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Outsourcing 101 - A Primer by A.B. Maynard

Originally published at Technology Evaluation Center.  Used by permission

Definitions and Options

Outsourcing is a very diverse topic, and there are many different outsourcing options and outsourcing service providers to choose from. Companies are telling the Technology Evaluation Center that they need a clearer picture of outsourcing, its potential benefits, and common pitfalls. They want examples of different types of outsourcing and advice on whether outsourcing is right for them. This primer addresses these questions. In addition, the Technology Evaluation Center is launching a research initiative into outsourcing and launching the Outsourcing Evaluation Center to help companies in their journey towards outsourcing, whether they are outsourcing for the first time or the fifth.

This is Part One of a three-part note and will discuss the history of outsourcing, describe outsourcing pros and cons, and introduce offshoring concepts.

Part Two will define and describe common types of outsourcing.

Part Three will recap outsourcing approaches and categories, describe recommendations for firms looking to outsource and describe recommendations for outsourcing providers.

An Outsourcing Anecdote

A CEO sits in his office one day, and begins to wonder about his company . . . His number one competitor sells its products and services for lower prices than his company, is able to provide 24-hour customer service, and lately has been offering a slew of innovative new products. The CEO has read his competitor’s annual report, and noted that they were profitable again this year. The competitor’s revenues are the same as the CEO’s company, but its costs are lower. Meanwhile, the CEO’s company is unable to raise prices, can’t afford to offer 24-hour customer service, and the competitor is starting to take market share at every turn. And, by the way, the CEO’s company lost money again this year. The CEO continues to ponder . . . “Both companies have similar transaction volumes. How does my competitor do it? Why are they able to offer lower prices, better service, and do it profitably?”

Meanwhile, Wall Street is demanding that the CEO’s company become profitable . . . Now!

What is the CEO going to do? How is the CEO’s company going to reduce costs so it can be profitable, and begin to invest more capital in research and development, sales, and marketing?

The first step this CEO takes is to hire away one of his competitor’s senior managers to learn all of his competitor’s secrets. Once the new manager is on board, the CEO questions the manager to find out how his competitor is doing so well. The answer is baffling . . . he learns that its executives aren’t more educated than his team, it doesn’t spend any more money on marketing activities, and its existing products are not any better. Each company has about the same number of sales people, they get mentioned the same number of times in trade articles, and they look similar in many respects. Only one thing seems to be different . . . all of the competitor’s non-core activities are outsourced, and sixty percent of its remaining staff is located offshore, in either India or China!

The CEO vows to learn more about outsourcing and offshoring.

What is Outsourcing?

In the English language (and most likely in other languages), “outsourcing” is a relatively new term. A 1967 edition of Merriam-Webster’s Seventh New Collegiate Dictionary does not carry a listing for “outsourcing,” but a recent check of Merriam-Webster’s Online Abridged Dictionary (http://webster.com/home.htm) found the following entry:

Main Entry: out•sourc•ing
Pronunciation: -"sOr-si[ng], -"sor-
Function: noun Date: 1982 ”The practice of subcontracting manufacturing work to outside and especially foreign or nonunion companies”

Though the term is relatively new, the concept of outsourcing has been around for a long time.

Since 1982, the term outsourcing has evolved to include all parts of the enterprise, not just manufacturing. In many ways, outsourcing is a synonym for sub-contracting. Literally any activity that is performed by a company can be, and probably has been, outsourced.


Outsourcing is not the same as Offshoring

Today, when a company contracts work from another company, it is called outsourcing. Outsourced work performed locally (i.e. in the same country) is called “onshore outsourcing”. Outsourced work performed in other countries that are in roughly the same time zone is called “nearshore outsourcing”. For the United States, nearshore would include Mexico, Canada, and many Caribbean Islands. Outsourced work that is performed in countries that are many time zones away or a long distance away is called offshore outsourcing. Examples of offshore locations for the U.S. include China, India, Singapore and South Africa.

A Short History

Believe it or not, outsourcing began to emerge a few thousand years ago; it started with the production and selling of food, tools and other household supplies. If you go back far enough in the history of humanity, each person or family provided everything for themselves. They gathered their own berries and nuts, hunted their own food, grew their own crops, skinned hides for clothing and so on. Then villages began to spring up, and people began to specialize. As such, they began to barter with each other for goods and services, and soon money was invented to help simplify the bartering process. In effect, each worker was outsourcing some activities to others workers.

Fast-forward a few thousand years to the industrial age. Very few companies, if any, in the 1800s and early 1900s outsourced any part of their processes; they were vertically integrated organizations. They may have produced or mined raw materials (steel, crops, rubber) and converted that raw material into finished products, and then shipped the finished goods on company owned trucks to company owned retail stores for sale to the public. They were self-insured, did their own taxes, employed their own lawyers, and designed and constructed buildings without assistance from other firms. In short, they outsourced very little.

But specialization, especially of services, led to contracting, which eventually led to outsourcing. The first wave of outsourcing began during the boom of the industrial revolution, and fueled the large-scale growth of services such as insurance services, tax services, accounting services, legal services, architecture and engineering services, and others. The companies who performed this work were typically located in the same country, most likely the same city, as was the customer. In essence, this was onshore outsourcing.

Next came manufacturing outsourcing for low-tech items such as toys, trinkets, shoes, and apparel goods and later, higher value manufactured items like high-tech components and consumer electronics. Manufacturing was the first activity to begin to move to offshore locations in search of lower costs. As transportation and logistics improved through improved infrastructure and the use of computer technology, the cost of transportation went down, and offshore manufacturing went up. As education and skills improved in lower wage countries, manufacturers moved up the value-curve.

More recently, outsourcing has moved into the world of information technology, pension and 401k benefits, data transcription, and call center operations. This realm is made more and more possible by continued investment in education, improved information technology, the wide adoption of the Internet, and the broad, but still emerging, availability of low cost telecommunications and data communications in third world countries.

How Does It Work?

How does a company engage and pay for the services of an outsourcing provider? Simply, the company contracts with an outsourcing provider to do a defined scope of work, and the outsourcing provider charges the company a fee. The fee can take many forms: by the transaction, by labor hour, cost per unit, cost per project, an annual cost, cost by service levels, or other possible arrangements.

In exchange for the fee, the customer is provided a product or service at a guaranteed quality or service level. Many contracts stipulate specific, measurable metrics called Service Level Agreements (SLAs). These SLAs might define the acceptable quantity of defects per lines of software code, quantity of rings to answer a telephone call, quantity of calls to correctly answer a query, average response time, quantity of transactions completed per unit of time, and so on. Many times the SLAs also have penalties associated with not meeting the specified metrics, and sometimes have rewards for exceeding the metric.

Needless to say, there are a multitude of ways to perform outsourcing services, and a multitude of ways to construct outsourcing agreements.

Why Do It?

There are a number of reasons that drive companies to outsource some or many of the work activities. The list of reasons include

  • Lower costs (or lower total costs). Sometimes achieved through lower wages costs, but also through economies of scale by providing the same service to multiple companies.

     
  • Improve service. Often, better educated or skilled people perform the task, and thus perform it better.

     
  • Obtain expert skills. An outsource firm is allegedly an expert in that particular activity, and thus should be able to do it better than the customer.

     
  • Improve processes. Given that outsourcers are very experienced at a particular set of processes, they can help the customer to improve their processes.

     
  • Improve focus on core activities. Outsourcing frees management from having to worry about the inner-workings of a non-core activity. The customer focuses on their core competence, the outsourcer focuses on theirs.
     

Outsourcers often can gain economies of scale. For example, it doesn’t make sense for 500 companies to have expertise in the new tax laws for 401(k). The outsourcing company can have 3-4 people focused on it, and leverage the knowledge over those 500 companies. This is an important point because costs aren’t just getting re-categorized or shuffled around, there is overall new efficiency in the supply chain.

Make no mistake about it. Except for two or three very specific examples, the number one reason that companies outsource is to reduce their costs for the same or better service or product.

Why Not Do It?

Outsourcing is not right for every company.

  • The company may be too small to effectively outsource (although a concept called “shared services” could be right for such a company).

     
  • The company’s culture may not appropriate for outsourcing.

     
  • There may be customer reasons that limit or prevent the company’s ability to outsource.

     
  • Some government agencies do not allow their contractors to outsource anything to an offshore location.

     
  • Outsourcing takes a type of management leadership that may be different than that which exists within the company today.

This concludes Part One of a three-part note.

Part Two will define common types of outsourcing categories.

Part Three will recap outsourcing approaches and categories, and offer recommendations for firms looking to outsource and recommendations for outsourcing providers.


About the Author

A.B. Maynard has over twenty years of technology, industry, management consulting and application software experience. He is an experienced executive with leadership experience in the software industry, Big 4 Consulting and Fortune 1000 industrial companies where he gained extensive experience in outsourcing, I.T. Services, and enterprise software solutions. In addition to the previous responsibilities and directing client outsourcing sites, he has managed offshore outsourcing provider selection, implementation and program management projects.

A.B. serves as the Outsourcing Specialist for Technology Evaluation Centers, and is President of Agilocity Consulting, a firm dedicated to helping companies improve their agility and velocity through technology, outsourcing and offshoring. A.B. can be reached at ab.maynard@agilocityconsulting.com

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