Chapter 17
Considering Outsourcing
In This Chapter
Understanding outsourcing’s pros and cons
Deciding what to outsource and choosing a supplier
Managing outsourcing relationships
Atidal wave of outsourcing — a term meaning that a company hires another firm or firms to perform specific operations — has been hitting businesses throughout the United States since the 1990s. Before, firms typically only outsourced support tasks such as human resources management or janitorial services. Then came call centers and technical support. Nowadays, companies are even outsourcing the production and delivery of the products and services that make up their core business. If these production and delivery operations aren’t performed well, a firm’s costs can increase, customer service can suffer, brand reputation can be harmed, and market share can decline — sometimes fatally.
This chapter describes the pros and cons of outsourcing and highlights the three most important decisions for successful outsourcing. We also point out some critical factors of outsourcing, including product design and management.
Seeing the Upsides and Downsides of Outsourcing
Hiring a separate company to build a product or provide a service can make sense for some companies because outsourcing may be cheaper, provide higher component quality, or reduce capital costs. But sometimes it’s better to just do it yourself. Outsourcing the wrong process, product, or service can, over the long run, end up increasing costs, harming overall product quality, and even leaking core technology. Some firms have spent billions of dollars reversing outsourcing mistakes.
In this section we describe the potential benefits as well as the risks of outsourcing.
Benefiting from the pros
Outsourcing has continued to be a popular business tool since the turn of the 21st century. Here are some of the most compelling benefits of outsourcing:
Better quality: Sometimes another company is just better at building a product or delivering a service than your firm is. And do you really want your company to produce its own pens and paper? Most automotive firms outsource the production of tires. Ultimately, that’s a pens and paper kind of decision. When the part or service to be outsourced, like tires, has a standard, easily defined interface with the overall product, the quality benefit rules. To buy a tire, even in the aftermarket, all you need to know are three measurements. If the tire matches those three measurements, you can put it on your car.
In contrast, very few automotive firms outsource transmissions because most transmissions are tailored to individual engines and automobiles.
Improved return on investment: A mainstay of outsourcing is its ability to reduce the investment in plant and equipment needed to produce a product, which must be booked as an asset. If you can retain the bulk of the profits for the product and not lose too much to supplier markups, then your return on investment should increase.
Lower costs: Some suppliers have economics in their favor. Generally speaking, outsourcing to low-cost labor means a company can reduce the labor cost that goes into the outsourced components. For example, labor costs in China are lower than in Western nations, so some firms hire Chinese companies to perform labor-intensive, low-skill activities, like cutting and sewing clothing. This also has a reinforcing effect. If a number of companies outsource to a common low-cost supplier, then that supplier can obtain economies of scale from specialization. Sometimes, it just doesn’t make financial sense for a company to set up facilities and hire employees to produce an item that another company is already making efficiently.
A transfer of fixed cost to variable cost: If you produce a product or component yourself, you incur a number of investment costs that you need to recoup before you can make a profit. If a supplier provides the part, you may be able to purchase it on a per-unit basis before repackaging and selling it. This transforms the fixed cost (investment and other costs that do not vary by unit) you incur into a variable cost (per-unit costs).
The upshot is that the number of product units you have to sell before you make a profit drops. Even if the product doesn’t sell well, you’re still likely to make a profit when you outsource.
Avoiding the cons
If the goal of outsourcing is to gain a competitive advantage in the marketplace, companies need to seriously weigh the outsourcing option. For some businesses, sharing intellectual property with partners is basically an invitation for trouble. This trouble, often referred to as an outsourcing trap, can manifest itself in a number of ways:
Creating your own competitor: If you outsource enough of the parts of your product to suppliers, another firm may be able to buy those parts (or ones very similar) and put them together to create a competitive product. This happened most notoriously in the U.S. television industry in the 1960s and 1970s.
Disconnecting with the customer: This is more of an issue with services than manufacturing. If a supplier is dealing with your customers, you may have a problem. The supplier’s personnel are representing your firm to the customer. They are effectively the face of your company! And those personnel may not have the same investment in your firm’s success that your own personnel do. (Witness this with call centers!) Another problem is that suppliers may subtly try to steer your customers to deal directly with their own business.
Experiencing leakage: The supplier who works for you also works for a number of other firms. Anything the supplier learns from you can be (and, historically, often has been) leaked to their other customers so that they can improve their products. This is true of suppliers in all regions of the world, but regions that traditionally provide less intellectual property protection (patents, trade secrets, and so on) pose a greater risk.
Forgetting your capabilities: Some firms successfully outsource all or part of the manufacturing of their products. Over time, when technology changes or people who understand the technology move on to other jobs, two problems emerge. One, you may not be able to specify to the supplier exactly what you want, so you may end up with a product or component that isn’t as well adapted to your needs as it could be. The other issue is that you’ll have less information on what the product or component should cost. This weakens your negotiating position with the supplier.
One way to get around this problem is to design and produce a small percentage of the components in-house, while outsourcing the remainder. What you produce in-house may be relatively expensive on a per-unit basis, but by improving your knowledge of component level design and manufacturing, you may improve your bargaining position enough to make in-house component production worthwhile.
Getting taken hostage by your supplier: If you outsource a key component to your supplier and divest yourself of the means to make it, you may create a problem. If no one else makes it (or, worse, knows how to make it), then you become dependent on your supplier. Losing the leverage that comes with the option of taking your business elsewhere can become expensive.
Outsourcing to multiple suppliers may help, but this too can get expensive because of managerial overhead.
Related to hostage-taking (but a bit different) is depending on only one supplier (known as sole-sourcing). It is good practice to develop a second source for critical or high-cost parts. This fosters competition and holds costs down. It also minimizes problems if the supplier goes out of business or is disrupted by earthquakes or other natural disasters.
Another downside to outsourcing centers is linkage costs, which are the costs to administer an outsourcing relationship that you wouldn’t need to spend in-house. These costs can be very high, averaging as much as 60 percent of the expected savings from an outsourcing relationship. Because linkage costs can actually overwhelm any projected savings, some companies determine that bringing outsourced work back in-house is less expensive.
Here are some common types of linkage costs:
Co-location: Many firms send one or two of their employees to be present at the supplier plant to facilitate communication or vice versa. Such co-location usually costs much more than just the salaries of the employees involved — you need to consider housing and relocation expenses. You may also have to pay a premium to induce your employees to work offshore if an offshoring relationship is involved.
Logistics: If you ship components very far from the supplier to your firm, you incur significant logistics costs. You also experience a significant delay. Shipping components by sea to the United States from Asia takes several weeks. In contrast, air shipping is fast, but it’s very expensive for large components. We know of at least one firm that, because it had to use air shipping so often to expedite orders, burned up all its savings from outsourcing to an Asian supplier. Because most companies today run with very lean inventories (see Chapter 8 for more on inventory), they don’t have a buffer against any disruption of the supply chain connecting the supplier to their firm.
Management: We discuss management linkage costs in detail in the later section Developing a lasting relationship. However, for various reasons, the number of potential miscommunications and disagreements increases in an outsourcing situation, which can be very expensive. Specialized managers can reduce these costs, but the managers themselves are expensive.
Secure data transfer: You don’t want your data to leak to other firms that may use it against you. Securing your data necessitates the use of appropriate software and training employees at both your firm and the supplier to use the software properly.
Telecommunications: You can significantly improve virtual conferences with appropriate virtual meeting software. The software, however, isn’t cheap.
Travel: Because most outsourcing involves suppliers at some geographical distance from your firm, your employees have to do a lot of traveling between your firm and the supplier. Virtual meetings can only do so much.
Getting Down to the Basics
When you’re developing an outsourcing plan, three critical questions exist. Successful planning requires you to know what, who, and how. In most cases, you answer the questions in that order. Companies first decide what to outsource. Outsourcing the wrong part of your product or service can result in poor quality, increased costs, and other mishaps. A poor outsourcing decision can result in key intellectual property being leaked or, worse, the creation of a new and fierce competitor.
Finding the right partner for outsourcing is also vital to a successful outcome. Much like a marriage, the choice of partner can make or break the outsourcing relationship. A particularly poor choice can harm or even destroy your firm.
The third decision is how to structure the outsourcing relationship to get the most out of it. This is more difficult than it looks. It involves questions of incentives, information sharing, and governance. Perhaps most important is the choice of the personnel to make the relationship work. People are the glue that holds the outsourcing relationship together.
Figuring out what to outsource
An important part of product design is the manufacturing process. You need to consider how an item will be made when designing it. You can’t just design a product, throw it over a wall, and hope that the manufacturing people can figure out how to produce it.
Outsourcing creates the same issue. If you outsource, you have to design your supply chain at the same time. You also have to design the components of your product that you want to outsource so that they’re easy to outsource.
Most of the factors that make a component or product easier to outsource reduce the amount of communication necessary between your firm and the supplier. We list a number of them here:
Legality: You can’t legally offshore certain things, such as certain defense-related technologies. This limits the choice of outsourcing partners to domestic suppliers. If you design your product to avoid such legal restrictions, the pool of firms you can outsource to is much larger.
Modularity: A component is modular if it has very few interconnections (electrical, physical, or informational) with the rest of the product. The more modular a component is, the easier it is to outsource. Tires are a great example of modularity because they have only three physical specifications. If they meet those specifications, they’ll fit the automobile. Everything else about tires is standardized (see the next bullet). Stereo speakers are similar. They typically have a single pair of wires that carries an electrical signal from an amplifier (or, these days, from a computer) that is turned into sound. Speakers don’t need to be produced along with an amplifier and don’t need any electronics or software connectivity. Speakers can be designed pretty much independently of the amplifiers that provide the sound signal. The design doesn’t have any physical constraints other than the plug at the end of the wire.
Standards: A standard is an agreement by a number of firms to create an interface to the same technical published specifications. Examples of standards include the USB connector that people use to connect peripherals to computers and the electrical outlets in your house that you plug things into. Standards make components easier to outsource because component makers don’t have to communicate or work with the outsourcing firm much because what they’re making is designed to universal specifications.
The beauty of standards is that it allows relatively complex interfaces between components to be agreed on without going into all the detail necessary to specify those interfaces (electrical, physical, information, and so on) that would be necessary if those standards did not exist. The use of standards combined with reducing the number of interfaces through modular design reduces the necessary information flow between your firm and the supplier, which makes components much easier to outsource.
Tribal knowledge: A lot of knowledge about how to produce a product never gets written down. The more of this tribal knowledge that a product or component has, the more difficult it is to outsource. One way to design for outsourcing is to try to include as much of this knowledge as possible in the specifications you send to your supplier. Another way is to substitute some standard for that tribal knowledge. Using standards is the better path if you can do it.
Figure 17-1 lists the risks commonly associated with outsourcing. If you can’t answer no to these risks (or have a plan to deal with problem areas), you need to rethink any plan to outsource your product or service.
Illustration by Wiley, Composition Services Graphics
Figure 17-1: Outsourcing checklist.
Choosing the right partner
Getting the most out of your outsourcing relationship depends on a number of factors. One obvious one is that the supplier needs to be financially stable so that it does not go out of business while working with you. A less obvious but no less important issue is a candidate supplier’s familiarity with serving firms similar to yours in terms of geography, product requirements, and sales volume. Lack of familiarity can create miscommunication. Sometimes, suppliers from one industry simply don’t have the technical capabilities to produce components for another industry.
An ideal outsourcing partner has some familiarity with your industry. Otherwise, you’ll likely spend a long time training the manufacturer about how to make your product properly. For example, imagine that a medical equipment company decides to outsource the production of a relatively uncomplicated measurement device to a toy manufacturer with significant experience in plastic injection molding. The firm makes a mock-up of the device it wants the supplier to produce, and the supplier creates a product that looks exactly like it’s supposed to, only to discover that the device can’t perform its main function, which is precision measurement of air exhaled by a patient. Toy companies are all about a product’s external appearance, and our fictional supplier is unfamiliar with how to make precision measurement products. Eventually, the toy company does a stellar job, but it takes literally thousands of hours of work by employees in both the buyer and supplier firms to overcome these issues. A supplier that’s familiar with the medical equipment industry wouldn’t need this time.
If a supplier firm needs to ramp up its volume significantly (see Chapter 18), then adjusting production levels takes time and investment to buy new equipment and hire new personnel.
When you find the right supplier, you want to stick with that supplier for the long haul. Switching from partner to partner to develop sophisticated products for your business is a recipe for disaster.
Developing a lasting relationship
Managing outsourced projects is almost always more difficult than people expect. The learning curve — for your firm and the supplier — that goes into the making of a smooth, successful relationship is often very difficult.
The following sections discuss ways to get to the facts about what outsourcing can and can’t do and how to overcome some common hurdles.
Busting some common myths about outsourcing
The conventional wisdom about managing outsourcing relationships involves a number of misconceptions, particularly that outsourcing makes managing the outsourced component easier and cheaper and doable with less management and personnel.
The following are some particularly common outsourcing myths:
External suppliers reduce the number of personnel working on your project. This is patently false. You will indeed have fewer people working directly for you, but you’ll have to hire a number of employees to coordinate the outsourced work from your end. The supplier has to do the same at his end. And there are still the people who need to do the actual work. So, in the end, the number of people working on the project will increase.
Managing an external supplier is easier than managing internal suppliers. You may think this at first, when the supplier wants your business. But, after the initial honeymoon, you’ll soon realize that your firms may not have the same goals and that you don’t have the same control over people in other firms that you do in your own firm. There’s no common boss that can resolve disagreements short of the CEOs of both firms.
Of course, you can always fire the supplier, but you’ll end up harming your own firm because you won’t have anyone to supply your component. The end result is that you have to manage external suppliers much more by persuasion than you would within your own firm.
You need fewer middle managers and can flatten your organization. It’s only going to look like your organization is flattening. The people who will manage these outsourced products, components, or services need to manage uncertainty, persuade and cajole, and hold perhaps hundreds of people accountable. This sounds very much like the job description for a middle manager. The only difference is that the people being managed aren’t at your firm but at the supplier. Moreover, there are counterparts to your supplier management personnel at the supplier. So rather than flattening the organization, you’ll probably add at least one layer of management!
Going into a partnership believing that everything will be easy is a recipe for failure. But take heart; we’ve worked with dozens of firms that have great outsourcing partnerships. How did they do it? By taking the time, being patient, and setting realistic expectations.
Bridging gaps
A number of issues can make managing an outsourcing partner especially difficult. Here are some of the challenges you need to address when developing an outsourcing relationship:
Culture: Nations have their own distinct cultures. Initially, this can lead to many mistaken assumptions and crossed signals. A yes answer from a person from some nations may not indicate agreement but merely that she hears you and understands what you’re saying. Some cultures like to solve problems themselves rather than communicate to you that they’re having problems. Other cultures tend to be very abrupt and blunt (relative to North Americans), which can be interpreted as anger or frustration when it’s nothing of the sort. In short, expect to be surprised at the number and variety of misunderstandings that occur when working with different cultures. The one bright side to this is that you’ll get better at intercultural communication after a while, especially if you continue working with the same counterpart. And learning about new people, places, and customs can be one of the joys of working across national borders.
Geography: Studies confirm that trying to coordinate with people in different time zones is difficult. For example, you’re likely to have only a one- to two-hour window of overlapping work time each day to communicate by phone between North America and Asia. E-mails aren’t any different because they just sit overnight before you can read them. In such situations, they may experience up to a 12-hour time lag each way, so resolving even a simple problem by e-mail often takes a day.
Industry: Different industries have different cultures as well. For example, one automotive firm tried to outsource some of its electronic control modules to a well-respected consumer electronics contract manufacturer. However, the contract manufacturer came from an industry in which high quality for its products was 99 percent good. The supplier had difficulty reaching automotive standards of reliability, which are much higher, especially considering that a typical car has about 3,000 parts, and even if only 1 percent of the parts are defective, that means that 30 parts aren’t working, which is likely to cripple the machine. In short, if your suppliers come from a different industry, don’t make the assumption that they understand your requirements.
Language: If you’re reading this book, you’ll most likely be communicating with your suppliers in one language (such as English). Fortunately, most suppliers have this capability. However, if the supplier’s first language is not the same as yours, communication will be hard. Remember, you’re probably having a discussion with your counterpart at the supplier in the first place because of some misunderstanding or technical difficulty. Communicating technical information across languages can be particularly challenging.
One helpful trick in these situations is double-confirmation. When you finish communicating something or giving an instruction, ask your counterpart to repeat to you in his own words what he thought you were trying to tell him. This catches a lot of potential miscommunications.
Integrating the product
Outsourcing a product is much like smashing Humpty Dumpty. After its components have been scattered to dozens of suppliers all over the world, all the king’s men may have a very difficult job putting Humpty Dumpty back together again. Still, it can be done.
Figure 17-2 highlights several ways to span the boundaries between your firm and the supplier to solve the Humpty Dumpty problem. We discuss how to use them in the following list:
Illustration by Wiley, Composition Services Graphics
Figure 17-2: Integrating the project by spanning the boundaries.
Incentives: Einstein said that physics models should be as simple as possible, but no simpler. Research suggests that incentives should follow the same formula. When incentives become overly complicated, they tend not to achieve their goals because they’re difficult to properly spell out beforehand to cover all situations, they’re prone to gaming and abuse, and they promote a contractual relationship as opposed to one based on trust and goodwill.
When developing incentives, you don’t want to only reward what’s easy to measure. Firms often incentivize suppliers based on cost. However, one way to save money is to shave on quality, which is hard to measure until the warranties and recalls come in. You also want to resist the temptation to nickel-and-dime suppliers. If you shave every possible cent from your suppliers, don’t be surprised if they take that out of the product in some way.
Specifications: Specifying what you actually want from your outsourced product, component, or service is surprisingly hard. Some of this difficulty is due to language and cultural assumptions. For example, an oil services project manager told us the following story:
“We make oil service equipment that involves literally miles of wires, as we put fiber optic cables down oil and gas wells. A couple of years ago, I was speaking with a client engineer in Malaysia on the phone. He asked me whether we had ‘monkey-proofed’ our equipment. We had big, colored, ergonomic buttons, user-friendly menus, and what not. It would be pretty hard to mess up the measurements. So I said, ‘Sure, we’ve monkey-proofed it.’
“Fast-forward six months and we’re in the jungle. Everywhere I look, there are hundreds of monkeys swinging on our wires and chewing on them. What our client really wanted was equipment that wasn’t foolproof but literally monkey-proofed.”
To give another perspective, consider the following. The U.S. Constitution is about 10 pages long as it was originally written. The Federalist Papers, written by proponents of the then-proposed Constitution, took 500 pages to explain it. This is approximately a 50:1 ratio. Even after that, there are still questions as to what the writers meant. Unfortunately, they are all dead, so it is difficult to give them a phone call.
One thing that research suggests helps in these situations is to explain not only what you want done but also why you want it done. This enables the supplier to figure out how to achieve your goals and make appropriate trade-offs. The supplier will probably arrive at better solutions than if you try to specify how to achieve these solutions yourself.
Modes of communication: Remember the 60/30/10 principle. Some researchers argue that your body language conveys about 60 percent of your meaning, your tone conveys another 30 percent, and your actual words convey only 10 percent. Therefore, you should use the phone whenever possible if you have a tricky misunderstanding to resolve. If you can set up a good-quality video conference, that’s even better (especially one that permits sharing drawings). However, if the video’s resolution is poor, don’t bother; it will just confuse the participants. A side effect of this principle is that you (or someone in your firm) is likely to do a lot of traveling to bridge the information gap because many things (such as brainstorming or negotiations) can be communicated much more effectively in person than over a phone, much less an e-mail.
Governance: Make sure that you set up the governance issues to resolve any disagreements upfront. The last thing you want to do is negotiate both the disagreement and the resolution mechanism for that disagreement at the same time.
Related to this, one interesting recent research finding is that assigning some of the purchasing department’s traditional functions for acquisition, negotiation, and quality assurance to the project managers responsible for the outsourced project can be beneficial for the project. However, this is only true if there are different first languages between your firm and the supplier. Apparently, the benefit of a single point of contact in such situations overbalances the additional leverage of a separate purchasing department conducting parallel negotiations with the supplier. If the supplier’s first language is the same as yours, however, the purchasing function should perform its normal role.
Co-located personnel: Many firms co-locate personnel from their firm at the supplier or vice-versa. Studies have shown that these personnel are quite helpful when there’s either a big time-zone difference (see the earlier Bridging gaps section) between the lead firm and supplier, probably because it reduces the time-lag issue, or a difference in first languages between personnel at the lead firm and the supplier, probably because the 60/30/10 principle (see the earlier bullet) is particularly important when bridging languages. However, don’t co-locate just to co-locate. Co-location seems to actually be counterproductive if there’s no time-zone or first-language difference because it inserts another layer of management without any of the benefits of time-zone or language bridging.
Supply chain integrators: These are the personnel that manage the outsourced project for your firm. Several things are helpful here. One is to realize that these are essentially middle managers because they’re effectively managing potentially hundreds of people at a supplier. So using a rookie engineer with raw people skills to save on personnel costs isn’t a good idea.
In fact, this job is even more difficult than a typical middle manager’s job because of the need to be persuasive at a long distance while bridging all the language and cultural gaps involved. Simply put, managing by walking around may work very well in a firm that makes everything in house, but it doesn’t work in an outsourced environment.
Your best bet are middle managers from vertically integrated firms that have experience in all the major aspects of the industry (in manufacturing, for example, they should have both product design and manufacturing experience). If you can’t find such managers, people with hybrid backgrounds in business and engineering in college tend to do particularly well in these positions, probably because hybrid backgrounds tend to emphasize the following skills, which are essential to managing outsourced projects:
• Decision-making: Backgrounds in systems engineering (which teaches how to evaluate the business benefits of engineering trade-offs) are quite beneficial. So is experience in business case evaluation.
• Project management: Both the hard skills (cost and timing estimation, and risk identification and mitigation) and soft skills (communication, persuasion, and negotiation) are quite important.
Research suggests that one- or two-day training courses in hard skills such as project cost and timing estimation work fairly well. However, one- or two-day classes in soft skills such as negotiation can be detrimental, probably because they train people just enough to be dangerous!
• Domain knowledge: The personnel can benefit from a broad (but not necessarily deep) knowledge of operations management (obviously!), product development (if appropriate), finance/budgeting, and information technology.
Integrators tend to get better with experience managing outsourced projects. But because of long hours talking to the other side of the world, extensive traveling, low pay relative to their skill set, and often unrealistic expectations by higher management, integrators burn out quickly. Given that they have steep learning curves, this is very bad news indeed. You may need to pay integrators more than you expect if you want to attract people with the strong skill sets you need and the tolerance for travel and odd work hours that the job requires.