Harvard Business School Working Knowledg e Archive

How to Think Strategically About Outsourcing

7/22/2002
Outsourcing isn't just a way to unload noncore costs. The real play with outsourcing is to use it as a tool to drive strategic value, transform businesses, and even fundamentally change industry dynamics. The key: Forget what you think you know about outsourcing.


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Outsourcing used to be viewed as little more than a ho-hum tactic for reducing the costs of back-room functions such as payroll and IT. It didn't have much pizzazz and was never confused with a breakthrough management idea. But things started to change in the early '90s, as companies began outsourcing more strategically significant functions such as manufacturing and logistics, and even product design and other innovation-related activities. All of a sudden, outsourcing had morphed into a critical management tool.

Then came the inevitable backlash. Outsourcing, so simple in theory, was turning out to be pretty tough to execute well. It wasn't living up to its promise—companies were outsourcing the wrong things for the wrong reasons and going about it the wrong way. Indeed, a recent study by Cap Gemini Ernst & Young shows that only 54 percent of companies are satisfied with outsourcing, down from more than 80 percent a decade ago.

Even so, now's not the time to give outsourcing the bum's rush. Its status as a strategic management tool remains secure, even if its evolution to this point has been far from smooth. But to get real strategic value from your third-party relationships, you often have to throw out much of what you thought you knew—for example, that shibboleth about always maintaining control of customer touchpoints. Some of the biggest success stories out there are turning this old saw on its head. UPS Supply Chain Solutions (Atlanta) handles everything from order taking to delivery to customer service for its clients.

Outsourcing can free managers to focus on more strategic, higher-value activities, but only if they discipline themselves to use the freed-up time appropriately. Ed Frey, a vice president at Booz Allen Hamilton, says he's seen clients take the outsourcing approach and then fail to reap its benefits because they micromanaged their outsourcing partners. To get the most out of outsourcing, companies need to think "longer-term, about moves with enterprise-level outcomes like improved ROI or greater shareholder returns," explains Jane Linder, senior research fellow and associate director of Accenture's Institute for Strategic Change in Cambridge, Massachusetts. "Usually this means outsourcing with a focus on external results—like repositioning yourself in the marketplace or changing your value proposition to customers in some key way, versus using outsourcing to save 5 percent on the cost of an internal administrative process."

The real play with outsourcing, in other words, is to use it as a tool to drive strategic value, transform businesses, and even fundamentally change industry dynamics. Here's how.

Take costs out, put value in
As outsourcing continues to move beyond back-room functions into more strategic areas of the business, the standard bidding process is losing favor: More and more companies are realizing that their best partner is the one that offers them the greatest value, not necessarily the lowest cost.

Some forward-thinking executives are beginning to use outsourcing as a change-management tool to drive major, enterprise-level transformation.
— Martha Craumer

In the high-tech industry, original equipment manufacturers (OEMs) like Cisco, IBM, Nortel, Palm, and Compaq have outsourced manufacturing to specialists like Solectron and Celestica. These contract manufacturers have expanded their services to include shipping, repairs, and even product design. To this end, many are buying up engineering firms. By offering design services, the contract manufacturers hope to help craft products in a more standardized way to cuts costs and reduce the risk of component shortages, which can hurt a Cisco or a Compaq—especially when it has a hit product on its hands.

UPS Supply Chain Solutions adds value by acting as a consultant to its clients, often drawing on its expertise from one industry and applying it to another. Dan DiMaggio, the company's president, tells how UPS Supply Chain Solutions helped Fender Guitar rethink its decentralized, country-by-country distribution model in Europe: "We brought them what we considered to be some of the best practices in the high-tech industry." Now, instead of keeping stacks of inventory in each country, along with localized quality assurance and other value-added services, Fender uses a centralized, pan-European system that cuts inventory, warehousing, and transportation costs. UPS Supply Chain Solutions also provides value-added services like inspecting and tuning guitars in the warehouse, so that store owners get ready-to-sell products upon delivery. This adds speed and quality to the value equation—and gives Fender a competitive edge.

A catalyst for change
"Companies aren't very good at change," says Linder. "Whether it's changing their business model or implementing innovations or reengineering, it's hard work and people don't get everything they expect."

Some forward-thinking executives are beginning to use outsourcing as a change-management tool to drive major, enterprise-level transformation, such as a shift in competitive position or a major increase in market share or stock price. Transformational outsourcing can work because it goes outside for the critical missing piece, drawing on the expertise of a partner who can hit the ground running.

Where outsourcing works is where it gets at some  major source of waste.
— Ed Frey,
Booz Allen Hamilton

Linder cites the example of a troubled Spanish bank that offered only mortgages. Realizing that the company would go under if it didn't transform itself, the CEO converted the bank from a small mortgage operation into a full-service bank with a big data center and branches in all the major metropolitan areas of Spain—and in just a year's time. How? By outsourcing all information technology development and implementation. The bank contracted with third parties to manage the data center and product development, and used consultants to help open branches and hire and train staff. As a result, the bank was able to stem its losses, achieve breakeven operations, and attract a buyer.

Transformational outsourcing is often faster and more effective for organizations than other major change initiatives, such as reengineering or acquisitions. Explains Linder: "Companies have tended to use mergers and acquisitions to get themselves into new industries and change the boundaries of what they were doing. That's a very blunt instrument—and hard to do right. With outsourcing, you get a finer point on your pencil."

Can outsourcing improve industry dynamics?
Frey believes that outsourcing has the potential to do away with the boom-and-bust cycles that many industries experience on an ongoing basis. Case in point: the recent high-tech meltdown—Frey contends that it was self-induced.

In times of strong or growing demand, he explains, OEMs like Cisco and IBM add cushions to the capacity forecasts they give to their contract manufacturers—think of it as a form of surge protection. For the same reason, their manufacturers add cushions to their own forecasts for needed components, so they don't get caught short. The result is speculative ordering on both ends of the value chain. This cushioning is completely independent of true demand; it wouldn't exist in a vertically integrated model, where manufacturing is done in-house and changing a forecast can be as simple as walking down the hall.

Outsourcing adds an extra layer to the supply chain, and that typically means one more safety cushion. These cushions didn't create the industry recession in and of themselves, but they heightened its severity. That's not to say that outsourcing is a bad thing—far from it. A company like Cisco probably couldn't have grown as big as it did as fast as it did with a vertically integrated model. Outsourcing allowed the company to use everyone else's manufacturing capacity instead of having to build its own plants.

Nevertheless, the high-tech supply chain could be vastly improved, says Frey: "I really believe that where outsourcing works is where it gets at some major source of waste, and the easiest one to find is risk—or the things you do to manage risk." That's why there's so much potential outsourcing value in the high-tech supply chain.

The solution, says Frey, is the strategic management of four levers: forecast, capacity, product design, and the relationship between the different parts of the value chain (who controls what). By learning how to adjust these settings to minimize and manage the inherent risks, companies can avoid the wasteful safety cushions that so often result.

Take product design, for example. The risks around component availability could be sharply cut by standardizing low-value components. "Do we really need ten or fifteen different kinds of CD-drive motors?" asks Frey. If the industry agreed on a smaller number of standardized components, the risk related to parts shortages would shrink dramatically.

Getting more value out of the high-tech supply chain comes down to "pooling component risk, pooling capacity risk, and standardizing the non-value- or low-value-added components of any product that comes out," Frey continues. And outsourcing is an integral part of that process.

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Excerpted with permission from "How to Think Strategically About Outsourcing," Harvard Management Update, Vol. 7, No. 5, May 2002.

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Martha Craumer is a business and marketing writer who lives in Cambridge, Massachusetts.

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Deciding What to Outsource

In theory, outsourcing is a no-brainer. Companies can unload noncore activities, shed balance sheet assets, and boost their return on capital by using third-party service providers.

But in reality, things are more complicated. "It's really hard to figure out what's core and what's noncore today," says Jane Linder, senior research fellow and associate director of Accenture's Institute for Strategic Change in Cambridge, Massachusetts. "When you take another look tomorrow, things may have changed. On September 9, airport security workers were noncore; on September 12, they were core to the federal government's ability to provide security to the nation. It happens every day in companies as well."

In some cases, companies leave themselves vulnerable to a market coup by former partners when they outsource. Such was the case with the German consumer electronics company Blaupunkt, notes Ed Frey, a vice president at Booz Allen Hamilton. To beef up the product line it offered to its dealers, Blaupunkt decided to add VCRs and contracted the work out to Panasonic (once a lowly circuit-board stuffer). Later, with the Blaupunkt reputation attached to its products, Panasonic approached the dealers directly and presto, it had a ready-made distribution network for its own product line. "In effect, all Blaupunkt did was give access to its dealer network to Panasonic," says Frey.

In their article "Linking Outsourcing to Business Strategy," authors Richard C. Insinga and Michael J. Werle advise companies to keep control of—or acquire—activities that are true competitive differentiators or have the potential to yield a competitive advantage, and to outsource the rest. They make a distinction between "core" and "strategic" activities. Core activities are key to the business but don't confer a competitive advantage, such as a bank's IT operations. Strategic activities are a key source of competitive advantage.

Because the competitive environment can change rapidly, the authors advise companies to monitor the situation constantly, and to adjust accordingly. As an example, they point to Coca-Cola, which decided to stay out of the bottling business in the early 1900s, partnering instead with independent bottlers and quickly building market share. The company reversed itself in the 1980s when bottling became a key competitive element in the industry.

Excerpted with permission from "How to Think Strategically About Outsourcing," Harvard Management Update, Vol. 7, No. 5, May 2002.