1. © Cengage Learning – Purchasing & Supply Chain Management 4 ed (1-84480-024-5) Planning 7. Outsourcing and risk management

2. © Cengage Learning – Purchasing & Supply Chain Management 4 ed (1-84480-024-5) Program Outsourcing as a business concept Definitions Rationales for outsourcing Success of outsourcing as a business strategy The outsourcing process Risk assessment Critical success factors of outsourcing

3. © Cengage Learning – Purchasing & Supply Chain Management 4 ed (1-84480-024-5) Outsourcing as a business concept Organizations turn to outsourcing to enhance their competitiveness Drivers behind outsourcing are:  Changes in the business environment  New management concepts (e.g. BPR)  Organizational restructuring  Benchmarking  Alliance management  Lean management The Outsourcing Institute reports that outsourcing in the USA has grown dramatically from 1996 onwards. Outsourcing expenditures in 2000 were around $340 billion and were expected to grow 15% annually. Also in Europe and Asia the market for outsourcing is expected to grow double digits (Corbett, 2002)

4. © Cengage Learning – Purchasing & Supply Chain Management 4 ed (1-84480-024-5) Outsourcing as a business concept The types of activities that are outsourced have evolved over time. Starting out with activities, more and more entire business functions are being outsourced. Transportation 5% Real estate10% ICT20% Manufacturing 7% Marketing and Sales 6% HRM 9% Distribution & Logistics10% Finance 7% Management 4% Customer services 7% Administration15% Source: The Outsourcing Institute, Dun & Bradstreet, 2000

5. © Cengage Learning – Purchasing & Supply Chain Management 4 ed (1-84480-024-5) Definitions Outsourcing is the transfer of activities, that were previously conducted in-house, to a third party Outsourcing means that the company divests itself of the resources to fullfil a particular activity to another company to focus more effectively on its own competence (NEVI, 2000) Outsourcing is the decision and subsequent transfer process by which activities that constitute a function, that earlier have been carried out within the company, are instead purchased from an external supplier (Axelsson and Wynstra, 2002)

6. © Cengage Learning – Purchasing & Supply Chain Management 4 ed (1-84480-024-5) Definitions Major characteristics of outsourcing are… 1. that activities that initially were performed in-house are transferred to an external party 2. that assets and people go over to that external party 3. that there will be an extended relationship between the parties involved over a longer period of time 4. that in transferring the activity to the external party the buyer is exposed to both a cost- and risk profile, both of which are new to the companies involved

7. © Cengage Learning – Purchasing & Supply Chain Management 4 ed (1-84480-024-5) Definitions Two different types of outsourcing: Turnkey (integral) outsourcing: responsibility for the execution and the coordination of the entire function (or activities) lies with the external supplier. Partial outsourcing: Only a part of an integrated function is outsourced. The coordination of the function still lies with the outsourcer.

8. © Cengage Learning – Purchasing & Supply Chain Management 4 ed (1-84480-024-5) Definitions AdvantagesDisadvantages Turnkey outsourcing Buyer has minimal responsibility for outsourced processes Buyer doesn’t need to have experience with similar projects The project generally goes smooth for the buyer The buyer has limited influence on the determination of the price and little insight in cost structure of provider Buyer has limited influence on the staff, technology and materials used and their quality Large dependence of buyer on provider resulting in high commercial, technical and performance risks Partial outsourcing The buyer has more influence on prices, rates and costs The buyer has more influence on the staff, technology and materials used and their quality Specific advantages can result in cost reductions Buyer is required to have knowledge of the seperate parts of the outsourced function/ activities The buyer is required to have the organizational capabilities to coordinate and integrate the outsourced function / activities Communication and coordination problems between parties involved can be a cause of delay and disappointment Partial versus turnkey outsourcing

9. © Cengage Learning – Purchasing & Supply Chain Management 4 ed (1-84480-024-5) Definitions Decision to outsource Transfer of the function and/or activities to an external supplier Transfer of the function and/or activities to an external supplier Outsourcing Outsourcing consists of two important dimensions

10. © Cengage Learning – Purchasing & Supply Chain Management 4 ed (1-84480-024-5) Rationales for outsourcing Strategic reasons for outsourcing 1. Improve company focus 2. Gain access to world class capabilities 3. Get access to resources that are not available internally 4. Accelerate reengineering benefits 5. Improve customer satisfaction 6. Increase flexibility 7. Sharing risks Tactical reasons for outsourcing 1. Reduce control costs and operating costs 2. Free up internal resources 3. Receive an important cash infusion 4. Improve performance 5. Ability to manage functions that are out of control All these reasons underlie one overall objective: to improve the overall performance of the outsourcing firm

11. © Cengage Learning – Purchasing & Supply Chain Management 4 ed (1-84480-024-5) Rationales for outsourcing AdvantagesDisadvantages Freeing up of cash: investments can be concentated on core activities Increased dependence on suppliers Optimal usage of knowledge, equipment and experience of third party Continuous follow-up and monitoring of the supplier relationship necessary Increased flexibility: fluctuations in the workload can more easily be absorbed Risks of communication and organizational problems during the transfer of activities to a third party Outsourcing leads to easier and more focussed primary processes in the organization Risks of leakage of confidential information Input through an independent party’s point of view which reduces the risks of introvert short- sightedness in the organization Performance incentives and penalties Risk of losing essential strategic knowledge Advantages and disadvantages of outsourcing

12. © Cengage Learning – Purchasing & Supply Chain Management 4 ed (1-84480-024-5) Success of outsourcing as a business strategy Determining the success of outsourcing is very difficult  External factors in the before and after situation may have changed  Often impossible to determine the costs of the function before it was outsourced  Outsourcing is often poorly evaluated to data is just not available The success of outsourcing as reported by various reports varies enormously. However, most reports conclude that outsourcing projects in more than half of the cases do not seem to produce the results that were expected from them.

13. © Cengage Learning – Purchasing & Supply Chain Management 4 ed (1-84480-024-5) The outsourcing process Competence analysis Assessment & approval Contract negotiation Project execution & transfer Managing relationship Contract termination Strategic phaseTransition phaseOperational phase Adapted from Momme, 2002

14. © Cengage Learning – Purchasing & Supply Chain Management 4 ed (1-84480-024-5) The Strategic phase  What is the motive to outsource? Focus on core competence? Focus on efficiency / effectiveness? Focus on service?  What activities are candidates for outsourcing? Transaction cost approach (Williamson, 1983; Arnold, 2000) Core competence approach (Quinn and Himler, 1994)  What qualifications should a supplier require? Supplier selection process (Momme, 2002; Wynstra, 2002) Monitoring practices in supplier partnership Three main questions in the Strategic phase

15. © Cengage Learning – Purchasing & Supply Chain Management 4 ed (1-84480-024-5) The Transition phase Lump-sum turnkey Contract is based upon a fixed price (per period) for executing the project or a certain activity Reimbursable turn-key The provider is compensated for all costs that he incurs for executing the project or a certain activity Semi lumpsum turn-key Part of the work is compensated on a fixed price basis; the other part is compensated on a reimbursable basis Lumpsum fixed price The supplier agrees to complete the work against a fixed price based upon a predefined, detailed scope of work. Everything that is not included in the scope of work is settled between parties on an ad-hoc basis Cost reimbursable The supplier agrees to complete the work on open book, open cost basis based upon a general scope of work. There is no sharing of savings Guaranteed maximum contract The same as a cost reimbursable contract, only the outsourcer pays to a certain agreed maximum. The extra costs are for the supplier Share the savings / loss (target price contract) The services are paid for on a reimbursable basis. When the contract costs are higher or lower than the original budget (target price), the difference is shared between parties on a pre-agreed basis Unit rate Rates are agreed for regular, routine activities, the size of which cannot be anticipated. Rates are defined per m2 of paint, meter of cable to be installed, etc. Payments are made based upon actual use. Different outsourcing contracts

16. © Cengage Learning – Purchasing & Supply Chain Management 4 ed (1-84480-024-5) The Transition phase The type of contract is just one of many issues to be discussed. Other ‘ingredients’ in an outsourcing agreement are:  Scope of services  Term of agreement  Service level agreement (SLA)  Rates, fees, incentives, penalties  Termination plan  Conflict resolution  Communication  Management and control  Other (e.g. warranty, confidentiality, audit rights, etc.)

17. © Cengage Learning – Purchasing & Supply Chain Management 4 ed (1-84480-024-5) The Transition phase Outsourcing transition can be very complex The transfer should be conducted using project management principles  Assignment of a dedicated project manager by  Sound transition plan  Project timeline with milestones Test phase before going ‘life’ Outsourcer should provide training and support to provider if necessary

18. © Cengage Learning – Purchasing & Supply Chain Management 4 ed (1-84480-024-5) The Operational phase It is in the operational phase that the outsourcing will deliver its expected results Successful outsourcing depends heavily on close cooperation with the supplier McQuiston (2000) identifies six core values as being critical to a successful outsourcing relationship Core valuesSupporting factors Shared goals and objectives Mutual dependence Open lines for communication Concern for the other’s profitability Mutual commitment to customer satisfaction Trust Developing a personal relationship Having professional respect Investment of effort by top management Commitment to continuous improvement McQuiston (2000)

19. © Cengage Learning – Purchasing & Supply Chain Management 4 ed (1-84480-024-5) The operational phase – Risk assessment In cases where trust and interpersonal relationships are not present, parties try to arrange for dealing with these risks and uncertainties by detailed outsourcing contracts These contracts are associated with the following kinds of risks:  Technical risks: related to the extent to which the supplier is able to provide the desired functionality and performance  Commercial risk: related to the uncertainty with regard to the price we will pay and the costs that we will incur when having outsourced our activities to the supplier  Contractual risks: e.g. does the contract in sufficient detail describe the performance that is expected from the supplier?  Performance risks: related to the chance that the supplier is not capable of doing the job he was hired for. Many authors have pointed out that in dealing with these risks, detailed contracts will not solve the problem. Trust and partnership are more important.

20. © Cengage Learning – Purchasing & Supply Chain Management 4 ed (1-84480-024-5) Critical success factors of outsourcing The Outsourcing Institute and others considers the following factors as critical for success in outsourcing:  Understanding company goals and objectives  A strategic vision and plan  Selecting the right vendor  A properly structured contract  Open communication with the individual groups involved  Ongoing management of the relationship  Senior executive support and involvement  Careful attention to personnel issues  The way the company is strategically positioned vis-à-vis its supplier. Can it still exert some control over its supplier, or not?