Make-buy decisions

From outsider to insider

A model based on three key pillars can help CPOs assert their right to play a leading role in strategic in-house versus outsourcing decisions

Winter 2006-07

by Simon Harper and Dave Phillips

With companies under increasing pressure to cut expenses and improve their return on assets, the dilemma of whether to keep key functions in-house or outsource them has taken centre stage. Manufacturing units are identified most often with outsourcing decisions because third-party suppliers in eastern Europe, China and other low-cost regions hold out the promise of significant advantages that many brownfield plants can't offer. But other critical activities - such as human resources, information technology, maintenance and customer relations - can gain (or lose) just as much from outsourcing and shouldn't be neglected when the in-house versus outsource options are considered.

What does this mean for chief procurement officers? We believe that CPOs should play a pivotal role in determining a company's course, because many of the activities that they are routinely involved in give them unique skills to take on this task. For example, CPOs must constantly evaluate potential partners and suppliers in order to engineer the most advantageous purchasing arrangements for their companies. A logical extension of this capability can be applied to the outsourcing decision: CPOs could lead business units in conducting detailed analyses that thoroughly evaluate costs, benefits, risks and rewards of outsourcing and the implications of keeping the activity in-house.

Before giving up on in-house operations, a company must objectively assess its core competencies and measure them against world-class standards. With their proficiency in overseeing and managing third-party suppliers to generate the highest possible level of quality and productivity, CPOs know the right questions to ask to make these determinations. Among them: if our manufacturing or HR capabilities are below global benchmarks, can they be improved to reach maximum performance and efficiency, which surpass the benefits that we would obtain from outsourcing? If so, what resources are required, and how long would it take to reach noticeably improved performance? Is technology innovation and alignment necessary for us to have a competitive edge? Do our customers expect a high level of service and response, much greater than we could offer if we outsource call centres to, say, India?

If, after these questions are answered, outsourcing is chosen, CPOs can work with the business unit to find the right partner. Pivotal indicators such as business strategies, manufacturing and engineering capabilities, design and innovation skills, labour costs, staff skills, employee training programmes, the ability to scale, capacity utilisation, and the social policies of the potential partner must be assessed. In addition, the risks in outsourcing must be accurately gauged, whether they relate to the supply chain or to proprietary technology and intellectual property.

CPOs can also help to structure the outsourcing deal so that their companies are protected from quality, delivery and other material failures. Lessons learnt from procurement - for example, maintaining the right balance between collaboration and competition - are similar to those that must be applied to outsourcing arrangements, in which the perceived value of the relationship [figure 1] may cloud initial judgment and lead to serious problems a few years hence.

With no direct management responsibility over departments that may be considering outsourcing, CPOs can produce an unbiased "rightsourcing" evaluation that takes into account all of the possible consequences - economic, human or technological - of outsourcing or internal operations.

This is an extremely important task, because too often these choices are based on precedent and poor or incomplete analysis. Keeping the process in-house is typically preferred only because the capability and capacity already exists internally. And outsourcing is frequently an emotional response, a way to avoid fixing processes that have become inefficient and flabby but whose true potential is not completely understood. In other words, outsourcing may be a poor alternative to confronting internal inefficiencies, and in the process improving company performance.

Faced with this level of inertia, CPOs must challenge their organisations to make more objective and informed decisions. Indeed, it is the responsibility of the CPO to ensure that all of the right trade-offs have been evaluated and all possibilities have been considered. This is far from their typical position: procurement officers, if they are involved in these choices at all, are usually brought in after high-level deliberations, not during them.

Booz Allen has developed a framework to help simplify the in-house versus outsource decision that is built on three key pillars: business strategy, risks and economic factors (see figure 1).

Pillar 1: Business strategy

Business strategy includes the strategic importance to the company of the product and service that's being considered for outsourcing and the process, technologies or skills required to make the product or deliver the service. This must be considered not merely in light of the current competitive environment but also in anticipation of how that environment might change in the future.

As a rule of thumb, it's desirable to choose in-house capabilities when a product or a function is critical to a company's performance or is considered a core operation. For instance, if a product is time-sensitive or prone to frequent design changes, third-party manufacturing would likely be a mistake.

Companies hope to attain an assortment of benefits by outsourcing:

eliminate the burden of asset- or labour-intensive processes on the balance sheet;

reduce costs;

• gain flexibility to increase or diminish output in response to changing demand;

• phase out management of paperwork

• or training;

• supervise fewer workers;

• gain access to new process or network technologies;

• leverage others' expertise.

Harley-Davidson illustrates the importance of business strategy in determining whether to make a product or buy it from a third party. The motorcycle company continues to thrive, in part because of its decision to manufacture mostly in-house in the US. Harley-Davidson's "Made in America" brand image is so strong today that consumers don't care if the company's motorcycle accessories and ancillary merchandise such as clothing are produced overseas by outsourcers; those operations are peripheral to the brand image of Harley-Davidson's primary products. (Ironically, but making the same point nonetheless, when the German beer maker LšwenbrŠu licensed North American production to another Milwaukee, Wisconsin-based company - Miller Brewing - in the mid-1970s, Lowenbrau's attractiveness to US customers fell because it no longer had the cachet of a genuine German beer.)

The CPO can act as an independent arbiter in resolving which aspects of the organisation rise to the level of strategic importance such that they must not be outsourced; and, similarly, when outsourcing is called for, assessing whether a prospective partner can meet requirements.

Moreover, in examining potential outsourcers, CPOs can use their knowledge of the supply base to determine the outsourcer's technologies, product development and supply chain management capabilities, and their ability to work in partnership. And, importantly, they can evaluate whether their company has the skills and resources to manage the supplier so that there are continuous quality and cost improvements over the life of the contract. Without that, the outsourcing arrangement will likely be a big disappointment.

Strategic value can be a subtle thing. For instance, if a product is based on proprietary technology or hard-won and coveted intellectual property, outsourcing is probably not a good idea.

Ethical concerns merit consideration as well. A company's reputation can be seriously harmed if it is connected to unsavoury activities such as sweatshop production, child labour or environmentally damaging manufacturing techniques - all of which are routine at some outsourcers.

Despite these caveats, outsourcing is worth considering under certain conditions. If a product or function's value has dwindled to being essentially a commodity or is derived from factors other than unique or differentiating capabilities, and the possibility of moving production or management to a third party does not give rise to significant risk to the company's strategy, outsourcing could be the perfect solution.

Figure 2 outlines the beginning of the process in which the strategic value of the services and manufacturing processes under consideration for outsourcing can be sorted into their respective categories: strategic, core and outsourcing candidates.

Pillar 2: Risk

Risks include quality, reliability and the predictability of outsourced solutions compared with in-house manufacturing or service, as well as risks inherent in the process of identifying and selecting the right supplier and structuring a workable ongoing relationship.

The CPO has multiple roles in managing risk. On the one hand, he or she should lead the training of the organisation to view the supply chain or service providers as partners that deliver an entire product or manage an entire function. The CPO must also oversee risk assessment during an in-house versus outsource evaluation with much more diligence than under traditional sourcing. Lastly, the CPO should supervise the writing of the contract so that it protects the organisation from the outsourcer's deficiencies.

When there are multiple suppliers, a single failure in the chain may not be fatal. And when suppliers are making components rather than finished products, manufacturing errors will likely be caught during assembly and not be passed on to the consumer directly. But because outsourcing introduces such a wide array of new risks, CPOs must be keenly aware of any potential pitfalls with suppliers, and evaluate outsourcing partners based on their importance to the organisation. Failure of service could be devastating if the outsourced operation is critical, such as an IT network or a payroll processing system, whereas a glitch in a training programme or a long-term product development plan would be much less of a concern.

It is rare for companies to hire multiple outsourcers for the same service, but General Motors did just that recently, primarily to minimise risk. In February 2006, the automaker announced that it would split its $15 billion contract for IT services among EDS, Hewlett-Packard, IBM, Capgemini, Covisint and Wipro.

The strategy has a number a benefits for GM. First, multiple suppliers should encourage competition, minimising the chances that the contract's cost competitiveness will decrease over time. Second, system failures at any of the companies will not harm GM's entire IT infrastructure. Third, the contracts are for only five years, as opposed to 10 in GM's expiring IT arrangements, to limit the automaker's long-term financial risk and to ensure accountability from the outsourcers.

In addition, GM and the IT suppliers jointly developed standardised approaches for all five companies to follow - involving everything from systems delivery to supplier interactions with the automaker - aimed at producing greater efficiency in the IT services provided.

Crucial to the mitigation of risk is the supplier selection process. It must be based on a clear understanding of the supplier's strategy, operations and cost structure. Choosing the lowest bid is not sufficient. Only a supplier that has a compatible business strategy and will maintain an advantaged cost position over time can offer competitive prices in the long term.

Outsourcing a broken process - for instance, an HR benefits call centre that is not equipped with the right answers to the most prevalent questions - will end up costing much more than if the function were fixed before handing it off to a third-party provider. The outsourcer will likely charge a significant amount to repair the process, and as an outside operation will probably not know enough about what the organisation needs to repair it properly.

The financial health of the outsourcer must be considered as well. Will the company be in business in a year's time? In five years? And is the company too dependent on your outsourcing contract for its survival? CPOs regularly assess all of these issues - from supplier selection to supplier evaluation - in putting together contracts.

Understanding the risks associated with the location of an external supplier is equally important. Besides gauging the source country's political stability, companies need to assess the safety and lead times of transport arrangements. They must also identify and evaluate potential secondary carriers or routes, or back-up suppliers in a different region that can provide incremental volume during peaks in demand or disruptions of the primary source of supply.

Supply chain management is a highly complex function, especially when combined with the outsourced manufacture of products or processes that require unique capabilities or assets and thus are difficult or expensive to re-source. But even these "hold-up" risks - that is, risks that a supplier will exploit a customer's highly dependent relationship by raising prices or demanding better terms - can often be managed with external solutions. It is critical, however, to consider the options and determine the best alternatives before any commitments are made with a supplier, because they can be hard to reverse (see figure 3).

Sometimes the risks are difficult to envision because they seem so trivial. That was the case recently with Harrah's Entertainment. The casino operator hired an external supplier to print 11,000 promotional coupons, most of which were to be of very low denominations, but with about 15 worth $525 each. In the past, Harrah's, like most in its industry, had printed these coupons internally, fearful that printer error could prove costly - which, much to Harrah's dismay, is exactly what happened. The printer produced the entire run of coupons with an indicated value of $525. When the error was discovered, the casino decided to honour all coupons at their face value, at a loss of almost $5.5 million.

Harrah's was remiss in two ways. Initially, the casino operator did not adequately assess the quality control procedures at its printing supplier, and then it failed to mitigate the risks of outsourcing by more diligently overseeing the job.

Pillar 3: Economic factors

This third pillar of the in-house versus outsource decision includes considerations of the impact of outsourcing on capital expenditures, return on invested capital, and return on assets, as well as the possible savings achieved through outsourcing.

The CPO's primary focus should be to determine new contractual arrangements that shift the discussion from the price of a finished product to the overall cost to provide the product or service. To do that, CPOs must identify the supplier's cost drivers and design a pricing mechanism that reflects the underlying costs now and how these costs will change in the future. The goal is to make sure that ongoing improvements in cost are reflected in the contract and are shared between the outsourcer and the CPO's organisation. Finding an effective gain-sharing mechanism that properly rewards the supplier for taking action but passes on the ongoing improvements to the buyer is important. Sometimes this requires placing staff at the outsourcer's headquarters, with a brief to encourage and monitor continuous improvement.

To understand how critical appropriate pricing mechanisms are, consider that most companies base their decision on whether to outsource solely on estimates of the in-house versus the external costs associated with the outsourced operation - that is, the price of each piece made or the cost of running an HR department or an IT network - but not on the total costs.

Among the total costs that must be considered are the outlays for managing the outsource provider, especially as the outsourced process changes. These can be significant. For example, software customisation on a third-party IT network can add a huge surcharge to the outsourcing deal. Handling it in-house, where the IT department can work closely and more productively with end-users to meet their needs, might be much less costly.

In addition, when outsourcing partners are not chosen well enough, organisations frequently attempt to protect themselves from failures or delays by duplicating in-house some of the effort that was originally farmed out. This results in multiple costs for the same project - potential expenses that are often not considered when the outsourcing deal is agreed.

The costs that are most often ignored in outsourcing manufacturing operations are:

• shipping and handling;

• expanded inventories;

• administrative expenses, such as supplier management and quality control;

• the added complexity and its impact on lean flows;

• a lower return on invested capital;

• production reliability and quality issues.

Considering all of this, relying on a one-time quote to gauge the competitiveness of an external supplier is generally not sufficient. CPOs can save their companies from this mistake by factoring into the outsourcing equation such economic factors as relative wage rates, labour productivity, equipment and staff utilisation, the leanness of both the labour base and functional processes, the capacity for process and product innovation, and component and materials purchasing power.

Possible top-line gains from keeping production in-house must be calculated as well. In choosing not to outsource, some companies have enjoyed significant revenue growth by taking advantage of the speed and quality of internal innovation cycles, the ability to deliver customised products to nearby consumers quickly and without a lot of advance planning, and the possibility of leveraging new lines of business from a favoured supplier's proposal.

Expectations must be clearly articulated so the company can avoid unpleasant surprises once the supplier feels the business is locked in or that its current performance will be sufficient in the future. To do this, it is vital to provide the appropriate specifications upfront. Any misunderstanding about the scope of the outsourcing programme will surely be more costly and potentially damaging to an organisation.

The contract must reflect how the business will unfold rather than its state at the signing of the agreement. In outsourcing, CPOs must be vigilant to create a customised contract rather than simply offering the standard terms and conditions.

A successful outsourcing relationship often includes the sharing of savings from productivity improvements, so that both parties have an incentive to collaborate. During the course of the relationship, it is also important to find the right balance between fully transparent supplier operations and the perception of micromanagement.

Once the outsourcing decision and supplier selection have been made, it is essential to agree upfront a fair and balanced pricing mechanism, productivity improvement and cost reduction expectations, and the required degree of responsiveness to design, service or delivery changes.

Outsourcing contract terms span multiple years - five- and 10-year agreements are not uncommon. During this time, business conditions frequently change, resulting in significant modifications in what is required from the outsourcer. For example, production rates may need to be increased or decreased depending on the market performance of the products. A hike in volume would likely reduce production costs as it would allow the outsourcer to put excess capacity to work. Unless this benefit is shared fairly between outsourcing partners, the venture often deteriorates; after all, why should the outsourcer alone gain from improved market conditions?

Similarly, should volume requirements fall, the outsourcer's production costs are likely to rise; that, too, should be shared. In the short term, outsourcing relationships can normally survive imbalances, but for them to endure for a long time, the contract must provide a fair mechanism for considering the cost implications of any major changes.

As the variety of factors and risks that need to be taken into account demonstrate, the in-house versus outsource decision should not be made without careful analysis. The CPO is essential to making sure that this analysis is initiated and conducted diligently, properly and objectively. This will put some strain on CPOs and their organisations, and new capabilities will be required. But by viewing it as a logical extension of the procurement role, both will be able to handle the new responsibilities with a high level of skill.

Although the choice to keep an activity in-house or use an outsourcer may be cross-functional and strategic, it will likely be the role of the CPO and the procurement function to make any outsourcing decision work.

Therefore, CPOs should rise to the challenge and lead their organisations to the right solution.

Simon Harper (harper_simon@bah.com) is a principal and Dave Phillips is a senior associate in the operations practice at Booz Allen Hamilton, based in London