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Evaluating the Choice to Outsource

By Richard E. Crandall, PhD, CFPIM, CIRM, CSCP | September/October 2011 | 21 | 5

An evolving management challenge

Many of today’s business leaders are rethinking the decision to outsource in light of natural disasters that have significantly upset supply networks. Risk management articles abound about the need to identify and develop strategies to mitigate or prevent such disruptions.

Numerous articles discuss the pros and cons of outsourcing and the related risk. (See Crandall 2010a; Goldberg, King, and Singleton 2011; Arnseth 2011; Marks 2011; and Katz 2011.) Some discuss how businesspeople are beginning to modify their outsourcing practices by considering nearshoring—for example, a US-based manufacturer outsourcing to Mexico instead of China (Smith 2011)—or even reshoring or inshoring (Isidore 2011).

On the manufacturing side, the make-or-buy decision has long been a basic consideration. On the services side, all types of companies have outsourced such business support functions as food and custodial services; information technology (IT), including call centers and help desks; and much more. Medical technicians can read X-rays, accountants can prepare taxes, and business journalists can interpret financial statements from thousands of miles away (Thottam 2004).

However, there are growing pains. As recently as six years ago, Aberdeen Group found the biggest challenge for companies working globally was keeping the supply chain moving without damaging available sourcing savings. This required synchronizing logistics, compliance, and finance processes. More than 90 percent of the companies surveyed felt pressure to improve their global trade process. Causes of this stress include longer lead times inhibiting the ability to respond to market demands and expected product cost savings being eroded by unanticipated global supply chain costs (Enslow 2005). For many companies, the answer is to establish an integrated system of outsourcing that more carefully takes into consideration the affected projects, often by weighing total costs and benefits.

Making the decision
For the purpose of this “Relevant Research,” I will view outsourcing from the perspective of the United States; however, it is certainly a global issue that involves both strategic and tactical decision areas. As the global marketplace becomes more complex, it is increasingly difficult for companies to be competent in all facets of the business. Therefore, it’s necessary to seek help from more qualified sources. Yuva and Trent (2005) offer the following reasons for going global: to gain an international perspective; to enjoy cost and value benefits; to gain greater access to product and process technology; and to facilitate the transition from selling to buying in a region.

There is a caveat: Outsourcing is complex. It requires a good decision-making process that is systematic and comprehensive to supplement good judgment. The choice to outsource is far from a no-brainer, and professionals should conduct a comprehensive analysis, rather than reacting to short-term considerations (Yuva and Trent 2005; Gottfredson, Puryear, and Phillips 2005; King and Malhotra 2000).

Following is a general approach to making the outsourcing decision, which corresponds to steps one through six in Figure 1. This method emphasizes the need to consider both strategic and tactical factors.

1. Understand management drivers and determine 
feasibility. Before spending time in comprehensive analysis, top managers should decide if outsourcing is a sound strategic direction for the company. What are the objectives of making the change? While the initial goal often is to reduce costs, there also is the possibility of added revenues, especially in emerging markets. As Figure 1 indicates, it is important to understand the management drivers, which include the following:

  • Short-term drivers often are tangible economic considerations, such as reducing product costs, improving quality, shortening response time, and increasing flexibility.
  • Long-term drivers are less tangible, but can be of equal or greater significance.

Of the short-term drivers, only the first—reducing product costs—is a likely result of outsourcing. In fact, outsourcing may have a negative effect on the remaining three. Consequently, the trade-offs should be explored carefully in the financial analysis.

The following questions can help clarify the issues:

  • Why should companies outsource? Businesspeople increasingly view outsourcing as a strategic decision, not a tactical one. As a result, they consider the impact of the choice over a longer time horizon and include a greater number of factors in making the decision.
  • What should they outsource? Companies continue to reduce the scope of support functions performed internally. At what point does the concept to preserve core competencies fall apart?
  • When do they outsource? As part of the longer-range perspective, more organization leaders will consider what the costs could be if they implemented continuous improvement programs, such as Just-in-Time, lean production, six sigma, and supply chain management. With internal improvements, outsourcing may not be as attractive.
  • Where do they outsource—and to whom? Should a company distribute its outsourced products or services among a number of suppliers to lessen the risk or concentrate its outsourcing on fewer businesses? Some major consulting companies are gearing up to provide integrated services. Accenture offers a “bundled outsourcing” consulting service (Accenture 2011). IBM has announced a variety of outsourcing-related services (IBM 2011). The decision boils down to a choice between spreading or concentrating risk.
  • What will happen if a company doesn’t outsource? Sometimes, it is important to consider the potential outcomes of taking no action. One issue that is emerging is the lack of available skilled workers in the United States. Manpower (2011) reports that the immediate problem is a talent mismatch. Employers are seeking not just technical skills, but also critical thinking skills, and there are not enough capable people available.

There also are considerations related to environmental, social, ethical, political, and brand integrity concerns. The sustainability movement is gaining traction and will become an accepted goal for most companies (Crandall 2010b). In addition, there is an increasing need for companies to carefully weigh their strategies with respect to their social responsibilities. Does outsourcing enhance this position or degrade it?

The ethics of outsourcing involves several stakeholder groups—employees, managers, shareholders, consumers, and the public. The overriding question is: Will customers buy more if a company’s outsourcing results in lower prices, or will they buy less because of negative feelings toward the company? In making the decision, businesspeople balance the tangible benefits of outsourcing with the increased risks and uncertainties of using remote suppliers.

Political implications also are fundamental drivers and are beyond normal analysis methods. What will governments at all levels and in all countries do with respect to outsourcing practices? Will they try to regulate it? If so, will they encourage outsourcing as a step toward expanding global markets, or will they restrict outsourcing because it causes job disruptions in the form of layoffs and the need for retraining and reeducation?

Top managers also must consider long-term marketing goals. If the objective is to sell more in foreign countries, will it help to buy from suppliers in those countries? Some major multinational, US-based companies are outsourcing as a means of entering foreign markets or expanding foreign sales.

2. Evaluate initial investments and identify infrastructure changes. This is when users select those variables most significant to the company’s decision to outsource, enabling evaluation of the critical success factors for the outsourcing initiative and verification of its feasibility. A wide cross section of the organization usually will be required to develop a meaningful plan. Because each business is different, the plan must be adapted to the particular outsourcing project.

Initial investments include the costs of searching for a supplier and all of the activities necessary to establish a working relationship. There will be costs for visiting sites, updating specifications, changing the existing organization structure, investing in new tooling, and so on. There also may be revenues from selling equipment deemed expendable when the outsourcing shift is complete.

In addition, as a company outsources its services, the remaining organization becomes more streamlined. While this may suggest that it is simpler, it is not. The relationships, both within the business and between internal and external entities, become more complex and require attention to assure satisfactory results. Davidson (1990) emphasizes that the human resource function is necessary to help with internal organization realignment and coordination of the strategic alliances formed by outsourcing. This requires greater synchronization among the involved entities.

The role and scope of the purchasing function will change significantly. There will be greatly increased responsibilities for internal and external coordination of the various outsourced projects. As the amount of outsourcing increases, some businesses may create an outsourcing function with greater cross-functional responsibilities. This initially may be a part of the purchasing department; but, eventually, a more senior-level function will be responsible to top management.

Additional costs may include travel to visit potential outsourcing locations, consultation with third-party firms, and related implementation expenses.

3. Determine economic benefits and consider hidden costs and benefits. Outsourcing costs include both the direct product and the indirect support expenses. Some recommend a regular (annual or at end-of-contract) review to reevaluate the effect of economic and political changes, as well as vendor performance (Yuva and Trent 2005). Others suggest the reviews should be often enough to prevent loss of in-house critical resources and competencies (Gottfredson, Puryear, and Phillips 2005).

In addition, there are costs involved with the day-to-day management of outsourcing, which would not be incurred if production remained in-house. Each organization must come up with its own way of estimating these expenses, which are over and above the cost of project setup.

There also may be intangible costs, such as loss of technical knowledge, establishment of a business relationship with foreign contacts that may spawn a competitor, and less public acceptance in the marketplace. Assigning dollar amounts will be difficult and will require a best-estimates approach. However, some of these factors are significant and could be the basis for rejecting the decision to outsource.

IT will be necessary to provide help setting up the electronic communication and interorganizational interfaces necessary for outsourcing. Some IT elements should be retained, not outsourced.

If the estimated savings is positive after an analysis of both direct and indirect expenses, the next step will be to more carefully assess the cost of the transition. While a cursory estimate may be considered in preparing the project plan, it is important to accurately verify transition expense before moving ahead.

4. Identify risks and quantify probability and impact. Up to this point, the cost analyses are based on ongoing normal operations. When outsourcing, the likelihood of disruption increases because of longer and multimode transportation requirements, as well as problems inherent in intercountry movement of goods.

These disruptions can range from normal everyday variations to an enterprise-threatening crisis (Crandall 2010a). The probability of occurrence also varies. Some crises may occur often, but with minor effect, and can be absorbed as part of the normal, tangible costs. On the other extreme, an urgent situation may occur that proves to be truly catastrophic. An expected-value analysis can be helpful in projecting the possible economic impact of such disruptions.

5. Establish timeline and goals and calculate return on investment capital. This is the point in the project when users employ a “time value of money” approach to assess the total return on invested capital for the outsourcing project. Selecting a reasonable time horizon is critical because it is unlikely that the initial arrangement will last for very long. A discounted cash flow analysis can show the return on invested capital. It should include the initial costs of dropping the present system, recovering these expenses over a relatively short period, and then making the transition back to in-house—or shutting down the total operation. At this point, top managers consider whether or not to go ahead.

After making the individual analyses described previously, there should be a final review by senior managers before implementing the outsourcing program. This summary can take a variety of forms. It is likely that the decision makers will add their own judgment to the analysis, especially in the areas of risks and benefits. They may have insight or inclinations that are not obvious, or available, to lower-level analysts.

If the decision to outsource is supported, the project is implemented. However, progress should be monitored periodically to ensure the results are as expected.

6. Measure progress and consider open system changes. Although informal reviews may identify major deviations, it is appropriate to prepare a formal analysis of the results, probably six months or a year after implementation. If called for, changes should be made to assure ongoing success or, if necessary, a reversal or major modification to the outsourcing project.

Arriving at the right decision
The outsourcing trend likely will continue in the United States; however, many companies are being more cautious and taking an exhaustive look at their initial decision to outsource. While finance and accounting bear the primary responsibility of bringing the analysis to an effective conclusion, this reevaluation process requires extensive participation of different areas of a business. All functions should be partners in strategic outsourcing.

References

  1. Accenture. 2011. “Bundled Outsourcing: Myths and Realities, Tradeoffs and Benefits.” Accenture.com.
  2. Arnseth, Lisa. 2011. “Japan’s Disasters Highlight Force Majeure.” Inside Supply Management 16 (4).
  3. Crandall, Richard E. 2010a. “Risk Management in Supply Chains: Minimizing disruptions to streamline flow regardless of complexity.” APICS magazine. January/February 2010, 30–33.
  4. Crandall, Richard E. 2010b. “Putting Together a Global Sustainability Movement,” APICS magazine. November/December 2010, 26–29.
  5. Davidson, W. H. and S. M. Davis. 1990. “Management and Organization Principles for the Information Economy.” Human Resource Management 29 (4): 365–83.
  6. Enslow, B. 2005. “Global Trade Management: Globalization Growing Pains.” Aberdeen Group Research Brief.
  7. Goldberg, Stephen N., Jeremy M. King, and Kristi Singleton. 2011. “Insure Against Disruptions.” Inside Supply Management 22 (4).
  8. Gottfredson, M., Puryear, R. and S. Phillips. 2005. “Strategic Sourcing: From Periphery to the Core,” Harvard Business Review 83: 132–9.
  9. IBM Outsourcing Services. 2011. http://ibm.com/services/us/en/it-services/outsourcing.html.
  10. Isidore, Chris. 2011. “Made in USA: Overseas jobs come home.” CNNMoney.com. http://money.cnn.com/2011/06/17/news/economy/made_in_usa/index.htm.
  11. Katz, David M. 2011. “All in the Timing.” CFO.com. http://www.cfo.com/printable/article.cfm/14577188.
  12. King, W. R. and Y. Malhotra. 2000. 
    “Developing a Framework for Analyzing IS Sourcing.” Information & Management 37 (6): 323–34.
  13. Manpower. 2010. Supply/Demand 2010 
    Talent Shortage Survey Results.
  14. Marks, Norman. 2011. “How to Manage Risk Management.” CFO.com. http://www.cfo.com/printable/article.cfm/14582289.
  15. Smith, Lori. 2011. “Will on-shoring be the trend for 2011/2012?” Industry Week. http://forums.industryweek.com/showthread.phy?t=26551&cid=NLIWMB.
  16. Thottan, J., Tumulty, K. and S. Rajan. 2004. “Is Your Job Going Abroad?” Time. March 1, 2004, 26–35.
  17. Yuva, J. and R. J. Trent. 2005. “Harnessing the Potential of Global Sourcing.” Inside Supply Management 16 (4): 33–40.

Richard E. Crandall, PhD, CFPIM, CIRM, CSCP, is a professor at Appalachian State University in Boone, North Carolina. He may be contacted at crandllre@appstate.edu.

For a free list of more than 50 annotated references on this topic, email the author at crandllre@appstate.edu.

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