While outsourcing can deliver benefits, there is a hidden downside warns Robert Davies

Outsourcing is big business and expanding rapidly. The Economist Intelligence Unit notes that while some 34% of firms outsourced all or part of their IT in 1997, this is expected to rise to 58% in 2010. Consultants Gartner predict a similar scenario, forecasting a 60% increase in IT outsourcing during the period 2000 to 2005. Interestingly, it looks as if these forecasts may be an underestimate: India's business process outsourcing industry is growing at a rate of over 50% per annum.

Outsourcing is also highly profitable. Accenture's annual profits rose by 12% in 2002 supported by increased revenue flows from outsourcing.

It is true that outsourcing can deliver benefits to an organisation that are beyond its internal capabilities. Those most frequently cited include:

- increased focus upon the core business
- access to lower process costs
- the restructuring of internal business areas that have resisted change - although some will argue that this is primarily management's responsibility
- higher value adding and more flexible services
- access to world-class knowledge sources to enhance innovation
- the achievement of better cross process co-ordination.

Of these, by far the greatest attention is given to lowering costs. Research shows that most outsourcing initiatives are driven by financial considerations.

However, a number of recent surveys point to the fact that outsourcing may not be delivering. Research indicates that nearly 80% of managers who have outsourced an IT function have terminated the contract early.

And the American Management Association reveals that 75% of managers thought that outsourcing had failed to live up to their expectations. End customers do not seem to have much confidence in the outsourcing process either; in one survey, 81% felt that the financial benefits of outsourcing would not be passed onto the end customer. Others feel that outsourcing may be just another management fad or cure-all.

Clearly, there are major risks associated with outsourcing. Problematically though, those most frequently identified are in many cases assessed in conjunction with service providers, and focus on non-delivery of proposed benefits, contract negotiations, provider selection and the cost of exit.

However, there are deeper risks associated with the outsourcing decision, which can have long-term implications for the business. These may not be assessed at the outset - and still less once the decision has been taken. And businesses need to consider these potential downsides if they are to avoid lasting commercial disadvantage.

Such risks fall into two main areas: diminution of the organisation's strategic capability, resulting in strategic inflexibility, and the human resources dimension. It is unclear which of the two may have the greater potential impact on the future of the business.

Strategies for this century

Strategy is changing, and an appreciation of this should be at the heart of the outsourcing decision. Competing in the opening decades of the 21st century will be not be the same as it was in the 1990s.

First, as Professor Michael Porter of Harvard Business School predicts, the cost reduction train is about to hit the buffers. Throughout the 1990s we have had a preoccupation with cost reduction. It has been at the heart of many organisations' competitive strategies. But it is a train going nowhere. As all organisations gravitate to the same cost base, there is no unique source of competitive advantage left. Operating using efficient processes will be a fact of life. It will not be an approach that will successfully differentiate one competitor from another.

One of the defining characteristics of 21st century strategy will be a shift from costs and products to relationships as the prime focal point of strategy. In the 1980s, products were the primary focal point. Do we provide a commodity product? Do we offer a product with many add-ons?

Do we supply products to a broad or narrow customer segment? These were the questions that drove the shape of competitive strategy in the 1980s.

In the 1990s, we have had a preoccupation with business process re-engineering, downsizing and cost reduction.

However, a combination of freedom of information, open standards and the outsourcing of product development functions means just one thing: Product development lead times, the traditional bastion against new entrants, have been slashed. As PDA (personal digital assistant) market leader Palm found out, a new rival - Handspring - could make use of outsourced product developers and open standards to produce a rival product in a matter of months, not years. This example is becoming the norm. So, organisations are starting to turn to relationships, particularly with end customers, as new sources of enduring competitive advantage. This change in strategic focus will demand a new organisational competency set.

Now, with cost reduction downgraded, innovation is back at the front of the grid. To stay ahead managers must refocus on innovation, primarily in the relationship management dimension.

Finally, we have uncertainty. We thought that life in the 1990s' competitive arena was uncertain. Now, managers have to cope with both economic and global uncertainty, making it impossible to predict the exact trading environment one year out, let alone three or five. In response, organisations are making more use of scenario planning - multiple views of a future environment and a response strategy for each. This technique was pioneered by Shell and enabled it to move rapidly when the oil crisis of the 1970s unfolded.

Each of these aspects of competitive life must be factored into the outsourcing evaluation process.

Negative innovation

If innovation is recognised as key to developing strategic advantage, what are we to make of a decision that has a negative impact on a company's ability to innovate?

Many supporters of outsourcing hold that outsourcing can greatly enhance the innovative capability - and indeed, in the right setting, it can.

However, before setting off on the outsourcing route it is important to understand the innovation trail of your business and how outsourcing might affect it. The innovation trail is the path that starts from idea generation and ends with a successfully launched new product or service.

Many of the organisations that have increased their innovative capability through outsourcing have focused upon innovations where this trail does not start with the end customer. Technologically-based innovation to transform business processes is an example. There, the trail begins with technology suppliers. But in many organisations, particularly service industries, the innovation trail starts with the end customers - it is their comments and ideas that really kick-start and drive innovation.

Importantly, some organisations, recognising the key role of customer contact in the innovation process, are not using outsourcing but innovation partnering to leverage innovative capabilities. Innovation partners help the organisation collect, analyse and manipulate customer contact information to enhance product, relationship and service offerings. Elly Lilly's approach in this area - its Innocenter - has become so successful that it is now a self-contained subsidiary, offering mediated innovation services to a range of organisations. It is also interesting to note that one of the leaders in the outsourcing arena, Dell - frequently championed as the customer-focused business par excellence - has just announced that it is to bring home its overseas customer-facing call centre operations.

The important point is to understand where in your business the innovation trail starts. If you are in an industry where it begins with the customer, beware outsourcing customer contact activities - you just might cut yourself off from future winning ideas. If you are worried about the innovative capabilities of your organisation, think first about using innovation partners.

Strategic inflexibility

The danger of simply following an industry trend is also a risk with outsourcing. Take the insurance sector. If all competitors outsourced their call centres to the same outsourcer, the scope for differentiation would be greatly reduced. Insurers will have effectively excised their capacity to be different and driven themselves into a position where they are suppliers of pure commodity products. That is why organisations like Procter and Gamble are careful to insource the development of processes and products - to build competitive advantage, not competitive parity.

Many authorities see this issue of outsourcing the ability of an organisation to be different as one of the major downsides in the process.

It is also vital to remember that strategy - how organisations gain competitive advantage - will change. This means that the required competency set will change too. A supposed benefit of outsourcing is that it enables the business to focus on core skills and processes. But the problem is that outsourcing decisions are inherently long term, and in many cases businesses do not take into account the fact that tomorrow's competencies and processes will be fundamentally different from today's.

In an uncertain business environment the capacity to be strategically flexible should be an essential part of the outsourcing risk assessment process. The strategic risks associated with outsourcing any process or activity should not just be tested against today's competitive environment but against multiple views of tomorrow's possible environment. Unfortunately, research shows that the competitive environment is not yet at the forefront of managers' minds when the outsourcing decision is made. The most important criterion still appears to be the scope for cost reduction.

The HR dimension

Managers using performance measurement concepts such as the Balanced Scorecard know that people are the true performance-driving dimension and the ultimate drivers of corporate excellence.

For risk managers, assessing the HR risk is more than simply ensuring that critical employees are not outsourced. If strategy is changing, so is the employment contract - what employees expect and what motivates them. To be motivated, employees expect, in addition to economic rewards, fair treatment, a degree of security, rewarding relationships with fellow workers and, most importantly, the support of the organisation in developing a skill and experience set that will help them survive in an uncertain environment. If this contract is broken or threatened, neither promotions nor pay rises will repair the damage.

There is an important lesson to be drawn from analysis of the effects of corporate downsizing during the 1990s. At the time, this was almost universally seen as a corporate panacea or cure all. But again, it has had a mixed track record. Commonly reported post-downsizing problems are:

- decreased levels of employee motivation and commitment to the organisation
- decreased levels of work effort on the part of surviving employees
- working atmospheres or cultures characterised by low levels of trust and high levels of insecurity
- the appearance of the 'survivor sickness syndrome', whose symptoms include decreased creativity, increased fatigue and extreme risk aversion.

Most worrying of all is the loss of the experience that really made the organisation different.

The effect of the outsourcing decision upon the motivation and retention of employees is now a central risk factor. Remember that employees across the organisation generally react to an outsourcing announcement by thinking that management underestimates their skills and contribution. To successfully manage the HR dimension the organisation must:

- identify and retain employees with the skills and knowledge that provide the organisation with the flexibility to excel in an uncertain environment. This requires the delivery of a clear vision of how retained staff will contribute to the organisation's success in the long-term
- retain a cadre of employees with a deep, firm specific knowledge of the outsourced processes, both to effectively manage the bridge between the organisation/outsourcer and, if all else fails, to manage the backsourcing process
- deliver an enhanced employment contract to outsourced employees. The treatment of outsourced employees is a powerful signal to core retained staff. It is important that they see their former colleagues receiving better opportunities and support than they had received in the past.

Negative environmental response

Finally, we have the unknown impact of what can be termed a negative environmental response to outsourcing. Just how far is outsourcing an acceptable management practice? The jury is out, but currently the threat of a backlash is high on the strategic agendas of overseas outsourcers.

Companies proposing an outsourcing solution should assess their core customers' reaction very carefully.

Benefit and risk assessment

A total reversal in our approach to benefit and risk assessment is needed if businesses are to gain real long-term gains from outsourcing.

The first thing that risk managers must change is the motivation to outsource.

We need a different motivational hierarchy behind outsourcing, which matches more clearly the strategic demands of the opening decades of this century.

In line with changing the motivations, businesses require a shift in their approach to risk assessment. The current risk headings are generally seen as:

- risk of dependence upon a single supplier
- financial failure of the supplier
- failure of the supplier to reach agreed service levels or deliver benefits on time
- failure to deliver cost savings
- failure to manage suppliers
- unrealistic benefit assumptions
- failure to negotiate an acceptable contract.

These are important, but in many ways mechanical, criteria. A more strategically relevant hierarchy for risk assessment is:

1. the future strategic responsiveness of the business
2. people
3. innovation impact
4. supplier dependency
5. supplier delivery continuity
6. environmental response risk.

Risk assessment must be tied very closely to the demands of tomorrow's business scenarios. Development of strategy is an issue that is organisation-specific, as the risk assessment process should be. We must fundamentally redefine the risks posed to an organisation by the outsourcing process.

Dr Robert Davies is managing director of Imhotep Consultants and senior visiting research fellow at City University Business School, Tel: 01895 623252; e-mail: mail@imhotep.com


Outsourcing does work and can help an organisation excel, but the decision needs to involve more than just costs. Too often, outsourcing decisions are driven by the prospect of short-term cost reduction. This approach must be challenged. Consider the following guidelines.

- If you are worried about costs, fundamentally review existing processes and buying arrangements. McKinsey has calculated that most organisations can deliver substantial process cost savings by conducting a ground up review of processes and purchasing practices. Up to a 30% gain in direct labour productivity, lower material costs and reductions in establishment costs may be achievable.

- Before the outsourcing question is considered, develop multiple scenarios of the competitive environment that the business might face over the next ten years.

- Understand where your business's innovation trail starts. Measure carefully the impact upon future innovation capability if you outsource customer contact processes. If you are worried about your organisation's innovative capability, consider innovation partnering as well as outsourcing.

- Analyse how your organisation's sources of competitive advantage may change in the 21st century. What might be core today may well not be core tomorrow.

The primary drivers of the outsourcing decision must at all times be the enhancement of your organisation's strategic flexibility and its supporting competencies. Cost saving come second.