Knowledge@Australian School of Business Strategic Management Research Article

Knowledge@Australian School of Business

When outsourcing hits the headlines, the story is usually about a struggling company slashing staff in a bid to stay afloat. The traditional economic view of outsourcing – where a company contracts a business function to someone else – is not so different, albeit couched in less emotive language. But an alternative view of outsourcing is emerging.

Research by Dr Sasan Bakhtiari, an economics lecturer at the Australian School of Business, suggests cost is only one reason for outsourcing. Companies that try to save money by hiving off important parts of the production chain may be left vulnerable to poor-quality outcomes, he warns.

The news is more encouraging, however, for companies that approach outsourcing as an opportunity – a means to improve their outputs by tapping into skills, expertise and technology that they lack in-house.

Bakhtiari analysed Australian Business Longitudinal Survey data on the profitability and operations of manufacturing firms to build a picture of local outsourcing. The study found that the least productive firms and those with the highest costs were the most likely to contract out – and these are the businesses that harvest the highest efficiency gains from outsourcing. "Relatively efficient firms seem to contract out for other reasons, such as penetrating export markets and focusing on innovation," Bakhtiari writes in the paper Efficiency and Outsourcing: Evidence from Australian Manufacturing.

Typical functions that are outsourced among manufacturers are maintenance, janitorial services, catering and transportation jobs, all of which have to be done locally.

While Australian firms outsource less to other countries than their foreign counterparts, the local economy is nonetheless part of the global trend towards increased outsourcing. For example, the Asia Pacific business process outsourcing industry is comprised of a large number of organisations across diverse operational services from animation to payroll processing and has an estimated value of over $6.4 billion per annum within Australia. The Australian BPO Report 2012, published by IBM and The Sauce, estimated that between 45% and 65% of Australian organisations engage in some form of business process outsourcing.

The trend has given rise to a new type of company where the traditional boundaries that define a firm are becoming increasingly blurred, with more and more functions being subcontracted to outsiders. Independent contractors now make up about 10% of the total Australian workforce.

Bakhtiari illustrates the difference in attitudes and results from outsourcing with the example of a notional manufacturer, which makes its products using processes A, B and C. "You have processes A, B, C and together they produce the output," he says. "So you start looking for someone who can do A very well. So I just get rid of A and allow them to supply me with that. So then I have a good A, and I was already doing a good B and C, so my product improves." Alternatively, the manufacturer may opt to outsource B with the intention of saving money. "But if B was what I was actually good at, and I got rid of that, I would actually reduce the quality of my product," highlights Bakhtiari.

While cost is still the primary motivator for outsourcing, more and more firms are also outsourcing to improve business outcomes. There's a growing trend for firms to use outsourcing to access skills and quality they cannot deliver internally. Clients are looking to their suppliers to provide innovation and quality improvement, rather than just the lowest cost.

Driving Competition

The trend is evident in the outsourcing of information technology, says Hamish Barney, a PhD student at the University of New South Wales who is researching IT outsourcing. "Usually the initial impetus [for outsourcing] is cost, but they often see the advantages later on of quality and access to resources that they would otherwise be hard-pressed to employ on their own," he says.

Companies are becoming more sophisticated in their use of external providers, using several providers rather than outsourcing the entire IT function to a single provider. "That has a couple of advantages. It means you can select the outsourcer with the best resources and skills and the most experience in that particular area," says Barney. "But also what they find is they can create competition and they can drive better deals so they can compare between the outsourcers much more easily."

When weighing up whether to contract out a function, firms are increasingly taking account of the benefits beyond lowering costs, according to David Champeaux, principal at management consultancy McKinsey & Company in Sydney. A firm might, for instance, make 50% of the business case around cost savings and productivity gains, and 35% of the business case around higher flexibility or better business outcomes, such as decreasing time to market or increasing customer satisfaction.

"We are definitely seeing the impact of business outcomes being factored into the equation much more prominently," says Champeaux. "Companies are actually saying ‘if I'm outsourcing not only for cost but also for access to skills and flexibility and capability, I'm getting a cost benefit and a business outcome benefit and I'm factoring that in'. They have a more sophisticated appreciation of the business case by factoring in the total cost, including something they ignored like hidden costs and netting off the negative impact on business outcomes against the productivity and cost gains."

But firms continue to underestimate the cost of managing the outsourcing vendor and the contract. The firm outsourcing the work has to retain some expertise in the outsourced function so its staff can ensure the contract is being adhered to and required services are being delivered.

According to a Deloitte study, the in-house cost of managing a large and complex outsourcing contract is about 15% to 20% of the total contract value. "Larger complex contracts, particularly if they involve technology, can involve quite a lot of work from the company doing the outsourcing," says Donal Graham, a Sydney-based partner at Deloitte who leads the firm's shared services practice.

Outsourcing is also no panacea for inefficiency. Companies need to be clear on why they're outsourcing, their objectives and exactly what they're outsourcing. Rather than expecting that outsourcing an inefficient process will fix a problem, companies first need to understand why they're inefficient, otherwise outsourcing could end up costing rather than saving money. "If you outsource a mess, it's going to take a while to sort that mess out," says Graham. "If you've got a highly inefficient company I'm not saying you shouldn't outsource, but I would certainly examine very carefully whether you shouldn't be trying to sort out a lot of the current inefficiencies before you outsource."

On the Inside

Graham says companies need to be very clear about what they're outsourcing and to have this stated in their contract with the service provider. "If you don't understand it you're putting yourself in a position of some weakness if you're going to enter into that arrangement without a deep understanding of what you currently have and what you hope to achieve and what improvements might be achieved."

While it is important to have a legal contract and an established governance system to resolve disputes between the outsourcers and the provider, Graham says it works best when the pair communicate and cooperate well and work with a good spirit of partnership.

After cost reductions and improved business outcomes, a third reason for companies to outsource is for scalability and flexibility of operations. Using outside providers can help a company through the difficult transition phase where they move from being a small enterprise to a large one, Bakhtiari argues in another recent paper, Size Evolution and Outsourcing: Theory and Evidence from Australian Manufacturing.

When companies grow quickly they are forced to take on extra layers of management, but might not yet be profitable enough to justify the additional managers or their cost. For some firms, the best solution is to outsource some non-core functions so they can do away with multiple layers of management and concentrate on their core business instead, says Bakhtiari. "Firms growing beyond some threshold in size have to use a more complex managerial structure in order to operate without loss of efficiency," he writes. "The additional overhead cost that stems from this management overhaul can be absorbed by the most efficient firms, whereas firms finding themselves operating close to the threshold outsource service tasks in order to keep their size small and their overhead costs low, while their manufacturing operates at the scale of a large business."

Bakhtiari's analysis of the Australian Business Longitudinal Survey reveals a paradox in the use of outsourcing – that some manufacturers actually shrink the size of the company in order to produce more. These tend to be the firms not efficient enough to absorb the loss of efficiency that comes with adding extra layers of management. These firms grow by expanding their networks of suppliers and contractors rather than physically hiring. "The firm is compelled to roll back its size to just below the transition point and outsource the difference in employment," he writes. "This way, the business keeps its scale of operation at the level of a large business, but internally operates at the level of a small business, hence, saves costs."

McKinsey's Champeaux says companies often want the option of having some reserve sourcing from outsourcers, particularly if they are not confident about how long their growth phase will last. "In cases where they didn't need complete visibility and didn't want to incur the internal fixed cost base of scaling up their operation they will say, ‘I want to have the flexibility to scale up faster, but I don't want to be tied into a big cost base internally because I don't have complete certainty'," he says.