strategic outsourcing

Purchasing and Supply Chain Managementby W.C. Benton

Chapter NineStrategic Outsourcing

Learning Objectives

1. To learn the precise definition of outsourcing.2. To learn why organizations outsource manufacturing

and services business processes.3. To learn the outsourcing process is not considered

contracting or joint venturing.4. To learn about the benefits and pitfalls of

outsourcing.

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Learning Objectives

5. To about the hidden cost of outsourcing.6. To learn about core and non-core competencies.7. To learn about the elements of strategic outsourcing8. To learn about the role of the outsourcing

relationship manager.

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Outsourcing

• Defined as the complete transfer of a business process that has been traditionally operated and managed internally to an independently-owned external service provider.

– A complete transfer of all associated internal business process activities

– Once outsourced, the people, facilities, equipment, technology and

other assets are no longer maintained internally

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Outsourcing

• Not the same as subcontracting, joint venturing or contract manufacturing

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Outsourced activities

Source: Handley, S.M., The Evaluation Analysis and Management of the Business Outsourcing process, Unpublished Dissertation, The Ohio State University, 2008 9-6

The concept of Outsourcing • A process rather than simply an event

Source: Handley, S.M., The Evaluation Analysis and Management of the Business Outsourcing process, Unpublished Dissertation, The Ohio State University, 20089-7

Reasons for Outsourcing Business Processes

The generic strategic benefits of outsourcing are: 1. Cost Minimization2. Refocus Organization to Core 3. Improvement in Operating 4. Increased Market Share and Revenue

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Outsourcing Business Processes

• The usual primary driver for outsourcing :• A reduction in direct operating costs which must be

significantly lower than the current direct operating costs

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Specific Purposes & Benefits of Outsourcing

1. To reduce and control operating costs2. To improve quality3. To change company focus4. To acquire external capabilities5. To refocus scarce resources for alternative uses6. To reduce cycle time7. To obtain cash infusion8. To reduce risks9. To gain flexibility10. To turn fixed costs into variable costs

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The Following are Important for Realizing Expected Outsourcing Benefits

• An extensive strategic assessment

• A true commitment to a cooperative relationship with the service provider

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The Hidden Cost of Outsourcing

1. Quality Costs

– Preventative– Appraisal– Internal failure– External failure

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Detecting Quality Failures

The buying firm will need a proper mechanisms that are capable of detecting quality failures by an external source.

This may be more difficult than with internal sourcing

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The Hidden Cost of Outsourcing2. Supplier or Vendor Relationship Management

The most effective external sourcing relationships involve considerable management time and coordination

External Sourcing which involve:

– Commodity products or services may not require extensive relationship building and coordination.

– Strategic products and services require extensive relationship building and coordination activities.

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• Relationship Management Costs– Labor expense of purchasing personnel – Travel– IT infrastructure and management– Supplier development programs (e.g. training and

performance evaluation systems)

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3. Internal Coordination• Contrasted against the internal coordination and overhead

costs associated with internally sourcing (Vertically integrate or Make)

• The costs of bureaucracy– Payroll, benefits management– Utility expenses, IT expenses, etc.

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Understanding Overhead Costs

Firms need to have a thorough understanding of these marginal overhead expenses and how they would be incrementally impacted by outsourcing

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The Hidden Cost of Outsourcing4. Implementation of External Sourcing Model

• Costs associated with the transition resulting from switching sources

– supplier search, evaluation and contracting– the transfer of physical assets– domestic and international travel during start-up– training of the new source

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Additional Hidden Costs Associated with the Internal Workforce

• relationship manager training for internal employees

• retention bonuses, severance packages, employee turnover

• management time required to thwart labor disputes

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5. Coordination of Product / Service Design and Development

– There appears to be a significant interplay between the architecture of the product or service and the cost of coordination.

– Cost of coordination: the number of engineering hours required to bring a new product to market

– Tightly coupled or integrated product designs require higher levels of coordination

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A Need to Coordinate Sourcing Alternatives

• Firms need to develop a deep understanding of the coordination cost implications of various sourcing alternatives

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6. Governmental and Political Related Expenses

• Costs involved with ensuring compliance with governmental laws, regulations, and even local business customs

– legal expenses incurred to learn about a foreign location’s laws and regulations, travel

– taxation, local content obligations, lobbying efforts– tariffs, quota systems, etc.

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7. Supply Chain Risk Management • Risk can be defined as a measure of the probability and

severity of adverse effects.

• Four iterative phases1. Risk assessment 2. Risk mitigation 3. Risk monitoring 4. Contingency planning.

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Supply Chain Risk Management

• A comprehensive risk management approach will introduce costs that are different for various sourcing alternatives.

• Different options will carry with them different types and

sizes of risks.

• Some specific costs includes – insurance, dedicated risk management personnel,

financial hedging, and operations hedging.

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8. Miscellaneous Financial ConsiderationsSources of financial benefit from outsourcing Vendor’s better economies of scale External suppliers’ capability to aggregate the demands

of their multiple customers

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Miscellaneous Financial Considerations

• The size of the buying firm’s portion of cost improvement is determined by competitive conditions in the supply market, power structures, and the overall threat of opportunistic behavior by the external supplier.

• If a firm’ internal efforts can generate nearly equal financial improvement as outsourcing, the outsourcing decision is called into question.

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Core Competencies

• Core Competencies are: • The collective learning in an organization • Unique combinations of thought, focus and

implementation methodologies • Achieved over the long term

• Outsourcing can provide short-term competitive benefits, but does not significantly improve Core Competencies

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Keys to Outsourcing Success in Today's Economy

1. Understanding and avoiding the pitfalls of cost-focused outsourcing and apply a total business-outcome-focus

2. Continuously re-evaluate contracts to improve efficiency and costs. The drivers of efficiency and costs are:

• Provider selection and retention, • Services delivery policies, contract pricing and etc.

3. Ensure a certain level of flexibility in contract terms in order to be response to corporate changes

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Elements of Strategic Outsourcing• The steps are

highly interrelated.

• Modification to the steps are required to fit each specific organization and outsourcing objectives.

• Concurrent relationships between steps reduce the implementation cycle time. 9-29

Elements of Strategic Outsourcing

1. STRATEGIC EVALUATION• Outsourcing is the act of reversing a previous decision to

“make” or perform a particular function internally.

• The first step is to understand the strategic importance (value) of the activity or system.

• Standardized processes, commoditized products, etc.: extremely low strategic value.

• Buying firms must make decisions as part of a comprehensive sourcing strategy.

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2. FINANCIAL EVALUATION

• Outsourcing decisions are required to make short and long-term financial sense.

• However outsourcing benefits are not mutually exclusive and independent constructs, but rather significantly interrelated.

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3. SUPPLIER SELECTION AND CONTRACT DEVELOPMENT• Supplier Selection

– Supplier profiles • Key management contacts, a company overview• SWOT analysis, Porter’s five key financial figures• Information on current contracts, “owners” of the

relationship within the firm, and an organizational chart.

• Functional evaluation of the content

– Establish expectations, scope of work, pricing

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Supplier Selection and Contract Development

• Contract Development– a minimum for an enforceable contract include:

1. A clearly defined scope of work and elements of the processes to be supplied

2. An agreed upon approximate price for each aspect of what is being supplied.

3. An understanding of an acceptable level of operating flexibility as circumstances and requirements change.

4. Consider a short term contract with provisions for extensions and renegotiations

5. Ground rules that encourage relationship and alliance maintenance

6. Determination of a means for measuring performance for each aspect of the agreement.

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Element of Outsourcing

4. TRANSITION TO EXTERNAL SOURCING MODEL

Begins with the contract execution to the transfer of the agreed upon activities and resources• The buying and selling organizations must both follow the

specific roles outlined in the contract • The buying organization must also appoint a relationship

manager• The relationship manager and the supplier must merge their

independent plans into one consensus plan

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Elements of Outsourcing

TRANSITION TO EXTERNAL SOURCING MODEL (continued)

• Consensus transition plan must include at a minimum – Communication Criteria – Personnel Criteria – Transition Criteria

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Elements of Outsourcing TRANSITION TO EXTERNAL SOURCING MODEL (continued)• Communication Criteria

– About the process of communicating external initiatives to the affected and unaffected employees

– The following actions should included in the process• Announce that the contract has been signed and awarded

to the supplying firm• Discuss how severance packages will be offered to

affected employees• Conduct extensive question and answer session

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Elements of OutsourcingTRANSITION TO EXTERNAL SOURCING MODEL (continued)• Personnel Criteria

– About the overall message itself that will be communicated to the affected and non-affected employees

– Create the perception of procedural and interpersonal justice

1. Communicate early and clearly why the decision was made2. All stakeholders need to feel as though their interests were

represented3. Retained employees need to be trained to enhance their

“lateral” skills such as relationship management, negotiation and consensus building.

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Elements of Outsourcing TRANSITION TO EXTERNAL SOURCING MODEL (continued)Transition Criteria

1. The schedule involving the transfer of activities and resources to the supplying organization

2. The list of activities to implement outlined in the project management schedule should include:– An organization meeting for employees being transferred to

the supplier’s organization.– A meeting with the buying firm’s manager whose activities are

being outsourced conducted on-site at the new location.

• A creation of a plan to address the issues involved in transferring significant physical assets

– a specific third-party agreement in the contract 9-38

Relationship Management

• In order to effectively cultivate the relationship, the buying firm must actively monitor and evaluate performance. The buying firm must also solve outsourcing related problems.

• The original contract establishes

• the performance measures • deliverables, due dates• the expected supplier requirements

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1. Performance measurement is the cornerstone of the buyer-supplier relationship. • It establishes control which provides the ability to manage

the relationship

2. The buyer and supplier relationship managers should develop and execute the reporting system established in the contract.

• A performance report is also needed. See the following slide.

Relationship Management

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Performance report PerformanceMeasures

PerformanceStandard

2009Actual

2009Variance

2008Actual

2008Variance

2007Actual

2007Variance

Number ofoutputs

Number oferrors

Number of on-time deliveries

Number of day-cycle time

Number of outputs per employee

The performance report should be designed to compare the actual performance to the contractual standards.

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Risk• Outsourcing risks include:

– Breaches in intellectual property– Provider shirking– Opportunistic renegotiation

• The combination of contractual incompleteness, asset specificity, and uncertainty gives rise to these risks when firms pursue external sourcing

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Performance Report

• Risk is the difference between risk and uncertainty • Risk as defined By Knight:

– Risk is measurable, but uncertainty cannot be measured

– Buyers outsourcing risks (BOR) = PA x NC– PA = the probability that an adverse event will

occur– NC = negative consequences if the adverse event

occurs, assuming that each of the adverse events is independent

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Forms of Governance

• Traditional theory– Hierarchy (i.e. internal sourcing) v. Market (i.e. external

sources) – Market: arm’s-length relationship between the customer and

supplier organization

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Forms of Governance

• Hybrid governance theory– From the observation of Japanese- style supply chain

relationships – Neither purely hierarchical nor a purely arms- length

market mechanism.– Seeks to realize the control, goal alignment, and improved

coordination associated with retaining an activity internally, while also benefiting from the potentially superior skills and cost position of specialized, external organizations.

– The relationship is more of a long-term, collaborative partnership

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Long Term Relationships• Benefits

– A reduction in transaction costs – Improve learning and control opportunism – Greater social capital

• Improved dissemination of information and reduced motivation for opportunistic behavior

• Social capital: the sum of the actual and potential resources embedded within, available through, and derived from the network of relationships possessed by an individual or social unit.

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Long-term relationships with service providers can mitigate many of the traditional concerns with external sourcing

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Requirements for Long Term Relationships

• Strong commitment from both parties 1. The sharing of timely, rich, and often proprietary

information including:–demand forecasts, detailed cost information–new product plans, strategic change

2. For building trust between the organizations 3. For more effective planning and execution

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• Joint effort by the organizations.

• Equitable distribution of pain and gain (tying their destinies together)

• A contract that defines performance incentives by means of penalty and reward structures

• A constructive and flexible change management and dispute resolution process

• A formalized procedure for communicating the buyer’s expectations and evaluating the supplier’s performance

Requirements for Long Term Relationships

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