Strategic Outsourcing: Leveraging Knowledge Capabilities
Strategically managing knowledge, innovation, and outsourcing combine to create a company’s greatest future challenge.
Today’s knowledge and service-based economy offers innumerable opportunities for well-run companies to increase profits through strategic outsourcing.1 Emphasis is rapidly shifting from outsourcing parts, componentry, and hardware subsystems toward the even greater unexploited potentials that intellectually-based systems offer:2
- Obtaining higher value, more flexible, and more integrated services than internal sources can offer.
- Improving the company’s capacities to stay current and to innovate by interacting with “best in world” knowledge sources.
- Achieving cross-divisional coordination and shareholder value gains that the company — for internal structural or political reasons — could not otherwise achieve.
Outsourcing Knowledge-Based Services
The drivers for these trends are formidable. As the service sector has grown to embrace 80 percent of all U.S. employment, specialized service firms have become very large and sophisticated relative to the scale and expertise that individual staff and service groups have within integrated companies — whether in services or manufacturing (see Table 1).
These specialists can develop greater knowledge depth, invest more in software and training systems, be more efficient, and hence offer higher wages and attract more highly trained people than can the individual staff groups of all but a few integrated companies. Given this greater knowledge depth and wider range of customer interactions, they can also become much more innovative than their internal counterparts might. Companies as diverse as British Petroleum, DuPont, MCI, Dell Computer, Beaumont Hospital, Ford, State Street Bank, Ameritek, Nike, and Argyle Diamonds dramatically illustrate potentials. Properly developed, strategic outsourcing substantially lowers costs, risks, and fixed investments while greatly expanding flexibility, innovative capabilities, and opportunities for creating higher value-added and shareholder returns.3 Dell Computer provides a classic example of how strategic outsourcing can revolutionize an industry:
- Dell has grown at an 89 percent compounded rate for some years, achieving $700,000 of sales per employee in its fast-moving, competitive business. Dell concentrates its own resources on a superb customer knowledge and support system downstream and a shared information system that deepens its relationships with suppliers upstream. Outside suppliers provide virtually all Dell’s componentry design and innovation, software, and (non-assembly) production for its computers. It invests only where it sees an opportunity for unique value-added and avoids the huge inventory, facilities, and development risks assumed by more integrated competitors or supply specialists.
Knowledge management is at the heart of Dell’s strategy. By serving its customers directly, Dell captures crucial information about the market. With 70 percent of its sales to larger institutions, Dell maintains dedicated knowledge managers for each major customer and an entire staff to track these customers’ changing needs and system configurations. These contact staffs and its interactive secure “Premier Page” web sites enable Dell to save customers crucial months in design and installation and millions of dollars by pre-configuring each customer’s purchases to its specific system needs. By making its own production needs and product interfaces transparent to suppliers, Dell lowers suppliers’ innovation costs and risks, encourages more customer-responsive innovations, and increases suppliers’ probabilities of commercial success. The suppliers, rather than Dell, provide both the scale of investment and depth of expertise needed to support innovations across a range of technologies and customer demands that Dell could not satisfy alone.
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Outsourcing for Intellectual Value, Not Just Cost
Executives increasingly understand that outsourcing for short-term cost-cutting does not yield nearly as much as outsourcing for longer-term knowledge-based system or strategic benefits — like greater intellectual depth and access, opportunity scanning, innovation, reliability, quality, value-added solutions, or worldwide outreach. Clearly, companies go to outside litigation, tax, advertising, or medical specialists primarily for such benefits rather than for lower costs:
- Royal Dutch Shell seeks outside experts’ different views and more specialized knowledge for the scenario building that is central to its renowned strategic planning activities. Oil and mining companies hire professional real estate firms to develop and manage their surface land resources. Some pharmaceutical companies have found that 30 percent of their pre-competitive research funds invested externally will produce 90 percent of their better leads. Ford has used ABB to develop new plants at 70 percent of its usual in-house cost. With shorter cycle times and its database of some 20 million installed units, ServiceMaster can maintain certain equipment specialties with such lower cost and higher quality than its clients that it often is willing to co-invest with them to lower their investment costs as well. Companies’ finance groups routinely outsource their international exchange, tax, pension, and custodial activities to accounting or financial houses better able to keep track of the enormous complexities involved.
In a landmark study, Price Waterhouse Coopers found that outsourcing had moved markedly from performing a single function more efficiently to reconfiguring or rebundling whole processes in new ways to generate greater shareholder value across the enterprise.4 As a consequence, the decision on whether and how to outsource is steadily moving up the organization to the CFO, COO, and CEO levels.5 As outsourcers’ capabilities improve, the strategic issues are, increasingly: Why not outsource? Where can we focus our own resources to create unique value? How can we best leverage our outsourcers’ capabilities? How can we manage potential outsourcing relationships for greatest shareholder value?
Special Problems in Intellectual Outsourcing
Certain unique features characterize outsourcing of intellectual activities. Because the provider typically has more knowledge depth than the buyer — and such experts may regard themselves as highly trained elites superior to their client’s personnel — the buyer cannot guide it by direct orders.6 Further, it is impossible to specify desired outcomes precisely in advance (e.g., an ad campaign or building design), and costs are difficult to estimate. Even after the fact, it may be impossible to precisely measure the impact of the supplier’s contributions. In these circumstances, clients often distrust their capacity to strike a balanced deal with the experts. Buyers are also legitimately concerned about losing the skills that they outsource, becoming overly dependent on the provider, creating an internal backlash from staff people who fear outsourcing, not achieving the responsiveness they think they could from internal units, losing control over timing and quality of outputs, having the provider sell or leak the client’s solutions to competitors, being “whipsawed” by a supplier at crucial times, and being able to effectively balance both short-term (cost) and long-term (value-added) goals. These are valid concerns. But I will show how an integrated knowledge and outsourcing strategy can mitigate these risks.
As companies disaggregate intellectual activities internally and outsource more externally, they rapidly approach a true virtual organization with knowledge centers interacting largely through mutual interest and electronic — rather than authority — systems. Each node of their organization form becomes a knowledge source; some nodes are internal, and some external (see Figure 1). In these circumstances, how can managers create the kind of focus a genuine strategy requires?
Strategic Focus in Knowledge Strategies
Companies with successful knowledge strategies follow certain well-accepted principles7 by: (1) concentrating more power than anyone else on a few capabilities that customers genuinely care about; (2) innovating constantly to ensure that their performance and value-added stay ahead of competitors; (3) developing conscious flexibilities to deal with changing competitor pressures and opportunities; and (4) leveraging their resources significantly by using the capabilities and investments of others.
“Core competency with outsourcing” strategies enable companies to:
- Focus and flatten their organizations by concentrating their limited resources on a relatively few knowledge-based core competencies where they can develop best-in-world capabilities.
- Leverage their internal innovation capabilities by hundreds or thousands of times through effective personal, IT, and motivational links to outside knowledge sources.8
- Eliminate inflexibilities of fixed overhead, bureaucracy, and physical plant by conscientiously tapping the more nimble resources of both their customer chain downstream and their technology and supply chain upstream.
- Expand their own knowledge and physical investment capabilities by orders of magnitude through exploiting the facilities and program investments of outside sources.
Creating a Best-in-World Focus
The essence of creating focus in a knowledge strategy is to develop a small number of intellectually-based knowledge activities — important to customers — to best-in-world levels.9 Starting with an analysis of the company’s value chain10 and staff support activities, executives develop a few critical activity groupings where they are, can be, or must be best-in-world to compete effectively. These — and these alone — are their core competencies (see the sidebar). They define the very essence of how the company delivers its value proposition and why customers and employees prefer its outputs or operating concepts to those of competitors. The most effective core competency strategies focus on a few (two to four) cross-functional, intellectually-based service activities or knowledge and skill sets critical to customers, where the company can build and maintain best-in-world capabilities and provide a flexible platform for future innova-tions.11 At least one of these competencies must connect directly to understanding the customer.
Once a company develops a true best-in-world core competency, it never outsources it and may even build defensive rings of essential competencies that customers insist it have or that protect its core — as Honda does by not outsourcing design, parts, or key equipment for its core competency, i.e., design and manufacture of clean, efficient, small engines. Other than its core and essential competencies, most companies can reap great gains by prioritized outsourcing of many activities where they are less than best-in-world. If it is not best-in-world at an activity (including transaction cost) and continues to produce that activity in-house, the company gives away a competitive edge that it could have had.
Upon serious investigation, most companies will find that 60 percent to 90 percent of their in-house activities are services12 that are neither being performed at best-in-world levels nor contributing significantly to competitive edge — and are not very risky to carefully outsource. These should be the first targets for analysis.
Figures of Merit: Creating a Strategic Block
To make the concept of “best in world” more explicit, all the leaders in my “most creative company” studies13 went beyond benchmarking (matching best competitors) and used some variant of another approach — figures of merit14 — to define “best.”15 Figures of merit look ahead and set forth a few crucial economic and technical characteristics that “if hit, will win” in competition. They define economic-performance targets sufficiently above normally expected trend lines to ensure the company has a competitive advantage that will attract customers to switch over to it, rather than stay with competitors (see the sidebar for several examples of such figures of merit).
Most successful knowledge strategies also carefully define “winning” strategic performance and focus sufficient investment and human resources to marshal the knowledge depth and support systems needed for that purpose. Thinking in these terms has important impact, not just on use of fiscal and human resources but on the capacity to leverage these resources much farther through outsourcing. Once a company achieves a true core competency of best-in-world capability, it has a “strategic block” that keeps its suppliers from bypassing the company and attacking its markets directly. The strategic block that core competencies create enormously elevates the bargaining power and security of the buying company in dealing with suppliers.
At a more detailed level, studies of productivity from IT investments found that those IT users that defined strategic superiority (not equality) as their target obtained both the highest returns from their IT investments and the highest overall corporate performance levels.16 Those that achieved marginal or negative returns did not use such targets. For example:
- State Street Boston’s CEO Marshall Carter recognized the custodial opportunities and problems that the emerging mutual funds industry would pose and set out to develop a unique competency to handle it.In a joint venture with DST Systems, Inc., State Street automated its custodial handling processes, hired top-flight IT people to fill six of its seven top posts, closed 90 percent of its branches, and outplaced or shut down many of its traditional banking businesses. Within a few years, it had 53 percent of mutual funds’ custodial business and now has more than $4 trillion under its management. Its special competency allows State Street to partner in a variety of mutual fund and investment management services and provides a unique skills and knowledge base for constantly innovating along with its knowledgeable clients in their rapidly moving businesses.
Three High-Leverage Outsourcing Opportunities
Once the company’s strategic block is in place, it can fully exploit three high-leverage areas for intellectual outsourcing. In increasing order of importance, these are:
- Components (or all) of traditional functional or service activities performed in-house (e.g., accounting, IT, payroll, or employee benefits functions).
- Complementary, integrative, or duplicative activities that need to be coordinated across the enterprise but are lodged in many different groups across the company.
- Those disciplines, subsystems, or systems where outsiders have much greater expertise or capabilities for innovation because of access to wider or different sets of customer needs or more specialized knowledge.
1. Outsourcing Functional Specialties
Outsourcing of specialties within a function (like human relations) is relatively common and can still be very productive. For example, in a recent sample of human relations activities, more than 75 percent of companies outsourced management of their retirement plans, 40 percent to 50 percent outsourced reimbursement and payroll activities, and approximately one-third outsourced health and welfare management activities.17 Companies often find that functional suppliers can provide much greater expertise, more current innovations, and more detailed knowledge about regulatory and reporting requirements than can all but the best inside sources. Employees have access to the provider seven days a week, but the company does not have to pay for a full-time staff. Providers can automate high-volume, low-value activities that in-house groups cannot. And internal HR staffs can concentrate on special problems and personalized contacts with more employees.18 For example:
- Arthur Andersen notes that its clients often initially outsource to obtain higher value in a specific function — like auditing complex financial derivatives — where they lack critical mass or deep expertise. However, the big payoffs occur when Andersen can help the client align the full range of its risk-monitoring and -management processes with its corporate strategies worldwide. Andersen can help clients not only to reduce risks but to gain competitive advantage and enhance shareholder value through integrated risk management and control (e.g., internal audit, compliance monitoring, credit and regulatory review, and so on). Andersen and the client together identify business risks across multiple geographies, functions, and operations; relate the risks to specific processes; and utilize the best control practices to manage them. Andersen’s intranet site KnowledgeSpaceTM captures best-practices knowledge about operating processes worldwide to reduce risks and costs across multi-unit activities — like managing procurement globally from sourcing to credit analysis, logistics, and accounts payable controls.
2. Integrating across Divisions
Perhaps the least exploited and highest-value opportunities for strategic outsourcing are activities that could be profitably integrated but — for various historical reasons — are dispersed among many different functional, regional, or divisional groups across the company. The costs can be high. Typically, these smaller units seriously lack the depth of knowledge, highly qualified specialists, or information systems that the best outside sources have. For example:
- In Europe, British Petroleum and Mobil Oil had to deal with six to eight different tax and statutory regimes for tax, accounting, and financial reporting. Finding it difficult to develop needed depth and coordination in their various divisions, the companies outsourced these activities to PriceWaterhouseCoopers (PWC), which consolidated them in a “center of excellence” in Rotterdam, saving 46 percent of costs in the first year and paving the way for future savings on the euro. PWC has also established centers of excellence offering other global services like environmental or system compliance audits. It now provides such services to brand- and socially-conscious consumer product and entertainment companies worldwide (verifying their suppliers’ compliance to global labor, health, and environmental standards), lowering the clients’ costs of verification, increasing objectivity and external creditability, and ensuring use of world-class measurement and risk-prevention techniques.
More importantly, the corporations’ or the dispersed entities’ incentives may strongly mitigate against effective cross-divisional solutions. Energy, communications, and computer services are typical of high payoff areas where history, incentive structures, or politics make it virtually impossible for decentralized internal groups to achieve a corporate optimum. Despite well-intentioned empowerment or reengi-neering programs, middle- to lower-level employees often will not recommend truly basic changes or out-sourcing, fearing they may lose their jobs, be out-sourced themselves, or lose power or compensation if components of their units are shrunk or out-sourced. Results are almost always suboptimized by cross-divisional consensus-building processes, failure to alter management and incentive structures to make changes effective and sustainable, and refusal by all parties to reallocate the capital essential to support the agreed-on thrusts. Frequently, there is no feasible way to implement or enforce needed systemwide perspectives without outsourcing. For such reasons, for example:
- EDS took over all information processing for seventy of South Australia’s government departments that had neither the capability nor the incentives to develop a common system, for a savings of $100 million. It developed and operates the EUROPARL Internet system for the European Parliament that provides the diverse countries’ staffs, representatives, and citizens a common communication platform they could not have achieved individually or jointly. EDS enabled Illinois Central to move from a mainframe to a client-server environment, supporting both its traditional railroad operations and its aggressive plans for growth into highly diversified new services. And at Hong Kong’s new Chek Lap Kok and Las Vegas’s McCarran airports, it is providing fully integrated database-sharing systems for gate, terminal, and functional (finance, HR, and maintenance) operations. Neither airport could have achieved its aggressive cost savings and timing targets without cross-divisional outsourcing.
Many companies and institutions have entirely separate organizations for generating and distributing energy internally, designing buildings, maintaining these facilities, operating the facilities as profit-making units, managing construction processes, and purchasing energy raw materials. Each unit has completely different performance measures and incentives relative to energy. Building designers want to achieve maximum functionality at lowest initial cost; construction oversight groups focus on building costs rather than long-term operating expenses; line units using the building seek lower near-term costs; maintenance groups seek reliability and lowest repair costs; and raw materials purchasing units seek lowest commodity costs with reliable supply. When corporate interests lie in lowest long-term costs (including cost of capital), these suboptimizations repeatedly lose tens of millions of dollars annually for even mid-sized institutions.
Often the most effective (or only) way to achieve desired effectiveness is to outsource the entire activity — be it energy, computer, communications, distribution, auditing, or facilities design, construction, or operation — to a group that has the needed specialists yet can flexibly adapt outputs to meet internal divisional needs. For example:
- Enron Energy Services uses its specialized capabilities and expertise about energy sources and costs, advanced financial instruments, and energy use management to optimize trade-offs among energy consumption, capital investment, and variable costs (labor, maintenance, and energy) across a client’s multiple facilities. If the system is fully outsourced to Enron, it can provide predictable and sustainable savings that the client otherwise could not realize. First, Enron can achieve greater economies of scale (for financing, equipment, and commodity purchasers, as well as technological know-how) than the client. Second, the client (rightfully) wants to focus its investments on its core competencies and not be burdened with the nuisance, support, and follow-up investments on a number of diverse energy projects that it can manage only marginally well. This gap in interest and capacity to manage provides a large profit opportunity for both parties to share.
Decreasing Costs and Risks.
If done properly, integrated outsourcing can both decrease costs and lower risks. Clearly, outside suppliers undertake investments and development risks that the outsourcer avoids; by sharing these risks among multiple clients, the supplier lowers costs for all its clients. However, risk management itself has now become one of the critical new tools and benefits of outsourcing. For example:
- Enron,under its fixed long-term contracts, specifically assumes the three critical energy risks that a client might have: (1) commodity price shifts, (2) consumption (weather-related risks), and (3) labor cost or investment risks. Two of Enron’s core competencies are evaluating energy risks and tailoring pricing solutions to fit the client’s different divisional needs. Wholesale electrical and fossil energy costs are among the most volatile of commodity costs. Nevertheless, through advanced financial and logistics techniques, Enron can provide clients guaranteed energy supplies at a fixed or predictable cost tailored to the client’s specific needs. It can offer energy prices per unit of output in manufacturing, per building or square foot for offices, and per room in hotels — stabilizing prices to suit the client’s key operating controls. To achieve maximum client value, Enron generally must take over all the client’s energy activities, including operations and investments in energy facilities on a long-term (more than ten years) fixed-price basis — as it did recently for Pacific Bell Park.
- Arthur Andersen has developed a comprehensive process for organizational assessment and risk management around a comprehensive set of tools (e.g., Global Best Practices KnowledgeSpaceTM intranet site, Business Risk Model,TM Business Process Auditing Methodology,TM and Business Risk Management IntegratorTM).19 Recognizing that the most effective risk management is risk prevention, Andersen first analyzes the full range of client risk for a particular operation. Then it assembles in the same room all the key people involved in the business process to ensure that the risks are understood and that appropriate personnel assume responsibility for controls. Using a cross-functional team and special methodologies, the group codesigns needed risk-control practices and measurements with Andersen, so that process managers better appreciate the nature of the risks — and both sides can identify and fix “holes” that the other might overlook. Often clients have neither the background to assess complex risks nor the technologies or methodologies to facilitate needed cross-unit solutions.
3. Assembling Expertise Quickly
Another reason for integrated outsourcing is that most large companies find it almost impossible to quickly assemble highly diverse expertise for special inter-unit projects, especially when these resources are several layers down in different divisions or geographies. Each unit is reluctant to give up its key people to such projects when it has so many other pressing needs to support its bread-and-butter goals and rewards systems and, as a result, may grudgingly release only second- or third-tier people. Outside professional firms, by contrast, are generally organized for this specific purpose worldwide. For example:
- When a financial services client was moving into a new area — account management for trusts — but did not have the internal experience or time before launch to set up adequate risk-management practices and controls, Arthur Andersen assembled a team of world-class experts to design, install, and coach management in essential practices within only a few weeks rather than the years that the client would have otherwise needed. In operation, its installed best-practices systems across multiple geographies achieved higher consistency, lower cost, and greater local flexibility than years of internal development might have.
Outside suppliers can also add enormous value to their physical products by providing rapid-response integrated services for clients. For example:
- Because of its extensive customer and supplier knowledge base, Dell can quickly specify and deliver up-to-date computer systems — using the most currently available subsystems — tailored to a customer’s specific needs, existing equipment, and software. Enron can design and deliver an integrated energy system for a shopping mall, industrial center, or building complex, obtaining maximum economies of scale on equipment (chillers or boilers), infrastructure (pipes, vents, and tunnels), and energy commodities (gas and electricity) purchases for all clients, yet pricing the energy to the specific uses, needs, and strategies of individual occupants or divisions. To help its clients plan and keep their strategies up-to-the-minute, Schlumberger — through its SNET — can give its clients information about all available and relevant drilling activities, costs, discovery and flow rates, and trends across its many fields.
Increased Innovation
The ability of providers to assemble diverse expertise rapidly can have enormous impacts on another critical strategic factor — the timing and amplitude of innovations. Many companies now outsource largely to tap into the much richer innovation skills that outside suppliers can offer. By using sophisticated out-sourcing and new electronic communications, modeling, and monitoring techniques, companies can decrease their innovation cycle times and costs by 60 percent to 90 percent, decrease investments and risks by equal amounts, and enhance the value of their innovations by orders of magnitude.
In basic and early applied research, the key to such leverage is to have one’s own technical people electronically linked as directly as possible to the worldwide knowledge sources, publications, databases, and research centers where such work is performed. Fortunately, researchers tend to exchange knowledge freely at this level.20 But equally important, a supplier can instantly provide a critical infrastructure for introduction or diffusion of innovations to new markets. For example:
- When a multinational wants to enter a new market, it often has to send in expensive teams of “expatriates” to set up its basic administrative, control, reporting, and distribution systems. PriceWaterhouseCoopers now essentially “crates up and delivers” the full range of needed talent — often providing or training local personnel from its centers of excellence to jump-start the new market or series of international markets, with world-class systems matched to the client’s needs. Such outsourcing substantially decreases the time delays, costs, and risks of introduction — and increases the strategic flexibility and impact of the client’s internal innovation capabilities.
At the process or product development level, many companies now open up their own process and product models sufficiently to allow selected potential suppliers to innovate freely for their needs. This is how MCI, TCI, financial services groups, and many publishing, entertainment, Internet, and computer companies encourage thousands of external sources to use their own money to create innovative new software, products, or services to sell through the larger company’s networks. Many large pharmaceutical, biotech, chemical, health care, and consumer product companies use similar techniques to encourage smaller potential suppliers to offer them early-stage concepts they can carry through the expensive final development, clearance, mass production, and wide-scale distribution stages.
Larger system producers in aerospace (Boeing, Aerospatiale), transportation (Ford, Newport News), communications (AT&T, GTE), or energy (Mobil, Enron) have increasingly realized that their central R&D groups cannot faintly match the innovative capabilities of a well-managed supplier system, except in the few areas that are their core competencies. Ford has gone from 70 percent insourced to 70 percent outsourced, BMW to 80 percent outsourced, Dell and Gateway to essentially 100 percent outsourced, and Boeing and Aerospatiale to almost complete electronic design and outsourcing of all but a few critical systems — in order to tap the flexibility, expertise, and innovation of the best worldwide knowledge sources.
The question for all but the most specialized small companies is not whether but how to develop these innovation sources. For managers, in addition to changing attitudes, the keys are: (1) developing and maintaining one’s own core competency at best-in-world depth (to create a strategic barrier); (2) establishing a flexibly compatible and integrated electronic capability — from customer interfaces, through internal operations systems, to upstream supplier and technological knowledge databases — to capture and use state-of-the-art knowledge systematically; (3) generating figure-of-merit targets to define critical goals, focus and stimulate high-level innovation, and screen alternatives; and (4) implementing a recognition-reward system that encourages the supplier to innovate on the client’s behalf.
Many knowledge suppliers comment that the inflexibilities and traditional measurement approaches of clients are a major barrier to new solutions. Designers, software creators, professional engineers, consultants, and accounting groups say that customers — accustomed to time-based costing for both their internal units and traditionally outsourced activities like audits or design — frequently complain or reject outsourcing when they compare their internal hourly rates with the provider’s higher hourly rates. Implicitly, such evaluations give no value to the substantial worldwide knowledge bases, technological investments, and accumulated learning and training that the provider brings to the party. Enron notes that when it takes over a complete energy system for a client, it must often make huge catch-up investments in training and equipment to achieve savings and quality goals that the client never thought feasible. Yet, when clients merely compare hourly-based labor costs, they are reluctant to sign long enough contracts for Enron to realize realistic returns on its investments through its fixed-pricing structures.
Although clients generally want a provider to innovate and keep its operations at state-of-the-art levels, they often unrealistically demand that suppliers both pass all gains from innovation through to the buyer in their pricing and use the client’s own specified practices to ensure consistency and quality. The results can be disastrous. Managed care groups’ demands on hospitals and clinics are a major case in point.
The most devastating error that both parties can make is not to encourage and reward continual innovation at that interface.
Providers report the three practices of outsourcers that are most stifling to innovation are: (1) their insistence on “specified practices,” (2) an unwillingness to move from hourly rates to value pricing or shared innovation incentives, and (3) the desire to manage the “how,” not the “what” of outsourcing. Fortunately, as trust and experience with innovation outsourcing grows, new methods of sharing benefits, ensuring “technology refreshment,” and protecting each party’s proprietary interest in knowledge are also appearing. The richest source of innovation is usually the interface of a supplier’s technological and systems depth with the new needs and market insights that the customer firm provides. The most devastating error that both parties can make is not to encourage and reward continual innovation at that interface. In a short time, the buyer will lose the very things it is seeking in outsourcing — greater knowledge depth, the most up-to-date systems, highest quality and lowest cost, maximum flexibility, and no front-end investment on its part. When done properly, whole new ranges of innovation appear. For example:
- In addition to making equipment and energy commodity purchases at economies of scale and with a knowledge base that no single customer can attain, Enron instantly incorporates its accumulated knowledge about energy management and process engineering into the customer’s system and its operations. Using its worldwide knowledge bases, Enron can guarantee energy supplies and prices to match each division’s special cost, environmental, or competitive needs and sell off-peak or excess capacity to other nearby customers, lowering costs and risks even more.
- Most Internet companies provide their products with software “hooks” or make them compatible with other Internet products and thus encourage other users, suppliers, or producers to innovate freely for their own purposes, creating hosts of new uses and variations they could never have anticipated for their products. The textile industry has been revolutionized as buyers, clothing designers, fabric manufacturers, and cutters work together electronically to supply exactly the product that the customer wants in eleven days instead of ten months — simultaneously increasing customer value, cutting costs, and decreasing risks by orders of magnitude. Other industries — from computers (IBM or Dell), to pagers (Motorola), to autos (Toyota and GM), bathroom fixtures (American Standard), and financial products (BankBoston) — are being structured this same way.
- To match this trend, several major consultants and Big Six accounting firms have innovated industry- or business-process–oriented service centers to deal with the new interfaces, structures, and complexities that such industry-level outsourcing presents.
Management Techniques for Better Outsourcing
If supplier markets were totally reliable and efficient, rational companies would outsource everything except their core competencies.21 Unfortunately, most supplier markets do entail some risks for both the buyer and the seller and some unique transaction costs, for searching, contracting, controlling, and recontract-ing.22 Yet an integrated producer, often unwittingly, encounters large internal risks and transaction costs — like lost innovation, introduction delays, suboptimizations by internal bureaucracies, and liability, product, and labor risks — it does not recognize.23
In each case, the question is not just whether to make or buy, but how to evaluate and achieve the desired balance between the independence and efficiency incentives needed to stimulate a supplier and the buyer’s needs for control and security. One of the most crucial steps is to shift the buyer outlook to managing “what” result is desired, rather than managing “how” the result is produced. A primary reason for outsourc-ing is to leverage the supplier’s greater skills, knowledge bases, investments, and processes. If the buyer specifies how to do the job in detail, it will kill innovation and vitiate the supplier’s real advantage. To encourage innovation, the CEO of a $4 billion company said, “I won’t worry about how much the provider makes from this transaction. … I will constantly want to know how our relationship with the provider is making us more money than we would have without the arrangement.”
How can a company best manage risks and develop the full potentials of intellectual outsourcing? Successful outsourcers carefully develop and implement certain crucial management controls. In addition to the strategic block of core competencies described above, these controls include:
Ensuring goal and value congruence.
Managers find that time spent in early stages to investigate and ensure the congruence of the supplier’s and buyer’s value systems and incentive structures is invaluable.24 In their service agreements, outsourcers and suppliers often jointly develop written goal statements for the relationship, specific agreed-on output measurements, incentives to ensure that goals stay aligned, and ways to periodically review that alignment. Without goal congruence, control costs become excessive for both parties. With it, benefits multiply and costs plummet.25
Building a much more professional and highly trained procurement and contract management group.
Many outsourcers find that neither their operating nor their purchasing managers have the kind of long-term relationship-management skills needed for successful outsourcing. As the number and complexity of outsourcing arrangements increase, there is need for a highly skilled corporate-level office capable of evaluating both insourcing and outsourcing options objectively; capturing the knowledge, successes, and patterns of problems from past outsourc-ing; developing the strategic and operating monitoring skills and systems needed for effective outsourc-ing; and actively staying at the frontier of outsourcing management techniques. Some have urged that these be centered in the office of a chief resources officer reporting to the CEO or COO.26
Developing a greatly enhanced strategic and operations information system at both the strategic and operations level.
Strategic monitoring ensures that the supplier is not moving in directions inimical to the buyer’s interests.27 In addition, successful out-sourcing companies move aggressively to develop detailed knowledge-based operations data systems that collect, evaluate, and ride circuit on changes that the best possible outside suppliers and experts are making.28 By constantly evaluating best-in-breed solutions from many sources, they improve their knowledge bases significantly beyond those that internal groups could provide. With proper monitoring, companies repeatedly find that — instead of losing knowledge capabilities — the sum of outside suppliers’ knowledge, the stimulation and insights they provide, and the solutions they develop will vastly exceed the potentials of any inside group, unless that group is the company’s core competency.
Including all insourcing transaction costs and actively measuring the benefits intended from the outsourcing relationship.
A most common error is to ignore the internal costs of non-innovation, missed opportunities, delays, management time expenditures, and inefficiencies due to internal suppliers’ having an ensured customer. Companies typically collect no information on these topics and are shocked or distrusting when outsourcing proposals surpass this mag- nitude. The backup and management investments necessary to bring or keep the internal operation up to best-in-world levels are also consistently ignored. Instead of being in contact with customers or interacting with people in their core operations, top executives in integrated companies tend to spend about 70 percent of their time on problems focused within a few yards of their office doors — often staff conflicts.29 Yet for emotional or political reasons, the provider is often loaded with all possible risk and transaction costs, creating a costly bias in decision making.
Developing feedback systems to leverage and share knowledge and innovation in both directions.
Innovation occurs when two previously disassociated matrices of thought intersect for the first time. The customer-producer interface is the most productive source for such innovations;30 studies show that more than 50 percent of all innovation occurs at this interface.31 As Dell Computer and other examples have shown, consciously developing interactive capabilities and knowledge sharing at both supplier and downstream partnering levels can easily leverage a company’s own innovation and knowledge resources by factors of ten to 100. Some of the greatest values of outsourcing are the opportunistic ideas that the company otherwise would never see.
Creating a mutual three-level contact system.
To fulfill these possibilities, successful large-scale out-sourcers carefully design and implement three levels of information exchange and personal contacts among: (1) the top managers who can break bottlenecks or ensure responsiveness when lower-level misunderstandings occur, (2) champions on both sides of the relationship whose careers depend on the success of the relationship, (3) numerous bench and operating-level personnel who develop the personal relationships and knowledge exchanges that solve problems before they occur or fester. Without well-developed relations at these three levels, the tacit knowledge of how things really get done, advance warnings of problems, and rapid conflict resolutions that maintain a joint outlook disappear. And people with occasional arm’s-length confrontations may dominate the relationship, making costs and apparent difficulties soar. Champions of both parties need to consciously broadcast and amplify successes internally, or resistance-minded politics will escalate inevitable minor difficulties and relationship problems to crisis levels.32
- Companies like Nike, Ford, and Sony have developed these capabilities in depth. For example, Nike frequently brings its suppliers’ top people to its Beaverton, Oregon, headquarters to exchange details about future opportunities, needed capabilities, and operating philosophies. Nike maintains full-time “production expatriates” on its major suppliers’ premises and keeps elaborate track of both present and potential new suppliers’ design, development, and production capabilities as the latter make proposals for future production contracts. Its information system carefully captures selected data and innovative ideas from all these sources, giving Nike an innovative edge substantially beyond its own internal capabilities. Meanwhile, its core competencies of superior feedback of information from the marketplace, specialized marketing capabilities, and its product design center (which can attract more talent and commit more resources to design of athletic shoes than any other company) both leverage these capabilities and create a strategic block between Nike’s suppliers and its marketplace.
A Top Management Issue
All this dictates that outsourcing has to become a top management, not operating, issue. Recommendations for the outsourcing of intellectual, innovation, and cross-divisional benefits are unlikely to come from below. In fact, lower- to intermediate-level managers tend to be actively hostile to outsourcing — fearing loss of jobs, prestige, or power. As outsourcing moves from cafeteria or mail-room functions to more creative or strategic levels, the higher the responsibility for the activity must move. To achieve the kinds of benefits described, providers constantly say that an executive at least one level higher than those affected must become the champion.
As outsourcing moves from cafeteria or mail-room functions to more creative or strategic levels, the higher the responsibility for the activity must move.
Equally important, the outsourced operation must not later be overseen by someone who has a vested interest in the way things were done before. Such people can easily become critics, not champions, and quietly sabotage the relationship. As one CEO said, “There are a thousand ways any operating manager can undercut such relationships if he or she wants to.” To cope with this, Arthur Andersen has created a human relations “transitioning methodology” to decrease outsourced people’s fears and to explain precisely what the move means to them, the new skills they will acquire, and how the provider can create whole new opportunities and career paths for them. When this transition management and, later, three-level oversight of the relationship are properly handled, PriceWaterhouseCoopers found that more than 90 percent of the parties surveyed found the outsourcing “very successful.”33 Fortune found that a vast majority of the mid- to lower-level executives transferred during outsourcing or downsizing increased their job satisfaction and incomes as a result.34
Increased outsourcing will be a natural outgrowth of our competitive system as it continues to globalize and move to knowledge-based services. For those who anticipate and manage these changes strategically, the gains can be enormous. For those who resist too long, the costs will be tragic. While nothing can eliminate all the personal displacement costs or psychological pain of outsourcing, these negatives can be substantially mitigated by proper management. Strategically managing knowledge, innovating, and outsourcing will be among the greatest and most rewarding challenges of the new era.
References
1. As used here, strategic outsourcing includes both the relatively permanent purchase of goods or services in a particular category from single or many different suppliers. It can include techniques from spot buying to strategic alliances. I have covered the use of these different techniques elsewhere. See: J.B. Quinn and F.G. Hilmer, “Strategic Outsourcing,”Sloan Management Review, volume 35, Summer 1994, pp. 43–55.
2. T. Elliott and D. Torkko, “World Class Outsourcing Strategies,” Telecommunications, volume 30, August 1996, pp. 47–49; and J. Greco, “Outsourcing: The New Partnership,” Journal of Business Strategy, volume 18, July–August 1997, pp. 48–54.
3. The first statement of how these elements fit together was in: J.B. Quinn, T.L. Doorley, and P.C. Paquette, “Technology in Services: Rethinking Strategic Focus,” Sloan Management Review, volume 31, Winter 1990a, pp. 79–87.
4. PriceWaterhouseCoopers, “Global Top Decision Makers Study on Business Process Outsourcing” (New York, London: PriceWaterhouseCoopers, Yankelovich Partners, Goldstein Consulting Group, 1998).
5. J. Barnsley explains the reasons and offers the main arguments. See: J. Barnsley, “Outsourcing as a Board-Level Decision I,” Directorship, volume 24, June 1998, pp. 3–5.
6. For a full range of intellectual management activities, see: J.B. Quinn, P. Anderson, and S. Finkelstein, “Leveraging Intellect,” Academy of Management Executive, volume 10, August 1996, pp. 7–27.
7. For the definitions, criteria, and dimensions of effective strategy, see: J.B. Quinn, Strategies for Change (Homewood, Illinois: Irwin, 1980), chapters 1 and 5.
8. For a view of these methodologies in depth, see: J.B. Quinn, K.A. Zien, and J.J. Baruch, Innovation Explosion (New York: Free Press, 1997).
9. Several early articles and books developed this concept in depth. See: J.B. Quinn, Intelligent Enterprise (New York: Free Press, 1992; Quinn, Doorley, and Paquette (1990a); and J.B. Quinn, T.L. Doorley, and P.C. Paquette, “Beyond Products: Services-Based Strategy,” Harvard Business Review, volume 68, March–April 1990b, pp. 58–68.
10. Boston Consulting Group and Braxton Associates were the first groups to develop value chain analyses for other purposes. See: B. Henderson, Henderson On Strategy (New York: Free Press, 1980).Quinn, Doorley, and Paquette were the first to redefine such analyses for core competency purposes. See: Quinn, Doorley, and Paquette (1990b).
11. For a discussion of each and numerous concrete examples, see: Quinn, Zien, and Baruch (1997), chapter 7.
12. Office of U.S. Trade Representative, U.S. National Study on Trade in Services (Washington, D.C., Government Printing Office, 1983).
13. Published in a series of articles including: J.B. Quinn, “Technological Innovation, Entrepreneurship, and Strategy,” Sloan Management Review, volume 20, Spring 1979, pp. 19–30; Quinn (1980); J.B. Quinn, “Managing Innovation: Controlled Chaos,” Harvard Business Review, volume 63, May–June 1985, pp. 73–84; and J.B. Quinn, “Innovation and Corporate Strategy,” Technology in Society, volume 7, 1985, pp. 263–279.
14. For perhaps the first systematic presentation of this concept for guiding technological activities, see: J. Bright, Technological Forecasting for Industry (Englewood Cliffs, New Jersey: Prentice Hall,1974).
15. The U.S. Air Force, in the design of combat aircraft, was probably the first institution to use this technique consistently and call it by this term, although DuPont used it extensively to establish priorities for its 1930s plastics introductions.
16. National Research Council, Information Technology in the Services Society (Washington, D.C.: National Academy Press, 1994).
17. Hewett Associates Study, reported in “Beyond Benefits: The Changing Face of HR Outsourcing,” Benefits Quarterly, volume 13, first quarter, 1997, pp. 41–46.
18. R. Maurer and N. Mobley, “Outsourcing: Is It the HR Department of the Future?” Personnel, volume 75, November 1998, pp. 9–10; and S. Lever, “An Analysis of Motivations Behind Outsourcing Practices in Human Resources,” Human Resource Planning, volume 20, number 2, 1997, pp. 37–47.
19. For a description of Andersen’s approach in some detail, see: F. Julien and L. Rieger, “Winning of the Game: Strategic Risk Management,” Bank Securities Journal, volume 7, September–October 1998, pp. 10–16.
20. For in-depth critical concepts and numerous examples for all phases of the innovation process, see: J.B. Quinn, J.J. Baruch, and K.A. Zien, “Software-Based Innovation,” Sloan Management Review, volume 37, Summer 1996, pp. 11–24; and Quinn, Zien, and Baruch (1997), chapter 2.
21. For the classic economic statement, see: R. Coase, “The Nature of the Firm,” Economica, volume 4, November 1937, pp. 386–405.
22. D. Williamson, “Transaction Costs,” Economic Organization: Firms, Markets and Policy Control (New York: New York University Press, 1986).
23. R. D’Aveni and R. Ravenscraft, “Economies of Integration vs. Bureaucracy Costs: Does Vertical Integration Improve Performance?” Academy of Management Journal, volume 37, October 1994, pp. 1167–1206.
24. J. Kotter and J. Heskett, Corporate Culture and Performance (New York: Free Press, 1992); and C.A. O’Reilly and M.L. Tushman, “Using Culture for Strategic Advantage: Promoting Innovation through Social Control,” in M. Tushman and P. Anderson, Managing Strategic Innovation and Change (New York: Oxford University Press, 1996), pp. 200–216.
25. R. Garner, “Strategic Outsourcing: It’s Your Move,” Datamation, volume 44, February 1998, pp. 32–41; and M. Useem, “The Lateral Leap,” Chief Executive, volume 136, July–August 1998, pp. 58–59.
26. F. Casale, “The Emerging Role of the Resource Officer,” The Source, volume 4, Summer 1998, pp. 1–4.
27. Strategic tracking systems monitor elements of the outside supplier’s performance that could affect the viability or direction of the company —not merely its cost efficiency. Strategic monitoring systems constantly reassess such things as the supplier’s personnel and facilities investments, partnership and marketing positions, changing strategic risks, and geographic and portfolio investments.
28. R. Hiebeler, T. Kelly, and C. Ketterman, Best Practices: Building Your Business With Customer Focused Solutions (New York: Simon & Schuster, 1998).
29. H. Mintzberg, Mintzberg on Management: Inside Our Strange World of Organizations (New York: Free Press, 1989).
30. For an amplification of this concept with many useful examples, see: D. Leonard Barton, Wellsprings of Knowledge (Boston: Harvard Business School Press, 1995) .
31. E. von Hipple, Sources of Innovation (New York: Oxford University Press, 1988).
32. Many books have outlined both the difficulties of and techniques essential to maintaining partnership relationships, such as: F. Contractor and P. Lorange, Cooperative Strategies in International Business (San Francisco: Livingston Books, 1987); J. Lewis, Partnerships for Profit, Structuring and Managing Strategic Alliances (New York: Free Press, 1990); and T. Collins and T. Doorley, Teaming Up for the 90s (Homewood, Illinois: Irwin, 1991).
33. PriceWaterhouseCoopers (1998).
34. J. Aley, “Where the Laid Off Workers Go,” Fortune, volume 132, 30 October 1995, pp. 37–38.
i. For a discussion of numerous in-depth methods, see: J.B. Quinn, K.A. Zein, and J.J. Baruch, Innovation Explosion (New York: Free Press, 1997), chapter 7, “Creating ‘Best-In-World’ Capabilities,” pp. 187–215.
ii. J.B. Quinn, P. Anderson, S. Finkelstein, “Managing Professional Intellect: Getting the Best From the Best,” Harvard Business Review, volume 74, March–April 1996, pp. 71–80.
iii. H. Mintzberg and J.B. Quinn, “Sony Corporation: Innovation System” (Case), The Strategy Process (Englewood Cliffs, New Jersey: Prentice Hall, 1996), p. 595.