OutsourcingPaper
Thinking Strategically: Outsourcing Well vs. Outsourcing Badly With the `Value Profit Chain'
By Alistair Davidson, Partner, Eclicktick


Executive Summary
Companies face enormous challenges in a difficult business environment. There is tremendous pressure to cut costs. Outsourcing is one popular way of reducing costs and capital expenditures. But troubled companies often gain no advantage from reducing their costs without altering their business model and motivating their employees. Five stages of outsourcing are identified that suggest new ways of defining outsourcing relationships that will improve business models and employee motivation.

Modeling costs without modeling changes to business models and iterative improvement in the business model may underestimate the opportunity for performance improvement. The Value Profit Chain, proposed by Heskett, Sasser and Schlesinger provides a useful framework for negotiating value creating outsourcing arrangements.


Introduction
Technocrats are people who think that technology is what counts.

Many managers are frightened of technology. They are as a result, too trusting of technocrats. They feel overwhelmed by the complexity.

But ironically, the largest single trend in technology usage today is the independent decision making about technology by business managers.

The result: sometimes good, sometimes bad. Sometimes, the managers do things that the businesses needs. They are pragmatic. They get things done. Customers are happy. Different business units, with different needs, pursue different strategies. The burden of centralization is avoided.

But bad things happen to good managers too. I just got off the phone with an IT manager. Her complaint: “Things are too complicated. Mainframes are connected to portals. The portal was designed to work with IBM's DB2. We were forced to make it work with Oracle SQL database. My system is always going down.” she complained. “The outsourcers don't catch problems fast enough.”

And I recently attended a .net conference run by Infoworld, where all the speakers talked glowingly of the ability of Microsoft's new abilities to tie together legacy, web and e-commerce systems.

But like most things in life, complexity costs. A lot. The technocrats talk about Total Cost of Ownership for a system - how much it is going to cost, select, purchase, set up and install, integrate, maintain and replace a system. The sophisticated consultants talk about Total Value of Opportunity or TVO - which forces managers to analyze more than the cost or size of a project.

But what senior managers and those who think strategically care about is: “What impact does all this stuff have on the business and the customer? How do all of these technology decisions add up to make my business better or worse? How do they affect my costs and profits? How does if affect my capabilities and competencies?”

Typical Approaches

Roughly speaking, there are three basic approaches to handling your information management and a major out-sourcing choices:

1. Centralize everything.
2. Decentralize everything.
3. Centralize some infrastructure and standards, delegate standardization to business units, so that they can select appropriate technology for their needs and value chain.
4. Do, what's important internally, and use out-sourcers, out-taskers, consultants, suppliers and software vendors to deliver or support the activities where you are not cost competitive or have insufficient competence.

In-House Control
and Delivery
External
Out-tasking
External
Supplier
Centralize
Decentralize
Some centralization,
some decentralization


Now, the challenge is that the first three strategies intersect with the fourth. You can contract out centralized parts of your business or your business units can contract out portions of their business activities. And when you think about, there are really two ways of outsourcing activities that you are not good at:

Use a narrowly focused information technology outsourcer or consulting firm. One can also include in this category software developers who provided a standardized solution that eliminates development and upgrade chores and is able to allocate their development costs over their customer base.
Contract out a portion of your value chain e.g. an automobile manufacturer that switches to buying a full “car seat system” from a supplier, rather than assembling the components of the seat directly.

The advantage of course, of the latter approach is simplicity. It is far easier to assemble higher value added components than having the complexity of managing thousands of individual parts. And I would like to suggest that simplicity always results in lower costs, something that many firms have lost sight of in their rush to build and integrate:

Portals
Supplier procurement systems
Personal decision support systems
Departmental servers
Information warehouses
Integrated enterprise resource planning (ERP) systems (e.g. SAP, PeopleSoft)
E-business systems
Legacy mainframe transaction processing systems


Losing Sight of How Businesses Make Money
The problem of course, is that merely to describe the problem is complicated. The organizational consequence of all this complexity is that many organizations have lost sight of their purpose. And without purpose, they tend to flounder around making attempts to optimize their business's information management but without achieving major results.

I am going to make a big claim here. It's controversial to some people, but I have found that it works in my consulting. And some perceptive academics like James Heskett, Earl Sasser and Leonard Schlesinger who have a long history of researching service businesses, make a similar point in their latest book, The Value Profit Chain (Free Press, April 2003). That is: the purpose of business is act as an agent on behalf of the customer in creating value.

Now there are some interesting consequences to this apparently simple definition of business.

First, it ends up changing what you think is important in your business. It affects the kinds of information you collect about customers.

Second, it alters your pricing policy. Which causes customers to like you more. And they will probably buy more of your product or service, which may, in turn change the way you interact with and support customers.

And, third, it changes the way you think about the role of employees, suppliers and outsourcers.

It's worth quoting here from “The Value Profit Chain” as the authors put it so well.

“The value profit chain comprises a series of interrelated phenomena…:

1. Customer loyalty and commitment are the primary drivers of growth and profitability.
2. Customer loyalty and commitment emanate from customer satisfaction compared to competition.
3. Value is created by satisfied, committed, loyal and productive employees….
4. Employee satisfaction results from… the `fairness' of management, the quality of peers in the workplace; the opportunity for personal growth on the job; capability, the latitude within limits to deliver results to the customer; levels of customer satisfaction achieved in customer facing jobs (the so called mirror effect); and monetary compensation, often in that order. It is at the heart of efforts to build the organizational capability to deliver both high value and low costs.
5. Relationships between elements of the value profit chain are self reinforcing. They can work for or against organizational performance.” (p. 19)

The Value Profit Chain vs. Outsourcing.
So, how does the Value Profit Chain (VPC) stack up against outsourcing, out-tasking and the use of suppliers.

For most companies, I suspect the answer is “Pretty badly.”

If your outsourcing activities are being driven by:

A desire to cut costs.
The pushing out of employees to an outsourcer.
Increases in riskiness of employment, resulting in demoralization of employees.
Lost of competences and reduction of opportunities for personal growth.
A lack of a focus on building a business model, culture and mission built around creating superior value and customer satisfaction,

Then it is likely that no amount of outsourcing and cost reduction, no amount of cutting costs without change to the business model of the company will succeed.

Take a look at the examples cited by Heskett, Sasser and Schlesinger:

WalMart with its emphasis upon low cost, low logistics, granular information, and low volatility sales and a culture that emphasizes creating value for customers though being exceptionally efficient and smart.
Vantage Mutual Funds with its emphasis upon the long term investors, high long term yields aided by low administration fees and low customer turnover.
Southwest Airlines with its emphasis upon fast turnaround, cross training, job security for employees, no meals, and a superb and fair pricing and web-based ticket booking system.

These firms are not making cost savings decisions in a piecemeal way. They have a set of values and unlike many technocrats, they understand that people, their motivations and their capabilities are what sets a business apart. And perhaps just as importantly, they understand that building a business is about improving the value you offer in many ways and all the time.

Who can love traditionally oriented telephone company in contrast? There was a period when aggressive telephone companies would call up and suggest a different plan to save you money. I cannot count the number of stories I have heard more recently of telephone companies demonstrating indifference to their customers concerns, emotions and values. Three personal examples may suffice:

A frequent problem for customers is failing to set up a reasonably priced long distance service on e.g. a fax line, leading to unexpectedly high long distance bills when a visitor uses the wrong phone line.
Nasty surprises from dialing out of your local toll area to an Internet line can also lead to unexpectedly high bills.
Customer service center phone systems that bounce you when you have been left on hold a long time to another service rep, causing you to have reinitiate a description of the problem that you have made to the previous three reps you have been bounced from.

These kinds of interactions create a “Profit Dooming Chain” that customers often store up emotionally and make customers much more likely to switch brands that current research might suggest. When a new high touch competitor comes along, market share erosion can be rapid. Traditional telcos are losing market share to both wireless companies and in the future will also see significant erosion from cable companies.

When to Outsourcing
Fashions in business come and go. But it seems to me that the Value Profit Chain gets to the heart of some important truths about business. Business is about creating exceptional value and delivering well, with people who care.

So, if you are setting up outsourcing, is it possible to do it well? Should you out-source? How should you write your contracts to ensure that you are not slowly putting yourself out of business?

Research from firms like Primary Matters on the cost of outsourcing suggests that in some situations doing activities within your organization will cost 10 to 15% less than outsourcing, but there are clearly activities which are not economic for organizations of certain sizes.  Some activities just require scale to operate efficiently. For these types of activities outsourcing makes a whole lot of sense.

And there are some projects where the learning curve is exceptionally steep - information warehousing, implementing an Enterprise Requirements Planning system - these are typically examples of situations where both peak loading issues and risk issues will certainly demand outside expertise, at least initially.

And there are lots of activities where purchasing applications and services makes a lot of sense because the supplier can allocate his R&D costs over multiple customers.

So clearly, there are situations where strategically, you have to purchase the service or product. In the 1980s, I recall visiting an oil company in Canada. It had built its own spreadsheet. No one today would even think about such an attempt.

But a key insight, I believe, is that outsourcing relationships are not all created equal.

The Capabilities Maturity Model (CMM)
An emerging theme in the software development business over the past two decades of so has been the emergence of the desire to “engineer” software development processes. In other words, the goal is to make them more predictable and more manageable, and to deliver what is required.

A key conceptual model that has emerged is the Capabilities Maturity Model, developed by the Software Engineering Institute (SEI), at Carnegie-Mellon University. This framework originally funded by the military, suggests that improvement in performance can be achieved in software engineering through gradual evolution.

The same idea is very appealing when applied to outsourcing. Outsourcing is closely related to software development - clearly not the same, as the first part of the article has demonstrated, but very similar. But as with any engineering problem, you can optimize the process for different goals. Optimizing your outsourcing can be done for cost saving, for revenue enhancement, for risk sharing or for supporting the Value Profit Chain.

The boundaries between the stages of outsourcing are not particularly important, but the objective is. And it is in the setting of objectives that most companies have found the difficulties in successful outsourcing.

Loosely speaking, you can think of outsourcing as having the following justifications, with implications for how you might negotiate a contract.

1. Cost and risk reduction.
2. Revenue and market share growth.
3. Capabilities improvement.
4. Improved customer satisfaction and value.
5. Improved customer satisfaction and value and risk sharing.

If we frame these objectives around the Value Profit Chain, then there are advantages and disadvantages to each set of objectives:


Type of Outsourcing
Advantages
Disadvantages
Cost and Risk Reduction
Simple to define in stable business.
Hard to define in evolving business.
Revenue and Market Share Growth
Use another firm's capabilities or product at an incremental cost.
May produce revenue and market share growth while demoralizing employees
Capabilities Improvement
Provides greater ability to create value for customers
May not contribute to employee morale and on the job growth
Improved Customer Satisfaction and Value
Congruence between objectives of outsourcer and company
Potential loss of core value chain activity
Improved Employee and Customer Satisfaction and Value and Risk Sharing
Focus upon Value Profit Chain issues
Requires more than a cost reduction mentality; requires leadership, a clear statement of values and purpose. Requires negotiation about participating in the upside, which poses problems for many firms.

What this all seems to suggest is that outsourcing is going to work best when five conditions are met:

Companies have a clear purpose tied to creating value for their customers.
Employees are provided with an environment that values them.
A culture of performance improvement is the norm.
Outsourcing is not used as a weapon to drive down labor costs, but is rather used selectively to create best of breed activities that create value for customers and create an environment where employees can flourish.
That the incentive schemes for the outsourcer and its client are similar and encourage risk sharing and improved value creation for customers through employee empowerment.
That relationships move from project relationships to longer term relationships.

Is it a big challenge? Yes.

It is an impossible challenge. Not at all. If you don't have goals for creating value with your outsourcer, you won't create more value than you hoped for.

It may not be possible, if you don't have a business model that is focused upon creating customer value. As with all areas of business, leadership matters. And so do values - how you treat people; how you treat customers; how you negotiate with suppliers and outsourcers.