Inevitability of outsourcing in modern business

¶ … Outsourcing Inevitable?

Outsourcing as a strategy and ongoing approach to staying competitive is permeating both manufacturing and services firms globally. Having started primarily as a strategy of cost reduction, outsourcing has steadily grown to include new product research and development, the permanent re-aligning of more routine and easily replicable tasks, and the re-definition of customer service. Spanning the entire value chain of industries including manufacturing, outsourcing's impact on global business is permanent and has already re-defined the cost structures of industrial manufacturing, consulting services than span application development and maintenance, business process re-engineering, customer service and support, and the use of outsourcing for significantly impacting new product development timeframes through the use of computer-aided design techniques.

The goals of this paper are to provide a literature review of outsourcing, specifically as it relates to industrial manufacturing and the resultant impact on business process reengineering, which is also a very significant force in the entire global outsourcing industry today. Primary research has also been completed to review attitudes of industrial manufacturers to global outsourcing, specifically looking at their attitudes and experiences with this strategy. The bottom line is that this paper shows that outsourcing is indeed inevitable for a multitude of factors, foremost being the integration and sharing of processes between manufacturers and outsourcers themselves.

Preface

Global outsourcing is re-aligning the global competitive landscape. The intent of this paper is to provide a thorough literature review and define the essentials of vendor selection. Included in this analysis is a 2-dimensional model for understanding the relationship of global outsourcing to a company's tolerance of risk vs. return, definition of vendor options and negotiation. The specifics of outsourcing are also defined, as is a series of results from primary research completed on global outsourcing.

Introduction

Outsourcing

Definition of outsourcing

Outline of paper

Importance of outsourcing

History of outsourcing

Advantages and disadvantages of outsourcing

Literature Review

Essentials for Vendor Selection

Framework for outline

Environment Analysis

Determining if outsourcing is right for the situation. Determining business focus and what to outsource.

Buy-in from key constituencies

2-dimensional model for understanding the relationship

Documentation

Identification of vendor options

Request for proposal

Data collection

Evaluation/Comparison of vendor options

Comparison of data to make decision

Recommendation for backup choice

Negotiations

Used if decision can't be reached because of equal performance among vendors

Differentiation from negotiation of relationship development

Should be win-win

Specifics for Off-shoring

Off-shoring is different

Legal Considerations

Validate that the entity is legal

Know legislation in the foreign country that may affect partnership

Cultural Considerations

Power distance and individualism/collectivism

Geographic considerations

Knowledge Transfer and privacy issues

Executive Summary

The intent of this research effort is to define the current state of outsourcing, showing its inevitability and to illustrate that, and in completing primary research where 500 manufacturing professionals were contacted and interviewed through a series of web-based questionnaires, telephone and e-mail interviews, the focus on what's the evolving best practices in this area were discovered.

The key insights gained include the convergence of business process reengineering and manufacturing outsourcing are leading to best practices in manufacturers attaining their ROI objectives for outsourcing strategies. Of all processes that drive manufacturing, the quote-to-order and inquiry-to-order processes were most mentioned by respondents and the convergence of business process reengineering and manufacturing the most pronounced in this area. The manufacturers contacted in this research effort also mentioned the need for transparency in manufacturing capacity and the need to deliver Available-to-Promise (ATP) on their quotes, in addition to the need for having transparency into the manufacturing status of their specific orders. What emerges is a hierarchy of product customization strategies that begin with Assemble-to-Order and progresses to Engineer-to-Order shown within this report. The payoff of making achieving transparency throughout an outsourcing network between contract manufacturers and clients is also reflected in the tables showing a 33% reduction in order cycle times and a 41% reduction in incorrect orders due to the transparency achieved by integrating outsourcers' manufacturing plants and their client companies.

Introduction

All companies are asking their IT departments to reduce IT costs and head count, and this is hitting white collar workers the hardest. These account for 19% of the IT budget by many industry sources, making them an attractive target for cost savings. However, rather than just cutting resources and doing without, many companies are lowering their costs by using offshore outsourced resources on a project-by-project basis. Although tactical, project-focused offshore outsourcing consistently saves companies money, increased project management costs, schedule delays, and project rework are common, creating project overhead and reducing savings by half. Only by adopting a strategic approach to offshore resources can companies minimize the overhead and maximize the savings and accomplish their strategies.

According to AMR Research, project-based offshore outsourcing can save companies 25% of in-house costs. By many accounts, an additional 25% to 30% of savings are possible. Although service providers are expanding their offshore service capabilities, most of the work being done offshore is application development and maintenance. In the future, companies will be able to use offshore Business Process Outsourcing (BPO) and IT operations service offerings to further increase their savings. Companies using offshore resources for development projects indicate savings from a low of 0% (no savings) to a high of 50%, but the majority of companies report 25% to 30% savings of the cost of doing the project in house.

25% reduction in labor costs sounds attractive; however, the labor rates for programmers in India (where most offshore work is being done today) are between 40% and 50% of the cost of an in-house salaried programmer. The difference between the labor rates and the actual savings achieved by companies is the result of communication and project management problems between companies and their offshore service providers. The problems increase costs as follows:

The growth of onsite contracted resources -- Companies using offshore resources are using a blended delivery model that comprises 10% to 30% onsite and respective 90% to 70% offshore resources. The onsite resources ease communication and project management concerns since they manage the offshore resources, but they cost 2.5 to 4.0 times that of offshore resources.

Managing Project delays -- Companies report that the transition to offshore resources takes several months: project management relationships need to get established and communications need to become efficient. The exact amount of time depends on the scope of the project and the ratio of onsite to offsite resources, but a 30% increase in project schedules for projects that comprise 20% onsite and 80% offsite resources is a reasonable estimate.

Unforeseen Project rework -- Rework caused by the misunderstanding of specifications and project plans contributes to the overhead. One company using offshore resources to build a B2B application reported that modules required three rework cycles to overcome the developer's misunderstanding of project requirements.

Companies can reduce the gap between the in-house and outsourced offshore labor rates and the actual savings by adopting a more strategic approach to offshore resources.

Project-based offshore outsourcing carries with it a high overhead. Worse, most companies engaged in project-based offshore outsourcing never improve their ability to manage offshore relationships and reduce the overhead. Projects are often done by independent groups with no communication of best practices among them. A strategic approach, however, can result in the following benefits:

Minimize the overhead associated with the projects by using expertise developed to manage offshore projects.

Increase the number of projects being supported by offshore resources to increase the overall savings to the company.

A strategic framework for using offshore resources includes two models:

model for segmenting projects into strong and poor outsourcing opportunities model for determining the optimal offshore delivery model for projects based on company process maturity and project specifics key lesson learned is to outsource based on a project's strategic value to the company first, and for cost reductions second. The guideline that most companies follow when selecting projects for outsourcing is to keep core competencies in house and outsource the rest. The problem with this is that companies often hold core competencies that provide little or no competitive advantage to the company. Worse, IT departments only waste management focus and in-house resources when perfecting their ability to perform low-value tasks, such as application maintenance.

Rather than following the core competency guideline, companies who are getting the best results from outsourcing are following three major strategies: saving money, accessing specific skills, and allowing management to focus on more strategic initiatives. To best achieve these goals, companies getting the best results segment their activities into three categories:

Activities that are strategic and provide competitive advantage - Companies should invest their own resources in activities that provide competitive advantage. Only in unusual circumstances should they outsource components of this work (e.g., the need for short-term skilled resources to complete a critical project). Lowering costs and reducing management attention are extremely bad reasons to outsource strategic tasks.

Activities that are critical but provide minimal competitive advantage - Critical tasks are essential for keeping a company functioning, and failing to execute these tasks at a high level of service can have severe repercussions. If you don't do them well, you can't compete, but doing them better than anyone else provides limited benefit. Companies should carefully examine these tasks for outsourcing opportunities, keeping in mind that they may require the outsourced resources to have specialized or more developed skills.

Activities that are necessary, but a commodity level of service is sufficient - Commodity tasks are necessary for keeping a company functioning, but they do not require specialized skills. Performing these tasks at a level higher than the industry norm provides the company no value.

According to industry estimates that for most companies, only 20% of their activities provide strategic advantage, 50% of their activities are critical, and 30% are at the commodity level. However, most companies outsource few critical tasks, though outsourcing critical tasks represents a large opportunity. Several Independent Software Vendors (ISVs) that have outsourced development have found that about 20% of their work (focused on architecture and product strategy) must remain in house, but the rest can be outsourced, including such critical tasks as new product development. Some of the other critical tasks, such as user documentation and user interface development, require more expertise than the offshore outsourced resources generally provide, so companies have to use a higher ratio of onsite to offshore resources to outsource them successfully.

Comparing Outsourcing Delivery Models - Three service delivery models are available to companies pursuing offshore resources:

Global service provider with strong local presence -- Work with a service provider that offers local (onsite or regional) resources and supplements these resources with offshore resources for specific tasks. Global service delivery companies, including Accenture, Avanade, BearingPoint, Cap Gemini Ernst & Young, Headstrong, IBM, Intelligroup, and Keane, supplement their onsite and regional capabilities with offshore development centers. However, for most companies buying services from these providers, the bulk of the resources provided are domestic. Specialized service providers such as Sapient and Virtusa and Application Service Provider (ASP) Corio also fit into this model.

Direct management of offshore resources -- Some work with a service provider that has minimal local capability and offers offshore services. This is the traditional delivery model of the pure-play offshore providers, such as HCL Technologies, Infosys, LUXOFT (in Russia), Satyam, Tata Consultancy Services, and Wipro. Note, however, that the large pure-play offshore companies are recognizing the need for onsite capabilities and developing domestic capabilities to supplement their offshore resources. This is also alleviating localized conflicts in originating countries.

Develop offshore capabilities in house -- Many companies have begun to expand offshore sales and support offices by adding additional technical resources as part of a distributed IT organization. They are able to reap the rewards of low-cost technical resources while minimizing the loss of control that typically accompanies outsourcing.

Evaluating factors for defining an offshore model - When choosing an offshore model, companies must evaluate process maturity, communication requirements, control requirements, project and resource flexibility, global experience, and industry-specific factors:

Process Maturity -- Successful offshore outsourcing requires a mature process for defining requirements, developing specifications, implementing the specifications, accepting the finished work, evaluating the results, and providing feedback toward a new implementation cycle. Companies cite immature processes as one of the primary causes of project failure with offshore resources.

Communication Requirements -- Individual projects have unique requirements for the amount of interaction required among project participants. Projects requiring serial communications are better suited for offshore development. Projects requiring highly iterative communications are better suited for onsite or offshore development in a company-owned facility.

Control Requirements -- Control requirements determine the level of governance and oversight required to complete a project successfully. Some companies require a high degree of control because the management culture rewards a hands-on management style. Some projects require a high degree of control because of their strategic importance or sensitivity. A lack of strong processes is another factor driving management control. Companies need to establish strong relationship management skills in order to successfully manage outsourced relationships.

Project and Resource Flexibility -- Project flexibility determines the ability of a company to start and stop projects and to raise and lower staffing. Some companies have fixed resource levels but ever-changing project requirements; other companies can vary their resource levels, but have very fixed project requirements.

Global Experience -- Global experience is a measure of the amount of expertise a company has in managing its own global resources. Companies with a high degree of global experience have sales, support, and perhaps technical resources in multiple countries and continents. Companies with minimal global experience have minimal global sales resources and no support or technical resources.

Industry-Specific Criteria -- Industry-specific regulations and unique business processes affect a company's ability to move work offshore. Regulations such as ITAR define what information can flow offshore, and regulations such as the Pharmaceutical industry's CFR 21 Part 11 define rules affecting change management procedures. A lack of experience with industry-specific processes is a common cause of failure in offshore processes.

Brief History of Outsourcing

The concept of outsourcing is not new yet the current exponential growth of this industry began in the early 1980s when contract manufacturing as a cost reduction strategy began to take hold in many westernized corporations. While these first steps in outsourcing resembles contract manufacturing, global outsourcing's major growth came as a result of the Y2K concerns all companies had regarding their computer systems. Y2K is the Year 2000 roll-over of systems and the intricate maintenance and programming needed to make these systems capable of running in the 21st century. Indian global outsourcers especially benefited from this market dynamic, with Infosys, Satyam, HCL, WiPro, and many others owing their first contracts and resulting market successes to this market dynamic.

From their collective work on modifying and maintaining software to combat the Y2K potential problems, outsourcers became adept at software programming and maintenance. Their customers for Y2K software enhancements started turning to these outsourcers for the fine-tuning of other systems as well, and as a result an entire industry of what began as outsourcing programming re-work and maintenance eventually has turned into a multi-billion dollar industry that today is 7% of India's GNP. IBM recently announced, in June, 2006 that they would be investing $6B in India in the next few years and significantly increasing their headcount there as well.

A secondary yet just as significant market development continues to be the many forms of compliance that U.S. publicly traded companies must contend with in the form of Sarbanes-Oxley (SOX) legislation which was enacted in 2002 by the U.S. Congress and ratified into law that same year. There are many other forms of compliance as well, yet SOX has been the continual fuel that has propelled outsourcing into the size and importance of an industry it is today. The fact that Infosys, in remarking about their financial performance for a given quarter, mentioned that $1 of every $3 earned was directly attributed to SOX one can see the impact of this compliance legislation on both the costs of U.S. corporations on the one hand and industry-making size of spending with outsourcers on the other. Compliance requirements within many U.S. corporations are often outsourced as headcount is thin enough already and there are not enough IT personnel available to complete existing projects much less take on new ones. The bottom line is that SOX and its many requirements on companies has created an even greater opportunity for outsourcers to show the many benefits of offloading critical work to a third party. The successes companies are having outsourcing compliance requirements leads naturally to considering outsourcers for other business critical tasks including manufacturing, accounting, routine financial and taxation work, and the enhancement and maintenance of application software to just name a few.

Advantages and Disadvantages of Outsourcing

Despite the many advantages companies report from outsourcing, there are just as many disadvantages and challenges to overcome. There is a summary of the advantages and disadvantages of outsourcing:

Lower costs from both a process and wages perspective - The primary motivation for many companies to outsourcing production and services or both is the ability to significantly drive down their wage costs, yet there are also the process costs that can also be significantly reduced. Take for example the direction of Infosys to offer outsourcing services for industrial manufacturers' order management systems, a task so critical to the overall functioning of a company, and yet Infosys is getting new clients throughout the rust-belt region of the U.S., in traditional industrial manufacturers. Clearly the process paybacks of outsourcing order management fall outweigh the cost reductions from wage reductions. In fact for many manufacturers the wage reductions are incremental to the process reductions and opportunity to focus on their core business including for manufacturers who sell to consumers, their brands.

Improving service and support - Thousands of manufacturers, financial services and healthcare companies are taking this route to deliver higher levels of performance on a 24/7 basis while achieving significant cost reductions in the process. The dual benefits of greater responsiveness and cost reductions in addition to stabilizing what for many companies is a high turn-over operation with attrition of 60% or more makes outsourcing service and support an imperative. The fact that outsourcing companies also keep trainers on staff in the event new employees need to be trained due to attrition also appeals to many manufacturing and services companies. The overarching strategy is consistent, always-on service at a low cost point delivered at a consistently high level. Call centers throughout India and the Pacific Rim for example are accomplishing this; as many of the employees of these call centers staffing telephones have college educations and consider working in call centers a great career move.

Obtain expert skills more economically than in the U.S. - This is the reason why so many U.S. publicly held companies rely on outsourcers for their SOX expertise; it is cheaper to hire them than create a staff of experts in this area on their own. This also is the case with lean manufacturing concepts for industrial manufacturers who are interested in getting significantly lower per unit production costs, and realizing economies of scale in procuring parts and components in India and China where costs for these key components are significantly lower than in the U.S.

Improve processes and seek best practices - In the article Virtual Champions the competitive globalization of Business Process Outsourcing (BPO) and the growth of this industry within India, and the impact this high growth industry is having both globally and within the nation itself is defined. One of the key lessons learned from this research project is the convergence of business process reengineering and traditional manufacturing outsourcing.

Improve focus on core activities - Manufacturers and service companies alike are under increasing pressure to make their core businesses successful financially, and that often requires a single-minded focus that is not possible when there are many conflicting priorities present. As a result many companies are off-loading all unrelated tasks and in some cases production lines to focus on their core strengths. Companies selling in the business-to-consumer (B2C) arena have done this for years, choosing to outsource production of their clothing, apparel, shoes and accessories to focus entirely on their brands. Nike, Wal-Mart and others are using this strategy today.

The following disadvantages also apply to outsourcing:

Too thinly staffed to manage outsourcing - This is certainly the case in many of the smaller manufacturers who hear of the significant cost savings and see their larger competitors outsourcing, and move to this strategy. Often they find their thin staffs are overburdened with the tasks of managing an outsourcing relationship.

Culture clash - This is prevalent in many industrial manufacturers for example where the company has a family-like feel and the structure of the company doesn't easily allow for outsiders to join in and become part of the culture. Often manufacturing cultures are rejecting both the outsourcing of manufacturing and business process tasks as paranoia of job security sets in, and is fueled by U.S. media. The fact is that many companies who outsource actually upgrade the positions of those affected and give them training to become more marketable.

Customers' requirements force local manufacturing - This is certainly the case with the U.S. government, which wants 60% or greater assembly of components for products they buy done in American manufacturing and assembly plants. This 60% rule also influences the origination of parts as well; the U.S. government expects the majority of their products purchased to be of American-made components. The recent discussions of Boeing for example moving the production of their Boeing 7e7 jetliner to an Asian nations for final assembly and testing so upset the U.S. Congress that the company was given special incentives to move their corporate headquarters from Seattle, Washington to Chicago, Illinois. Additionally there are non-defense related companies who also expect the majority if not all of their products to be produced in U.S.-based factories due to quality control, Six Sigma auditing, and 100% review of components before they are shipped.

Ethnocentrism and lack of flexibility on the part of management - The fact that many manufacturers began due to technological innovation and a focus on engineering which in turn led to manufacturing core competencies makes the task of offloading what is considered a core part of the company very difficult to achieve. The "Not Invented Here" syndrome can easily become a part of a manufacturing company's culture when process improvements from an outsourcing company are made. Ethnocentrism is the attitude that ones country or company is superior to all others in the world, and that any competing area is inferior or deficient. When this attitude pervades a company the use of outsourcing is difficult to impossible.

Unorganized series of processes in manufacturing makes their replication nearly impossible - Plainly put, some manufacturers have such unorganized processes on their production floor that outsourcing is nearly impossible for them.

Statement of the Problem

Essentials for Vendor Selection - In defining an outsourcing strategy, industrial manufacturers first need to define a vendor selection strategy and work through the specific components of this critical stage of selecting an outsourcing provider.

Best practices includes defining the parameters of the relationship before initiating contract negotiations - Offshore development firms all offer extremely flexible pricing models, so take the time to negotiate everything up front. The very good firms will work with you in developing a requirements document and scoping out your specific needs. It is important to solidify a quote for development resources as part of the upfront negotiations. Time and materials and fixed bid pricing models are the most popular, though blended rates, prepay, and Service-Level Agreements (SLAs) have also been used successfully.

Defining and aligning relationship models prior to signing the contract - Picking the right model is critical to the project success. The majority of customers have at least one project manager onsite throughout the duration of the engagement. It is important to note that some firms do not provide a person onsite all of the time. In this case, frequent teleconferences, open communication, and status updates are imperative. At the beginning of the project, request that the vendor send a team onsite to get up to speed on existing processes and project details. Those same resources will then return offshore for the duration of the development phase.

Having a predefined set of role and responsibility definitions - During the negotiation phase, spelling out who is responsible for what deliverables and setting the target completion dates is very important. It is also necessary to establish differences between onshore and offshore responsibilities and ensure that everyone is in agreement. Most offshore firms will handle travel, work visas, and boarding for their employees while they're staying in the United States. Some firms pay for training for your Information Technology (IT) staff in your offices once a project is completed.

Service Level Agreements (SLA) are critical for the management of any outsourcing relationship - This is especially true in the areas of industrial manufacturing outsourcing where the many requirements inherent in producing a product need to be defined at the outset of the relationship. Industrial manufacturers however have to consider the Service Level Agreements (SLAs) that promise high performance but deliver only mediocre results as a potential long-term liability to their outsourcing strategies. For many manufacturers it's time to reevaluate their vendors' performance vis-a-vis their SLA commitments. SLAs have been used by vendors in the past, but they have lost power as a Bill of Rights, and this is especially true in manufacturing outsourcing. The best strategy for many of these manufacturers relying on industrial manufacturing is to get out all their SLAs and review them for the specifics regarding performance, quality, pricing, and delivery. In fact many companies pursuing manufacturing outsourcing arrangements may be shocked at the variation in the service you asked for and what you are actually getting. Start posting the results to shake up the stakeholders on these projects and get corrective strategies underway. Organizational growth forces many companies to rely on geographically dispersed people, processes, and products, which has manufacturing outsourcing so popular. Manufacturing outsourcing vendors fail to live up to their SLA commitments because they have little vested interest in having the accelerated cost reductions happen for their clients. An alternative to ending the relationship with the vendor is to start measuring the actual performance to the SLA plan, rewarding your vendor for exceptional performance, and demanding recompense for poor or mediocre performance. Manufacturers need to realize that when they complete manufacturing outsourcing, the SLA is their own Bill of Rights, and it can be used for protecting against substandard performance in manufacturing outsourcing.

Environment Analysis Linking Outsourcing To Business Strategies

The specifics of environmental analysis and their linking to business strategies include the following key decision points for any manufacturer considering outsourcing their manufacturing:

The decision to pursue offshore vs. onshore - One of the respondents to the research completed mentioned the labor rates in China alone made for the best possible economics for their consumer products. The decision to offshore was driven primarily and by cost alone.

Make vs. Buy - This is another aspect of environmental analysis that respondents to this research completed, and shows that for manufacturers decided that it would be easier to teach Chinese workers how to create necessary components near the final assembly plants in their country, versus building them in Europe and air shipping them to China for final assembly.

Qualifying and validating supplier sources - The focus on creating a network of third party suppliers throughout China was the preferred approach to attempting to synchronize suppliers throughout a global supply chain. The specific aspects of synchronizing Chinese suppliers with the assistance of third party agents in China were a critical aspect of one manufacturer's strategy.

Two-dimensional Maturity Model for understanding the Outsourcing relationship

From the research completed and the literature review, an Outsourcing Maturity Model emerges that is shown in Figure 1. This Maturity Model highlights a key finding from the research described in this document, and that is there is a convergence of business process reengineering and traditional manufacturing outsourcing. To the extent there is greater integration of business processes and traditional manufacturing is to the extent there are higher levels of Return on Investment in outsourcing strategies.

Figure 1: Outsourcing Maturity Model

Note also at the highest level of maturity in this model, or the Orchestrating Layer, there is a high levels of visibility, transparency and sourcing across a federation of suppliers. This maturity model is specifically focused on the dynamics found in the research completed for this study.