the mid-2000s, the company was looking for new ways to improve shareholder returns while still delivering best-in-class service to business units.

P&G turned to outsourcing, forming strategic supplier relationships that tapped the strengths of external partners to improve service levels, reduce cost-to-serve, and provide greater access to innovation. After assessing back-office processes on the basis of several financial, market, and strategic factors, P&G identified a broad range of processes in five distinct areas that appeared ripe for outsourcing: (1) IT Infrastructure, desktops, application development, and maintenance (2,000-plus FTEs); (2) facilities management (600-plus FTEs); (3) HR and employee services (800-plus FTEs); (4) transactional finance processes (2,000-plus FTEs); and (5) consumer relations. Because of the project's wide scope, P&G chose a best-of-breed vendor strategy to engage the best providers for each process and mitigate the risk of underperformance. P&G also visited prospective suppliers to confirm their capabilities and cultural compatibility. On these visits, company executives met highly educated and experienced workers who were committed to continuous improvement and innovation.

In the end, P&G entered into five outsourcing contracts ranging in duration from 5 to 10 years, with total expected billings of more than $4 billion. The contracts not only generated more than $1 billion in operational savings, but also improved service levels and productivity, turned fixed expenses into variable costs, created seasonal staffing flexibility, and gave P&G “follow the sun” capabilities. Strategic partnerships with external service providers also help P&G integrate acquisitions faster and at lower cost. P&G sees outsourcing and its strategic partnerships as a competitive advantage that makes the company stronger in key back-office functions, freeing up the organization to focus on the consumer.

Outsourcing Best Practices

Organizational buy-in and commitment from the top. Like the broader Fit for Growth transformation, an outsourcing program needs buy-in at all levels. This starts with a commitment from top leaders to move quickly and make the right choices for the company. Strong leaders push aside organizational resistance to outsourcing, making it clear that “not doing this” isn't an option. They base decisions on clear business reasons, and make sure the organization understands their rationale.
Clearly defined objectives, scope, and measures. Companies that outsource successfully understand their own internal costs and performance levels, and the trade-offs inherent in their suppliers' cost structures and delivery models. They outsource processes only when performance is measurable and an external provider can be held fully accountable for achieving clearly defined objectives. Undeterred by the complexity of managing multiple vendors, they distribute processes among best-of-breed providers when it will generate more value.
A case to beat. Strong outsourcing programs start by determining the best result the company could achieve by transforming a process internally, assuming access to the best technology and other transformation tools. This “internal case to beat” establishes a baseline for outsourcing decisions and negotiations with service providers.
Effective transaction management. Pace and timing matter a great deal in outsourcing. The best-managed programs allow enough time to define project scope and select a provider, but don't drag out decision making. They maintain momentum by sticking to a strict timetable—usually three to six months for defining scope, choosing a provider, and signing a contract.
Good advice. Outside expertise can add considerable value, especially for companies unfamiliar with outsourcing. Legal counsel with outsourcing experience can help companies manage their contractual liability while building in the flexibility to terminate outsourcing relationships when necessary.
Win-win contracts. A good outsourcing agreement is fair to both parties. It ensures reasonable profits for the external service provider and competitive market prices and service levels for the company. The best contracts include incentives such as gain-sharing to encourage innovation, and penalties for failure to meet agreed-upon service levels. While 7- to 10-year IT and business-process outsourcing deals have been common, we see a recent trend toward shorter deals that provide more flexibility and the ability to test the competitive market sooner.
Ongoing involvement. Outsourcing isn't abdication. You still own the overall results, so you need to actively manage your external service providers. Successful companies establish robust vendor management offices to oversee outsourcing relationships and monitor service quality. They also retain critical knowledge of outsourced processes, so they can manage external providers effectively. Yet they balance rigor and flexibility, avoiding micromanagement of service providers without “handing over the keys.” Focused on results, they give providers leeway to propose creative solutions, and rely on service level agreements and metrics to evaluate performance.

Pitfalls to Avoid

Outsourcing broken processes. It's tempting to ask somebody else to clean up your mess. Don't outsource a broken process without a plan to fix it.
Focusing only on cost. Companies that focus only on unit cost savings blind themselves to the broader benefits of outsourcing. In their zeal for short-term savings, they sacrifice the greater value to be reaped from true process optimization.
Underestimating internal challenges. It takes time and concerted effort to overcome internal opposition to outsourcing. Companies sometimes fail to confront the misconception that “outsourcing won't work here,” or allow managers to protect their organizations without putting forward a business case for keeping the function in house.

8 Outsourcing Let External Providers Generate Value for You