PMO Basics: The Downward Spiral Of Cost Based Outsourcing

Business is changing. Look at the number of books published about the economy’s move from atoms to electrons. Don Tapscott’s wrote an excellent example, “Wikinomics: How Mass Collaboration Changes Everything.” The title says it all. The Internet has connected everything to everything. That “connectedness” has transformed outsourcing from a niche solution to something that touches every function in the corporation. Now add the unprecedented string of economic disasters… the collapse of the tech bubble, 9/11, the end of cheap oil, the collapse of the real estate bubble, and the global financial collapse… and outsourcing is suddenly everywhere. Not surprisingly, the increasing pressure to deliver savings has changed the direction of outsourcing from long-term productivity to short-term cost savings. Stripped down outsourcing has delivered savings, but it’s running out of gas and mature programs are becoming more of a drag on corporate performance than a benefit. Is the transformation of outsourcing into “Dumbsourcing” a threat to corporate profitability? Today’s blog will walk you through the issues and explain the hidden risks and costs of dumbsourcing.

Dumbsourcing doesn’t mean that you made a dumb decision to focus purely on cost. In the middle of a financial crisis you have limited options. Before the decade of crises, outsourcing programs had time to identify core and non-core functions, time to understand the benefits and risks of outsourcing location, and time to develop a program that leveraged outsourcing to move business objectives forward. Dumbsourcing delivers cost reductions, but over-reliance on the lowest-cost  option created long-term risks. When a cost focused contract is renewed, even an aggressive renegotiation may not deliver new cost savings. Many outsourcing programs are in their 3rd generation, and are feeling pressure from rising labor rates and offshore inflation. Recent government talk of penalizing offshoring may further diminish the value of cost focused programs.

It takes years to accrue and analyze enough data to understand what works and what doesn’t. One study that examines the results of cost focused outsourcing is, “The Outsourcing Productivity Paradox: Total Outsourcing, Organizational Innovation, And Long Run Productivity Growth.” This study analyzes the rise of IT outsourcing from $3 billion to $250 billion, between 1989 and 2006. The primary conclusion is that cost focused outsourcing ultimately damages corporate productivity. The Productivity Paradox is that focusing on cost alone and ” undertaking to deliver a pre-specified set of services to the client for a set price and quality…  [delivers a] short-term cut in the wage bill…  [but can] have a negative impact on long run productivity.”  Alternatively, programs that focus on integrating outsourcing (working as a partner and not just as a service provider) along with a real focus on innovation deliver higher productivity. Let’s take a deeper dive into a typical cost focused outsourcing program to understand how it undermines productivity.

  1. Contract Price: When a work process moves outside your firm, the fundamental mechanics of talent acquisition fundamentally changes. When your HR department looks for new workers they pay the market wage or higher to get the best talent. When your Procurement department negotiates a service contract they pay the market rate or lower. Procurement departments often negotiate a “most-favored nation” agreement, guaranteeing that if any other account receives a lower rate, your rate is also reduced. By itself this clause does not define your program, but together these contract conditions will define how successful your program can be. Let’s move on.
  2. Innovation Budget: Everything has a cost, including innovation. Does your firm have an R&D budget? Does the training department provide courses to develop innovation?  Does your firm hire consultants and experts to identify and support innovation? Firms that don’t budget for innovation, probably (but not always) end up with less innovation. Your outsourcing contract may require line items for facilities, staff costs, telecommunications, but no contract that I’ve seen in the past 5 years explicitly budgeted for innovation. But in the late 90’s contracts regularly offered innovation incentives. Such as…
  3. Performance Bonuses: During contract negotiations the client usually asks for penalties, if performance falls below service levels. Fair enough. The vendor usually counters with a request for a bonus when they exceed service levels. Dumbsourcing always rejects bonuses (”Why would I pay for higher quality than I contracted for?”) If we slightly change the wording, the vendor asked you if will reward them for delivering higher productivity (faster turnaround, higher quality, reduced labor, fewer errors, etc.).  Alternatively, when this service was internal, workers who performed above the standard were promoted, bonused and generally recognized for superior performance.
  4. Program Management: In many “total outsourcing” programs, one (or a few) individuals remain on the client side. These individuals either become contract managers or perform similar functions. If you have these positions, look at the job description. Does this position have authority beyond managing conformance to service levels? In dumbsourcing, they have no authority to authorize vendor innovations. In fact, making any changes to the program may require unanimous agreement between the business group, Procurement,  Legal, IT, Corporate Security, Compliance and other groups. Far more authorizations than when the function was internal. Typically, innovation will not thrive when you increase the required number of authorizers.
  5. Program Scale: Dumbsourcing is  opportunistic, leading to the creation of program fragments, rather than a single well thought out function. For example, outsourcing just a copy center or a document production function is not a coherent program. “Documents” start in the heads of workers, are edited by these workers plus secretaries and other workers, stored on IT servers, printed on copiers (Procurement, Facilities?), managed in a document repository (IT?) and archived in some external location. A whole program benefits from economies of scale. Program fragments have few benefits of scale, even when they are outsourced to the same vendor, even when as a group they account for many workers. Economies of scale follow concrete economic rules (see “A Tale Of Efficiency… Why Bigger Is Better“). Imagine a heavy sleigh that requires two 1,500 lb draft horse to pull it. You could substitute sleigh dogs for horses but smaller animals  have less pulling power. It takes 6,000 lbs of dogs to provide the same pulling power. That means managing a team of over 100 dogs! THATS why economies of scale are important!
  6. Knowledge Sharing: When innovation occurs, will it take root? I once managed a document center in an investment  bank. We developed tools to automate document editing. Bankers saw how efficient these tools were and asked for them, which we provided. When I managed a vendor’s document center, the team was not permitted to discuss tools or program improvements with clients. I demonstrated these tools to various client managers, but no one on the client side felt they had the authority to pursue issues outside of the contract, and innovation discussions ended. The client also developed innovations, including a directory which could have helped us to update clients on their work, but it requires an employee ID to use; while the client managers agreed it would improve productivity, again no one had authority to move the issue forward. Cost focused outsourcing creates fractures, which prevent processes from fully integrating and innovation from spreading, reducing performance across the firm.
  7. Corporate Fractures:  According to The Productivity Paradox, these fractures present a hidden danger. Just like a bone fracture, a corporate fracture creates weak points that can break under pressure. Cost based outsourcing creates many opportunities for fractures throughout your firm.  When the volume of business rises or there’s a change in business direction or there are additional cost pressures… these fractures can break up and disrupt business. These fractures are where outsourcing programs lose productivity and decrease their value.

Innovation is a primary driver of value creation in corporations. For more than a decade an increasingly challenging economic environment as pressured corporations to give more weight to cost savings than innovation when developing an outsourcing program. The focus on cost cutting can deliver short-term savings, but by the time you renew your contract your program may have run out of benefits. When outsourcing does not allow for innovation, is not a true partnership between the client and vendor, and is not integrated into the function of the firm “corporate fractures” appear that diminish the benefits of the program and eventually rob your firm of  productivity. There’s a long list of reasons why cost focused outsourcing damages productivity, but that doesn’t mean that it’s too late to turn around your program.  Today we defined a “dumbsourced” program; in our next blog we’ll review how your outsourcing program can be converted into full-featured smartsourcing. But that’s my Niccolls worth for today!

This entry was posted in Best Practices, Common Sense Contracting, Decision Making, Improvement, Continuous or Not and tagged , , , , , . Bookmark the permalink.

1 Response to PMO Basics: The Downward Spiral Of Cost Based Outsourcing

  1. Pingback: PMO Genius: 8 Lessons Learned For Outsourcing | Niccolls AND Dimes

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