Outsourcing occurs when a company purchases products or services from an outside supplier, rather than performing the same work within its own facilities, in order to cut costs. The decision to outsource is a major strategic one for most companies, since it involves weighing the potential cost savings against the consequences of a loss in control over the product or service. Some common examples of outsourcing include manufacturing of components, computer programming services, tax compliance and other accounting functions, training administration, customer service, transportation of products, benefits and compensation planning, payroll, and other human resource functions. A relatively new trend in outsourcing is employee leasing, in which specialized vendors recruit, hire, train, and pay their clients' employees, as well as arrange health care coverage and other benefits.
The growth in outsourcing in recent years is partly the result of a general shift in business philosophy. Prior to the mid-1980s, many companies sought to acquire other companies and diversify their business interests in order to reduce risk. As more companies discovered that there were limited advantages to running a large group of unrelated businesses, however, many began to divest subsidiaries and refocus their efforts on one or a few closely related areas of business. Companies tried to identify or develop a "core competence," a unique combination of experience and expertise that would provide a source of competitive advantage in a given industry. All aspects of the company's operations were aligned around the core competence, and any activities or functions that were not considered necessary to preserve it were then outsourced. Today, outsourcing is embraced by companies of all sizes and industry orientations. As analysts Tom Osmond commented in Employee Benefit News, "many companies have decided that transactional and administrative functions are neither core competencies nor value-added activities. In fact, some companies are putting themselves at risk as a result of using outdated technology and not complying with government regulations. Vendors, by focusing on administration as part of their business model, provide better service enforced by contracts and service-level agreements."
Successful outsourcing requires a strong understanding of the organization's capabilities and future direction. As William R. King explained in Information Systems Management, "[d]ecisions regarding outsourcing significant functions are among the most strategic that can be made by an organization, because they address the basic organizational choice of the functions for which internal expertise is developed and nurtured and those for which such expertise is purchased. These are basic decisions regarding organizational design." Outsourcing based only upon a comparison of costs can lead companies to miss opportunities to gain knowledge that might lead to the development of new products or technologies.
Outsourcing can be undertaken to varying degrees, ranging from total outsourcing to selective outsourcing. Total outsourcing may involve dismantling entire departments or divisions and transferring the employees, facilities, equipment, and complete responsibility for a product or function to an outside vendor. In contrast, selective outsourcing may target a single, time-consuming task within a department, such as preparing the payroll or manufacturing a minor component, that can be handled more efficiently by an outside specialist.
Vendors providing outsourcing services are generally grouped into two models: Business Process Outsourcing (BPO) and Application Service Provider (ASP). In the BPO model, major resources and assets are transferred from the company to the vendor. Under the ASP model, on the other hand, vendors concentrate on providing selected services for multiple clients. But as Osmond told Employee Benefit News, many variations exist within these two models. "Each vendor has a particular focus and/or point of entry to the market, particularly in the ASP space," Osmond stated. "There is also a wide range of pricing models and option. The good news is that there is a seemingly endless combination of service, pricing, and delivery, providing a solution for most situations. The bad news is that it can be difficult to compare vendors on an apples-to-apples basis."
ADVANTAGES OF OUTSOURCING
Companies that decide to outsource do so for a number of reasons, all of which are based on realizing gains in business profitability and efficiency. Principal merits of outsourcing include the following:
Cost savings. Many businesses embrace outsourcing as a way to realize cost savings or better cost control over the outsourced function. Companies usually outsource to a vendor that specializes in a given function and performs that function more efficiently than the company could, simply by virtue of transaction volume.
Staffing levels. Another common reason for outsourcing is to achieve headcount reductions or minimize the fluctuations in staffing that may occur due to changes in demand for a product or service. Companies also outsource in order to reduce the workload on their employees (freeing them to take on additional moneymaking projects for the business), or to provide more development opportunities for their employees by freeing them from tedious tasks.
Focus. Some companies outsource in order to eliminate distractions and force themselves to concentrate on their core competencies. This can be a particularly attractive benefit for start-up firms. Outsourcing can free the entrepreneur from tedious and time-consuming tasks, such as payroll, so that he or she can concentrate on the marketing and sales activities that are most essential to the firm's long-term growth and prosperity. "What an outsourcing partner really sells is focus," wrote Adam Katz-Stone in Baltimore Business Journal. "In accounting for instance, that is something that typically is seen as necessary but not essential, not the core of the business. So you bring in an outsourcing partner and then you don't have to think about that any more. You can focus your energies on sales, marketing, all the other things that matter more."
Morale. This is an often-overlooked but still notable benefit that can sometimes be gained by initiating an outsourcing relationship. "Often a business's lack of internal expertise or dedication to non-core tasks results in poor attitudes and ultimately poor performance," wrote Kevin Grauman in CPA Journal. "This can lead to overlap and duplication of internal efforts. An effectively designed and ongoing communication process emanating from one or more outsourcers can greatly reduce or eliminate these duplications."
Flexibility. Still others outsource to achieve greater financial flexibility, since the sale of assets that formerly supported an outsourced function can improve a company's cash flow. A possible pitfall in this reasoning is that many vendors demand long-term contracts, which may reduce flexibility.
Knowledge. Some experts tout outsourcing of computer programming and other information technology functions as a way to gain access to new technology and outside expertise. This may be of particular benefit to small businesses, which may not be able to afford to hire computer experts or develop the in-house expertise to maintain high-level technology. When such tasks are outsourced, the small business gains access to new technology that can help it compete with larger companies.
Accountability. Outsourcing is predicated on the understanding—shared by business and vendor alike—that such arrangements require quality service in exchange for payment. "Paying for a business service creates the expectation of performance," stated Grauman. "Outsourcers are well aware that this accountability is both practical and legal, with fiscal implications. The same cannot be said for internally provided functions."
DISADVANTAGES OF OUTSOURCING
Some of the major potential disadvantages to outsourcing include poor quality control, decreased company loyalty, a lengthy bid process, and a loss of strategic alignment. All of these concerns can be addressed and minimized, however, by companies who go about the outsourcing process in an informed and deliberate fashion. Info World's Maggie Biggs counsels businesses to define "exactly what business processes and/or functions it makes sense to maintain via a service relationship. Unless you have a lot of resources to expend, it may make sense to prioritize outsourcing projects based on the number of benefits you expect to gain from the arrangement." There may also be inherent advantages of maintaining certain functions internally. For example, company employees may have a better understanding of the industry, and their vested interests may mean they are more likely to make decisions in accordance with the company's goals. Indeed, most analysts discourage companies from outsourcing core functions that directly affect the products or services that the business offers.
STEPS IN SUCCESSFUL OUTSOURCING
Once a company has made the decision to outsource, there are still a number of factors it must consider in making a successful transition and forming a partner relationship with the vendor. First, the company should determine what sort of outsourcing relationship will best meet its needs. "Decide what's important," urged the Journal of Accountancy. "If a function is not strategic to your business—for instance, payroll services or health insurance needs in a recruiting agency with only ten employees—consider outsourcing it to an expert provider." Some businesses share strategic decision-making with their vendors, while others only outsource on a limited, as needed basis.
As Ethel Scully noted in National Underwriter, the company needs to obtain the support of key personnel during this time. Many companies encounter resistance from employees who feel that their jobs are threatened by outsourcing. Scully suggested forming a team consisting of an outsourcing expert, representatives from senior management and human resources, and the managers of all affected areas of the company to help address employee concerns about the decision.
Once your business has decided which functions to outsource, it should initiate a search process that utilizes referrals from other companies and service-provider directories. You can then begin contacting potential vendors and ask specific questions about the services they provide and their abilities to meet your company's unique and specific needs. Ideally, the vendor you select will have experience in handling similar business and will be able to give all of its clients' needs the priority they deserve. "Consider the service company's knowledge of the entirety of your business, its willingness to customize service, and its compatibility with your firm's business culture, as well as the long-run cost of its services and its financial strength," said service provider Carl Schwenker in Money. During this period, you should also reexamine your own company culture and business needs to make sure that the outsourcing arrangement under consideration is a good fit. Many outsourcing experts counsel businesses to select vendors that can effectively integrate all their outsourced business functions so that they do not have to find individual vendors for each function.
Finally, you should select a vendor you trust in order to develop a mutually beneficial partner relationship. It is important to develop tangible measures of job performance before entering into an agreement, as well as financial incentives to encourage the vendor to meet deadlines and control costs. The contract should clearly define responsibilities and performance criteria, outline confidentiality rules and ownership rights to new ideas or technology. It should also include a means of severing the relationship if the service does not meet your expectations. Since the vendor is likely to have more experience in preparing outsourcing agreements than a small client company, it may also be helpful to consult with an attorney during contract negotiations.