The trouble with outsourcing

Outsourcing is sometimes more hassle than it is worth

WHEN Ford’s River Rouge Plant was completed in 1928 it boasted everything it needed to turn raw materials into finished cars: 100,000 workers, 16m square feet of factory floor, 100 miles of railway track and its own docks and furnaces. Today it is still Ford’s largest plant, but only a shadow of its former glory. Most of the parts are made by sub-contractors and merely fitted together by the plant’s 6,000 workers. The local steel mill is run by a Russian company, Severstal.

Outsourcing has transformed global business. Over the past few decades companies have contracted out everything from mopping the floors to spotting the flaws in their internet security. TPI, a company that specialises in the sector, estimates that $100 billion-worth of new contracts are signed every year. Oxford Economics reckons that in Britain, one of the world’s most mature economies, 10% of workers toil away in “outsourced” jobs and companies spend $200 billion a year on outsourcing. Even war is being outsourced: America employs more contract workers in Afghanistan than regular troops.

Can the outsourcing boom go on indefinitely? And is the practice as useful as its advocates claim, or is the popular suspicion that it leads to cut corners and dismal service correct? There are signs that outsourcing often goes wrong, and that companies are rethinking their approach to it.

The latest TPI quarterly index of outsourcing (which measures commercial contracts of $25m or more) suggests that the total value of such contracts for the second quarter of 2011 fell by 18% compared with the second quarter of 2010. Dismal figures in the Americas (ie, mostly the United States) dragged down the average: the value of contracts there was 50% lower in the second quarter of 2011 than in the first half of 2010. This is partly explained by America’s gloomy economy, but even more by the maturity of the market: TPI suspects that much of what can sensibly be outsourced already has been.

Miles Robinson of Mayer Brown, a law firm, notes that there has also been an uptick in legal disputes over outsourcing. In one case EDS, an IT company, had to pay BSkyB, a media company, £318m ($469m) in damages. The two firms spent an estimated £70m on legal fees and were tied up in court for five months. Such nightmares are worse in India, where the courts move with Dickensian speed, or in China, where the legal system is patchy. And since many disputes stay out of court, the well of discontent with outsourcing is surely deeper than the legal record shows.

Some of the worst business disasters of recent years have been caused or aggravated by outsourcing. Eight years ago Boeing, America’s biggest aeroplane-maker, decided to follow the example of car firms and hire contractors to do most of the grunt work on its new 787 Dreamliner. The result was a nightmare. Some of the parts did not fit together. Some of the dozens of sub-contractors failed to deliver their components on time, despite having sub-contracted their work to sub-sub-contractors. Boeing had to take over some of the sub-contractors to prevent them from collapsing. If the Dreamliner starts rolling off the production line towards the end of this year, as Boeing promises, it will be billions over budget and three years behind schedule.

Outsourcing can go wrong in a colourful variety of ways. Sometimes companies squeeze their contractors so hard that they are forced to cut corners. (This is a big problem in the car industry, where a handful of global firms can bully the 80,000 parts-makers.) Sometimes vendors overpromise in order to win a contract and then fail to deliver. Sometimes both parties write sloppy contracts. And some companies undermine their overall strategies with injudicious outsourcing. Service companies, for example, contract out customer complaints to foreign call centres and then wonder why their customers hate them.

When outsourcing goes wrong, it is the devil to put right. When companies outsource a job, they typically eliminate the department that used to do it. They become entwined with their contractors, handing over sensitive material and inviting contractors to work alongside their own staff. Extricating themselves from this tangle can be tough. It is much easier to close a department than to rebuild it. Sacking a contractor can mean that factories grind to a halt, bills languish unpaid and chaos mounts.

So far and no further

None of this means that companies are going to re-embrace the River Rouge model any time soon. Some companies, such as Boeing, are bringing more work back in-house, in the jargon. But the business logic behind outsourcing remains compelling, so long as it is done right. Many tasks are peripheral to a firm’s core business and can be done better and more cheaply by specialists. Cleaning is an obvious example; many back-office jobs also fit the bill. Outsourcing firms offer labour arbitrage, using cheap Indians to enter data rather than expensive Swedes. They can offer economies of scale, too. TPI points out that, for all the problems in America, outsourcing is continuing to grow in emerging markets and, more surprisingly, in Europe, where Germany and France are late converts to the idea.

Companies are rethinking outsourcing, rather than jettisoning it. They are dumping huge long-term deals in favour of smaller, less rigid ones. The annualised value of “mega-relationships” worth $100m or more a year fell by 62% this year compared with last. Companies are forming relationships with several outsourcers, rather than putting all their eggs in few baskets. They are signing shorter contracts, too. But still, they need to think harder about what is their core business, and what is peripheral. And above all, newspaper editors need to say no to the temptation to outsource business columns to cheaper, hungrier writers.

In a pinch

How the financial crisis will affect the outsourcing industry

IN ONE respect it has been a record couple of weeks for “outsourcing”. Around the world, governments and taxpayers have agreed to help ailing financial firms offload their toxic loans and resolve their liquidity worries. Banks are not the only ones hoping that this will help keep them afloat. The multi-billion-dollar outsourcing industry that runs computer systems and other things on companies’ behalf is keeping its fingers crossed, too. After all, financial giants have helped drive the industry’s stellar growth in the past few years. Now they threaten to undermine it.

Huge outsourcing deals involving banks are still being done—on October 8th Tata Consultancy Services (TCS), a big Indian firm, announced a $2.5 billion, nine-year deal with America’s Citigroup—but they are getting rarer. TPI, a consultancy which tracks outsourcing deals worth over $25m, says that in the first nine months of 2007 financial-services firms signed 132 such deals, worth a total of $17.9 billion; in the first nine months of 2008 there were only 101, worth a total of $10.8 billion.

Some outsourcing folk claim that the financial crisis could ultimately help their business, even though it threatens to harm it in the short term. For one thing, they say, banking survivors that already use outside contractors will give them more to do as they cut costs. For another, banks that have hitherto shunned outsourcing will have to embrace it to protect their margins. And those with their own offshore activities will be more likely to turn them over to specialists. As part of this week’s deal, Citi is selling its Indian back-office operation to TCS for $505m. “This deal sets the stage for a lot of future revenue,” says Subramanian Ramadorai, TCS’s chief executive.

Other industry bosses are more cautious about forecasting the impact of the banking debacle. “It’s like driving blind at the moment,” says Girish Paranjpe, co-chief executive of Wipro, another leading Indian outsourcing firm. As they struggle for survival, many banks have put discussions about outsourcing contracts on hold or just cancelled them altogether. Once the dust settles there will be far fewer financial institutions around, so competition for the remaining contracts will be stiffer.

American outsourcing giants such as Accenture and IBM will suffer from all this too, but India’s behemoths are particularly exposed. Unlike their American rivals they do not have other activities, such as consulting, to fall back on. NASSCOM, a body that represents India’s outsourcing firms, reckons that financial-services work accounts for 30-40% of the industry’s activity. To make matters worse, other areas such as back-office operations for airlines and retailers are also slowing. Hence predictions that contract prices charged by Indian firms are likely to drop. CLSA, a brokerage firm, predicts they will fall by 3-5% in the next fiscal year, starting in April 2009.

Faced with tougher times, more outsourcing firms sitting on piles of cash will turn to acquisitions as a way to boost revenues. Infosys and HCL Technologies, two other big Indian companies, are already locked in a battle for control of Axon, a British firm that provides outsourced computer services. On September 26th HCL bid £441m ($813m) for Axon, trumping an earlier offer of £407m from Infosys.

As they chase new revenues, outsourcing companies will also need to clamp down on costs. These have been soaring, especially in India, where a ferocious war for talent has driven up wages and led to very high staff-turnover rates. But now companies are hiring new staff only once deals are in the bag, and turnover rates are falling, says Mr Paranjpe. That is good news, but it signals trouble ahead.

Outsourcing

Outsourcing is a term used to describe almost any corporate activity that is managed by an outside vendor, from the running of the company’s cafeteria to the provision of courier services. It is most commonly used, however, to apply to the transfer of the management of an organisation’s computer facilities to an outside agent. This transfer of management responsibility is frequently accompanied by a transfer (from the buyer of the outsourcing service to the vendor) of the specialist internal staff who are already carrying out that activity.

Outsourcing has three main advantages:

• The greater economies of scale that can be gained by a third party that is able to pool the activity of a large number of firms. It is thus frequently cheaper for a firm to outsource specialist activities (where it cannot hope to gain economies of scale on its own) than it is to carry them out itself. Some firms gain the economies of scale by taking on the activity of others, becoming an outsourcer themselves.

• The ability of a specialist outsourcing firm to keep abreast of the latest developments in its field. This has been a particularly significant factor in the area of information technology, where technological change has been so rapid that companies’ in-house capabilities are hard pressed to keep up with it.

• The way that it enables small firms to do things for which they could not justify hiring full-time employees.

The most commonly cited disadvantage of outsourcing is the loss of control involved in derogating responsibility for particular processes to others.

Outsourcing is not a new phenomenon. Companies have outsourced their advertising, for instance, for almost as long as advertising has been in existence (and J. Walter Thompson has been in business since the 1880s). Financial services such as factoring and leasing, the outsourcing respectively of the accounts receivable function and of capital funding, have also been available from outside providers for many years.

But it has grown exceptionally fast in recent years. According to one estimate, in 1946 only 20% of a typical American manufacturing company’s value-added in production and operations came from outside sources; 50 years later the proportion had tripled to 60%.

Much of the increase came from the outsourcing of IT functions. This was bolstered later by the outsourcing of other functions (such as logistics) that were in areas that themselves had a high degree of it content. Banks, for instance, began to outsource the IT-intensive processing of financial instruments such as loans or mortgage-backed securities. The savings from such moves could be dramatic. By deciding to outsource the origination, packaging and servicing of all its personal loans, both old and new, one British bank cut the average cost of processing by over 75%. In the car industry in the 1990s, firms with the biggest profit per car, such as Toyota, Honda and Chrysler, were also the biggest outsourcers (sourcing around 70% to various suppliers). Those that outsourced the least (General Motors, for example, which outsourced only 30% of its value-added) were the least profitable.

The nature of outsourcing contracts has changed over time. What started off as a straightforward arm’s-length agreement between a buyer and a supplier moved on to become structured more like a partnership agreement. In this, not only is any increase in the clients’ volume of business reflected in the outsourcer’s scale of charges, but both parties in some way share the risks and rewards of the outsourced activity.

Relationships like this vary over time and require firms to learn how to work together in entirely new ways. In the early 1990s, in a groundbreaking five-year outsourcing agreement with BP, Accenture (then called Andersen Consulting) took over responsibility for running the day-to-day operation of BP’s accounting systems. BP retained control of accounting policy and the interpretation of data for business decision-making. In return, Accenture guaranteed BP that it would reduce the cost of running the service by 20%.

Some firms have been so taken with the idea of outsourcing that they have left themselves with little to do. An American company called Monorail Computers outsourced the manufacture of its computers as well as the ordering, delivery and the accounts receivable. Only the design was left to be handled in-house.

Date: 2016-01-14; view: 1077