Case Study on Outsourcing

Academy o/ Management Executive. 2003, Vol. 17. No. 2

The seven deadly sins of outsourcing

Jerome Baitheiemy

Executive Overview While outsourcing is a powerful tool to cut costs, improve performance, and refocus on

the core business, outsourcing initiatives often fall short of management's expectations. Through a survey of nearly a hundred outsourcing efforts in Europe and the United States, I found that one or more of seven "deadly sins" underlie most failed outsourcing efforts: (1) outsourcing activities that should not be outsourced; (2) selecting the wrong vendor: (3) writing a poor contract; (4) overlooking personnel issues; (S) losing control over (he outsourced activity; (6) overlooking the hidden costs of outsourcing: and (7) failing to plan an exit strategy (i.e., vendor switch or reintegration of an outsourced activity^. Outsourcing failures are rarely reported because firms are reluctant to pubJicize them. However, contrasting them with more successful outsourcing efforts can yield useful "best practices."

Outsourcing can be defined as turning over all or part of an organizational activity to an outside ven- dor. In the services industry, outsourcing was tradi- tionally restricted to basic support activities. It was also primarily used when restructuring firms that were in bad financial shape. Today, outsourcing per- vades the management of most companies. It has also become increasingly clear that outsourcing is more than a passing fad. According to a report from the Economist Intelligence Unit, 34 per cent of firms outsourced all or part of their information technology (IT) in 1997. The proportion was expected to reach 58 per cent by 2010. Similar increases are expected for activities such as telecommunications, accounting, and human resources.'

Empirical evidence suggests that carefully crafted outsourcing strategies increase the overall performance of the firm.̂ As the CEO of a medium- sized firm that had outsourced activities a s diverse a s IT, logistics, financial services, and facilities management pointed out: "Outsourcing enabled us to double our operating income before tax while our revenues remained stable." Outsourcing is generally considered a s a very powerful tool to cut costs and improve performance. Through outsourc- ing, firms can take advantage of the best outside vendors and restructure entrenched departments that are reluctant to change. Outsourcing can also help focus on the core business. Since building

core competencies and serving customer needs is critical to firm success, anything that detracts from this focus may be considered for outsourcing.^ His- torically, many activities were performed inter- nally because there were no outside suppliers. The continuing growth of supply markets has provided the opportunity to reassess which activities should remain in-house and which should be outsourced.''

While firms may now have the opportunity to outsource, outsourcing initiatives do not necessar- ily fulfill all their expectations. For instance, three quarters of the U.S. managers surveyed by the American Management Association reported that outsourcing outcomes had failed to meet expecta- tions.^ While literature on outsourcing h a s often sought to draw lessons from highly visible compa- nies that have been successful in outsourcing, this article sheds light on failed efforts.^ Failed out- sourcing endeavors are rarely reported because firms are reluctant to publicize them. Firms do not like to report their failures because such informa- tion can damage their reputation.' However, valu- able "best practices" can be inferred from out- sourcing failures, especially when such failures are compared with successful outsourcing efforts.

My study is based on an in-depth analysis of 91 outsourcing efforts carried out by European and North American firms. Primary data was collected through face-to-face interviews and a detailed

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questionnaire with managers in charge of out- sourced activities. While most current research on outsourcing focuses on a single activity (typically IT), this article simultaneously deals with several crucial services such as IT, telecommunications, logistics, and finance (See the Appendix for more details on the empirical research). Through this survey, I found that the same mistakes underlie most failed outsourcing efforts. These mistakes have been termed the seven deadly sins of out- sourcing. It is likely that firms will encounter each of the deadly sins at some time during the out- sourcing process. Though the deadly sins are con- ceptually distinct, they are not mutually exclusive. Hence, they must be viewed a s interrelated com- ponents of a complex system.

First Deadly Sin: Outsourcing Activities That Should Not Be Outsourced

In the early 1990s, the newly appointed top man- agers of a car rental company decided to outsource information technology (IT) to reduce costs. At that time, IT costs stood at 5 per cent of revenue, which was higher than the industry average (3 to 4 per cent). Three years into the outsourcing contract, IT costs stood at 10 per cent of revenue and the car rental firm could not get out of the contract. Accord- ing to the chief information officer: "The entire IT department has been outsourced, but we should have kept applications development and mainte- nance in-house. These activities are too close to our core business, and it's hard not to have total control over them . . . If the vendor goes bankrupt, all I can do is try to hire its former employees."

Insights for Managers

Outsourcing is often associated with automatic cost reduction and performance improvement. This overly optimistic view of outsourcing derives from the fact that most articles about outsourcing are writ- ten during the so-called "honeymoon" period (i.e., just before or after the contract is signed). At that time, the reported benefits are not actual but only projected. This leads to a bandwagon phenomenon, where firms outsource to mimic competitors they ex- pect will be successful with outsourcing.^

Determining which activities can be best per- formed by outside vendors requires a good under- standing of where the firm's competitive advan- tage comes from. Resources and capabilities that are valuable, rare, difficult to imitate, and difficult to substitute for lead to superior performance.^ Ac- tivities that are based on such resources and ca- pabilities (i.e., core activities) should not be out-

sourced because firms risk losing competitive advantage and becoming "hollow corporations.""^ On the other hand, non-core activities may be out- sourced for two reasons. First, outsourcing non- core activities allows firms to focus on the activi- ties they do best and improve their overall performance." Second, transferring non-core activ- ities to specialized vendors can help reduce the costs and improve the performance of such activi- ties.'^

Determining which activities can be best performed by outside vendors requires a good understanding of where the firm's competitive advantage comes from.

In the middle of the 1990s, for instance, a high- tech firm decided to set up a new subsidiary to enter the Southern European market. This firm de- fined its core business a s designing, manufactur- ing, and selling high-resolution color screens. All the activities that didn't belong to any of these categories (e.g., logistics, after-sales service, and various types of marketing activities) were out- sourced to outside vendors. This strategy enabled the high-tech firm to enter the new market not only quickly but also at very low cost. This successful outsourcing effort can be compared with the case of the car rental company above. Outsourcing IT applications development and maintenance was clearly a mistake. The car rental industry is a highly IT-intensive industry where a good reserva- tions system is the key to competitive advantage. Therefore, the IT applications that underpin reser- vation systems were too close to the core business to be safely outsourced.

As most activities have parts that belong to the core business and parts that do not, implementing a core vs. non-core dichotomy at the firm level often proves difficult. Hence, the core vs. non-core dichotomy should rather be implemented at the activity level.'^ For instance, an oil company de- cided to outsource IT. Several competitors had al- ready done so, and their endeavors weren't always successful. As their lack of total success could largely be attributed to total outsourcing (i.e., out- sourcing the entire activity), the oil company care- fully separated core from non-core IT activities. As the IT outsourcing project leader put it: "The rec- ommendation to outsource was drafted by a study feam who examined the overall effectiveness of IT service delivery and determined that only non- strategic commodity services could be outsourced fo external third parties. This recommendation

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was then endorsed by a corporate council consist- ing of operating company presidents and corpo- rate executives." This company ended up outsourc- ing mainframe, telecommunications {LANAVAN voice and data operations, management, and sup- port), cross-functional (help desk, change coordina- tion, service coordination) and carrier services. Crucial IT activities such as application develop- ment and maintenance were kept in-house.

Second Deadly Sin: Selecting the Wrong Vendor

Acting on instructions from its U.S. headquarters, a European equipment manufacturer outsourced its entire logistics activity.''* The logic underlying this decision was the following. While most customers wanted increasingly small and frequent deliver- ies, the U.S. top management was not sure that the internal logistics department of their European subsidiary had a sufficient level of expertise to implement a just-in-time organization. They also knew that a badly implemented just-in-time organ- ization results in tremendous costs. As the head- quarters asked for the move to be made very quickly, the managers of the subsidiary had to find a third-party logistics provider, sign a contract, transfer the activity, and hand over the manage- ment, all within only six months. Shortly after the contract was signed, things started going sour a s the third-party provider did not live up to expecta- tions. Goods were either delivered too late or not delivered at all. There were large shortfalls in in- ventory. A benchmark study showed that this par- ticular subsidiary had the highest logistics costs of all European subsidiaries.

Insights for Managers

Selecting a good vendor is crucial for successful outsourcing. In the case above, for instance, the third-party logistics provider was selected be- cause it had offered the lowest bid. However, its main business was transportation. It did not have the capabilities to manage a full logistics function, let alone implement a just-in-time organization. The client's requirements had been made clear from the outset, and the failure of this outsourcing effort could essentially be attributed to a lack of expertise of the third-party logistics provider.

While one important argument for outsourcing is that specialist vendors have lower costs than their clients, it is important to note that firms do not necessarily outsource to cut costs.'^ According to the VP of supply chain management of a U.S. con- sumer goods firms, outsourcing logistics to a third- party provider is more expensive than keeping lo-

gistics in-house. Yet, the cost increase is more than offset by an increase in revenues and a reduction in opportunity costs. Revenues increase due to the ability to implement innovative logistics practices, and economic value-added (EVA) measures im- prove because outsourcing avoids keeping fixed assets,'"''

Firms do not necessarily outsource to cut costs.

The literature has identified numerous criteria for successful provider choice.'^ A useful distinc- tion can be made between hard and soft qualifica- tions:

• Hard qualifications are tangible and can be easily verified by due diligence. They refer to the ability of vendors to provide low-cost and state-of-the-art solutions. Important criteria also include business experience and financial strength.

• Soft qualifications are attitudinai. They may be non-verifiable and may change depending on circumstances. Important soft criteria include a good cultural fit, a commitment to continuous improvement, flexibility, and a commitment to develop long-term relationships. Trustworthi- ness is an important soft criterion.'^ High levels of trust are often associated with outsourcing success.'^ In most cases, the client and the ven- dor have different business objectives that can result in conflicts of interest. For instance, the beginning of the contract is generally more ben- eficial for the client than for the vendor.^° As time goes by, the contract becomes subject to negotiation and misunderstanding. As one of the interviewees bluntly put it: "Outsourcing is a profitable operation in the short run. It must remain profitable in the long run."

The surest way to spot the best providers—on both hard and soft criteria—is through first-hand infor- mation. A useful technique is to entrust a large number of vendors with commodity activities be- fore outsourcing more sensitive activities to the best vendors.^' A manager from a large European energy firm reported: "We spent approximately two years with small deals and a large number of suppliers, followed by one year taking a "strategic position" and outsourcing to an alliance of a few key players." Not surprisingly, outsourcing turned out to be a huge success in this firm.

First-hand experience is both a time-consuming and costly way to discover whether or not a vendor is proficient and trustworthy. An alternative and

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less costly way is to use second-hand experience (i.e., to examine the vendor's reputation). A reputa- tion for proficiency and trustworthiness is a useful asset that vendors care about because it helps attract new clients.^^ However, issuing a Request For Proposal is often not enough to determine whether a vendor has a good reputation. Inter- views with clients of potential vendors and indus- try experts are useful to learn about the technical skills and the reliability of potential vendors.

Third Deadly Sin: Writing a Poor Contract

A European bank outsourced its entire telecommu- nications network \o cut costs and refocus on its core business. This endeavor turned out to be a complete failure with increasing costs and de- creasing service quality. The main reason for the failure was that the management had rushed to enter the relationship with the vendor. Too little time was spent on developing a good contract and several mistakes were made. The contract, though very long, was not precise. For instance, the bank had to pay extra fees even for basic services. There were no objective performance measurement clauses either. Fixed fees had been set when the client's business was booming. As turnover shrunk, the ratio of telecommunications fixed fees to total revenue became increasingly large. More- over, the contract made it impossible to switch vendors even after the relationship with the incum- bent vendor had become increasingly sour.

Insights for Managers

Since the 1980s, vendor partnerships have emerged a s a model of purchasing excellence. Partnerships replace market competition by close and trust-based relationships with a few selected vendors.^^ The no- tion that outsourcing vendors are partners and that contracts play a minor role was popularized by a landmark IT outsourcing deal. In 1989, Eastman Kodak outsourced a large part of its IT operations to IBM, Digital Equipment, and Businessland. As the relationships between Eastman Kodak and its ven- dors were both cooperative and based on loose con- tracts, it has been wrongly inferred that tight con- tracts were not necessary to be successful with outsourcing. However, there are pitfalls in partner- ship management.^^ A good contract is essential to outsourcing success because the contract helps es- tablish a balance of power between the client and the vendor.^^ Spending too little time negotiating the contract and pretending that the partnership rela- tionship with the vendor will take care of everything is a mistake.26 Drafting a good contract is always

important because it allows partners to set expecta- tions and to commit themselves to short-term goals. Moreover, it provides a safety net in case the rela- tionship fails.

Regarding the actual content of the contract, I found that the best contracts are simultaneously:

• Piecise. Ill-defined contracts often result in high costs and poor service levels. Cost and perfor- mance requirements should be established from the outset and clearly specified in the contract.^^

• Complete. Writing a contract that is a s complete a s possible has two important benefits. First, the more complete the contract, the smaller the risk of potential opportunism of the vendor. Second, the more complete the contract, the smaller the probability that it will involve costly renegotia-

• Incentive based. The contract should be written to encourage the right behavior from the vendor. For instance, the vendor may get a bonus when its performance boosts indicators of business value. This incentive could help align the goals of vendors with the business objectives of their clients. The contract should also address how the relationship will change over its life cycle. For example, unit-based pricing may be used at the beginning of the relationship. The pricing could switch to cost-plus a s the relationship de- velops. The contract could eventually call for a change to a gain-sharing arrangement so that the client and the vendor have a joint stake in the outcome.

• Balanced. In general, one-sided contracts do not last long. Even a contract that is weighted against the vendor is not necessarily beneficial for the client: service levels quickly drop, and the vendor tries to win back some value by im- posing extra fees.

• Flexible. Due to evolving technology and chang- ing business conditions, medium and long-term outsourcing contracts should not be written in an inflexible way. Flexibility clauses can help both parties accommodate to environmental changes.2^

The failure experienced by the European bank can essentially be attributed to a badly drafted con- tract that lacked preciseness (i.e., extra fees had to be paid even for basic services), flexibility (i.e., fixed fees had been set when the business was booming) and completeness (i.e., it was impossible to switch vendors because extremely huge penal- ties would have been incurred). The bank learned the hard way. As pointed out by a manager: "Spend a s much time a s possible developing the contract. A contract is an investment whose value

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really becomes apparent if the relationship with the supplier becomes sour."

Fourth Deadly Sin: Overlooking Personnel Issues

A European department store had to close for two days because its 70 facilities management person- nel went on strike. The shutdown took place during an important sales promotion and resulted in the loss of several million Euros. This strike was partly due to constant rumors that facilities management would be outsourced. These rumors were essen- tially fueled by the fact that retiring facilities management employees were never replaced. Basically, their colleagues were afraid of being transferred to the vendor (with lower pay and ben- efits) or being laid off.

Insights /or Managers

The efficient management of personnel issues is crucial because employees generally view out- sourcing a s an underestimation of their skills. This may result in a massive exodus even before an actual outsourcing decision has been made. Se- crecy in outsourcing feasibility and decision- making is very difficult, and open communication is the key to managing personnel issues in out- sourcing. When attempts at secrecy fail, rumors start spreading. As soon a s employees know that outsourcing is under consideration, counterpro- ductive anxiety arises and employees begin hand- ing in their notice in anticipation of outsourcing.

The efHcient management of personnel issues is crucial because employees generally view outsourcing as an underestimation of their skills.

Firms that contemplate outsourcing must face two interrelated personnel issues. First, key em- ployees must be retained and motivated. For most activities, outsourcing does not mean transferring all the employees to the vendor. When an activity has been performed in-house for a long period of time, firm-specific knowledge about how to run the activity smoothly has accumulated. Employees who possess this firm-specific knowledge must be identified. To keep them in-house, the manage- ment must be prepared to offer them higher sala- ries and benefits. Outsourcing has a negative im- pact on employees' sense of job security and loyalty even when they keep their positions within the firm. This may lead to decreased productivity

or even dysfunctional actions such a s strikes. New responsibilities may be offered to secure the com- mitment of retained employees. Generally, their role tends to shift from service delivery to interface with the vendor and end users. This important shift requires new skills that can only be acquired through considerable training and ongoing sup- port.

A second personnel issue is that the commitment of employees transferred to the vendor must also be secured. As a manager in charge of a finance outsourcing contract put it: "Retention of knowl- edge and skills is a key issue. Irrespective of the profile of the service provider, the actual work is done by individuals harnessing their skills, knowl- edge, experience, and the technology available to them. If high staff turnover is experienced, then the quality of the work will deteriorate noticeably, par- ticularly in specialist technical areas and analyt- ical work." The outcome of an outsourcing effort is highly dependent on the commitment of employees who have been transferred to the vendor. Employ- ees working in activities that do not belong to the firm's core business are often given low-priority. Once they are transferred to specialist vendors, they may be offered opportunities for better career paths in what is regarded a s the vendor's core business. To many employees, vendor employment is more attractive than continued employment in an organization where the outsourced activity is viewed a s a mere utility.

Taking ethical considerations into account can help avoid most personnel issues related to out- sourcing.^'^ A utilities firm paid very careful atten- tion to its employees when the decision was made to outsource 85 per cent of its IT budget to an outside vendor. The CIO summarized: "We wanted to find a solution that was not detrimental to the IT employees." In this deal, the vendor was contrac- tually asked to offer the same pay and benefits to the 160 employees transferred to the vendor. The vendor also promised to neither fire outsourced employees nor to transfer them to other accounts without their approval. The outsourcing deal was endorsed by the works council and finally turned out to be quite successful.

At first glance, it seems surprising that firms may gain something from outsourcing if they merely transfer their employees to the third party and ask that they maintain the same pay and ben- efits. However, there is more to outsourcing than transferring people and renegotiating their pay and benefits. Multiple clients enable specialized vendors to operate at a scale unattainable by their individual clients. Because of the variety of their clients, specialized vendors also have a depth and

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range of experience that an individual client can- not match.3i

Fifth Deadly Sin: Losing Control Over the Outsourced Activity

Outsourcing at a specialty retail firm had resulted in the total dismantling of the internal IT depart- ment. Shortly after the outsourcing decision had been made, the CIO was left alone to manage the vendor. Outsourcing ended up a s a downright fail- ure. IT costs increased by 20 per cent, and IT per- formance did not improve at all. The five-year con- tract was cancelled three years after it was signed. According to the CIO, outsourcing had resulted in "a total and dangerous loss of control over IT, in- ability to cope with the changing environment and command over the future." He also noted that "while there are important cost decreases at the beginning of the relationship, extra costs are quickly incurred."

Insights /or Managers

When the performance quality of an activity is low, managers are often tempted to outsource it. If poor performance is attributable to factors such a s in- sufficient scale economies or a lack of expertise, outsourcing makes sense. If poor performance is attributable to poor management, outsourcing is not necessarily the right solution. On the one hand, it is often easier to manage an outside vendor than an in-house department.^^ Qn the other hand, out- sourcing entails great changes regarding the man- agement of an activity. With outsourcing, control through direct ownership of assets and employ- ment of staff is replaced by control through a con- tract. Instead of issuing orders, managers in charge of outsourced activities must negotiate re- sults with vendors. They must also ensure the ef- fective use of the outsourced service by internal users who are often reluctant to work with external vendors.

For an outsourcing client, it is particularly im- portant to avoid losing control over an outsourced activity. Such a loss of control has two distinct origins. First, the client may not have the capabil- ities to manage the vendor. Second, the client may not actively manage the vendor. In the case of the specialty retail firm explained above, two mis- takes were made simultaneously. The internal IT department was totally dismantled, and the CIO was not sufficiently involved in the management of the vendor. He had very few contacts with the vendor's management, meeting them formally

once a month and informally less than once a week.

When an activity is outsourced, it is crucial to retain a small group of managers to handle the vendor. These managers must be able to develop the strategy of the outsourced activity and keep it in alignment with the overall corporate strategy. While vendor management skills are very impor- tant, they must also be complemented with techni- cal skills. If no one in the company is able to assess technological developments, outsourcing is bound to fail. New employees may even need to be hired to manage the outsourcing vendor. Outsourcing clients should essentially look for managers with prior experience in outsourcing or joint-venture management, involvement in an outsourced activ- ity, and experience in leading cross-functional teams.^^ When a department store outsourced part of its IT, 85 per cent of the IT employees were transferred to the vendor. Half of the remaining personnel were dismissed shortly thereafter. It turned out they were neither able to manage the vendor nor handle changes in the scope of the outsourcing contract. They were replaced by man- agers with extensive experience in outsourcing.

When an activity is outsourced, it is crucial to retain a small group of managers to handle the vendor.

Outsourcing does not mean abdicating! A lack of active management must be avoided at all cost, as the following example clarifies. A computer man- ufacturer outsourced a large part of its after-sales service activity. Though the rationale for outsourc- ing was essentially cost reduction, a high standard of performance from the vendor was also impor- tant. In the computer industry, after-sales service is crucial, and the computer manufacturer did not want to lose business due to its outsourcing ven- dor. The first way to deal with this important issue was to devise a contractual clause stating that the vendor had to fix 85 per cent of the problems en- countered by end-users within a day. However, the interviewee made clear that such a clause is use- less if it is not correctly implemented. As he ex- plained: "Without a constant monitoring of the vendor, its performance rate would decrease to around 70 per cent [instead of 85 per cent]). We cannot accept such a low rate because it would result in a loss of business for us." While a good contract is necessary, good enforcement is also essential.

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Sixth Deadly Sin: Overlooking the Hidden Costs oi Outsourcing

Table 1 compares the hidden costs of two logistics outsourcing contracts. The first case is a manufac- turing firm which outsourced a subset of its logis- tics activity: warehousing. In this firm, warehous- ing was considered a commodity. The second case is a manufacturing firm which outsourced its en- tire logistics function. To take over this activity, the vendor had to acquire specialized knowledge about the business of its client and the idiosyncra- sies of its logistics activity.

Insights for Managers

Outsourcing clients are generally confident that they can assess whether or not outsourcing results in cost savings. However, they olten overlook costs that can seriously threaten the viability of out- sourcing efforts.- '̂' Transaction cost economics (TCE) suggests two main types of outsourcing hid- den

• Outsourcing vendor search and contracting costs. Search costs are the costs of gathering intormation to identify and assess suitable ven- dors. Contracting costs are the costs of negotiat- ing and writing the outsourcing contract. Both search and contracting costs are incurred before the outsourcing operation actually takes place;

• Outsourcing vendor management costs. These costs have three different dimensions: monitor- ing the agreement to ensure that vendors fulfill their contractual obligations, bargaining with

vendors and sanctioning them when they do not perform according to the contract, and negotiat- ing changes to the contract when unforeseen circumstances arise. Outsourcing vendor man- agement costs are incurred while the outsourc- ing operation actually takes place.^^

TCE suggests that the hidden costs of outsourcing are essentially influenced by the idiosyncrasy of the resources underlying outsourced activities.^'^ Specific physical resources refer to specialized equipment tailored to a single firm's requirements. Specific human resources refer to expertise that employees have acquired through years of train- ing and that is useful only in the context of a single firm. When idiosyncratic resources have been transferred to an outside vendor, switching ven- dors or reintegrating the outsourced activity is quite difficult. As vendors know they cannot easily be replaced, they may act opportunistically. Op- portunistic expropriation occurs when vendors standardize IT services instead of offering unique services. While such commoditization enables vendors to reap greater economies of scale, it also means that the unique needs of their clients are no longer met.̂ ^ Firms that select the right vendor and write up a good contract are less likely to suffer from the potential opportunism of their vendor. A good vendor must be proficient and trustworthy {see second deadly sin). A good contract must be simultaneously precise, complete, incentive based, balanced, and flexible (see third deadly sin).

However, searching for a reliable vendor and

Table 1 The Hidden Costs of Outsourcing in Two Logistics Cases

Contract amount Contract duration

Number of internal employees Outside consultants and lawyers Total search and contracting cost Fiatio of total search and contiacting cost

Low level of idiosyncrasy (i.e., warehousing)

$1.5 million 1 year

Search and contracting costs

4 0

$10,000 to to(a] con(rac( amount 0.7%

Vendor management costs

High level of idiosyncrasy (i.e..

entire logistics function)

$4 million 3 years

5 4

$250,000 6.2%

Number of employees Number of formal meetings per year Number of informal meetings per year Annual vendor management costs Ratio of annual vendor management costs to total contract amount

2 1 4

$100,000 6.7%

2 12 12

$200,000 15%

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draiting a good contract is expensive. In the two cases stated above, search and contracting costs were nearly ten times higher for the entire logistics activity than for the warehousing outsourcing con- tract (6.2 per cent vs. 0.7 per cent). Vendor manage- ment costs were more than twice a s high for the entire logistics activity as for warehousing (15 per cent vs. 6.7 per cent).^^ The figures for the second case were high enough to nullify the cost savings from outsourcing.

The hidden costs ol outsourcing are an important topic for managers because they can challenge the rationale for outsourcing. It is also paradoxical that these costs are both necessary and detrimen- tal to the outcome of outsourcing efforts. While successful outsourcing requires substantial spend- ing on vendor searching, contracting, and manage- ment costs, these costs can also turn potentially successful outsourcing efforts into a complete fail- ure. While carefully selecting the vendor and craft- ing contracts with well-articulated expectations and clearly set performance measures is expen- sive, such expenses are necessary to keep vendor management cost at a decent level. Considering the potential impact of the hidden costs of out- sourcing, it may be worth the additional cost of hiring outside experts. Such experts are familiar with outsourcing and know how certain pitfalls can be avoided. Legal experts are useful when it comes to writing the outsourcing contract and ne- gotiating with the vendor. Technical experts can help develop precise measures such a s service- performance level.

The hidden costs of outsourcing are an important topic for managers because they can challenge the rationale for outsourcing.

Seventh Deadly Sin: Failing to Plan an Exit Strategy

One retail company outsourced several IT activities that senior management considered to be commodi- ties (data centers, applications maintenance, and user support). However, outsourcing failed due to high costs and low performance. Though the vice president of information services wanted to get out of the contract, he was reluctant to cancel it. Indeed, he knew that a vendor switch would take over six months while reintegrating the activities would re- quire as much a s ten months. All he could do was to

renegotiate the contract, implementing a 15 per cent reduction in services due to poor performance.

Insights for Managers

Many managers are reluctant to anticipate the end of an outsourcing contract. Therefore, they often fail to plan an exit strategy (i.e., vendor switch or reintegration oi an outsourced activity). For in- stance, the manager in charge of a facilities man- agement outsourcing contract stressed that "this outsourcing deal is based on a long-term relation- ship. A vendor switch is altogether out of the ques- tion." This attitude is a mistake because switching vendors does not necessarily mean that outsourc- ing didn't work. Shrinking the vendor base and establishing long-term relationships with a few selected vendors is not always the best solution.

Actually, outsourcing relationships can be viewed on a continuum. At one end are long-term relation- ships where investments specific to the relationship have been made by one or both partners. There is a considerable advantage in recontracting with the same vendor because switching vendors or reinte- grating the outsourced activity is very difficult.̂ ^ At the other end are market relationships where the client has a choice of many vendors and the ability to switch vendors with little cost and inconvenience. In this case, there is no real advantage in recontracting with the same vendor. For instance, a firm in the computer industry successfully outsourced telemar- keting. The duration of the contract was only one year. Every year, the incumbent vendor's price and performance were benchmarked against other ven- dors. If the incumbent vendor had not made the best offer, its contract would never have been renewed.

Managers who do not want to anticipate the end of an outsourcing relationship also have a ten- dency not to include material reversibility clauses (i.e., option to buy back premises and equipment from the vendor) and human reversibility clauses (i.e., option to hire back employees from the ven- dor) in the contract. The absence of such clauses leads to weak power bases for any negotiation with the vendor and makes it very difficult to back out of an outsourcing agreement.'" This is exactly what happened in the case of the retail firm de- scribed above. Even when an outsourced activity is not very idiosyncratic, it is important to plan an exit strategy. Switching vendors or reintegrating the outsourced activity was hardly feasible be- cause it had not been anticipated in the contract.

Table 2 summarizes the seven deadly sins of outsourcing and the lessons to be learned.

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Table 2 The Seven Deadly Sins of Outsourcing and Lessons Learned

Timetable Deadly sin Lesson learned

Original idea to outsoutce

Beginning ol the relationship

Outsourcing activities that should not be outsourced

Selecting the wrong vendor

Writing a poor confract

Overlooking personnel issues

Losing control over the outsourced activity

Overlooking the hidden costs of outsourcing

Vendor switch or reintegration of Tailing to plan an exit strategy the outsourced activity

Only activities that do not belong to the core business can be safely outsourced. The core vs. non-core approach can be implemented both at the lirm and activity level.

Outsourcing clients should look for vendors that are able to provide state-of-lhe-art solutions and are trustworthy.

The contract is the main tool to establish a balance oi power in outsourcing relationships. Good contracts have four characteristics. They must be precise, complete, balanced, and flexible.

Loss of key employees and lack of commitment can seriously threaten the viability of outsourcing efforts. However, good communication and ethical behavior towards employees can help avoid such problems.

In order to keep control over outsourced activities, clients must retain a small group of qualified managers. An active management of the vendor is also crucial.

The hidden costs (i.e., search, contracting, and managing costs) can threaten the viability of outsourcing efforts. Hidden costs are likely lo be lower when commodities are outsourced.

The end of the outsourcing contract musi be planned from the outset. Building reversibility clauses into the contract is crucial.

Outsourcing: Dangers and Opportunities

Historically, outsourcing was restricted to basic support activities such a s janitorial services. To- day, outsourcing has extended to more crucial ac- tivities such a s IT, telecommunications, finance, and logistics. Increasingly complex types oi out- sourcing have developed. For instance, the emer- gence of fourth-party logistics providers is a major trend with U.S. auto manufacturers. General Mo- tors has a joint-venture with Menlo Logistics, called Vector. Vector is responsible for all out- bound logistics for General Motors. It operates a s a fourth-party provider that manages multiple third- party providers for GM.'*̂

Based on a survey of 91 outsourcing efforts, I uncovered seven major pitfalls that can threaten the viability of outsourcing efforts. As shown in the Appendix, statistical results confirm that the seven deadly sins are good differentiators between out- sourcing success and failure. Several important implications can be drawn from the statistical re- sults:

• Some sins were "deadlier" than others. "Writing a poor contract" and "losing control over the outsourced activity" had the largest impact on the outcome of outsourcing efforts. On the other hand, "failing to plan an exit strategy" was not a good differentiator between success and failure.

perhaps because planning an exit strategy only becomes necessary in the case of vendor switch or reintegration of an outsourced activity;

• Mistakes were made even in successful out- sourcing efforts. Mistakes such a s "outsourcing activities that should not be outsourced," "writ- ing a poor contract," and "failing to plan an exit strategy" were the most frequent. However, mak- ing only one or two mistakes does not necessar- ily lead to failure.

"Writing a poor contract" and "losing control over the outsourced activity" had the largest impact on the outcome of outsourcing efforts.

By contrasting successful and failed outsourcing efforts, I provided advice on how to avoid the seven deadly sins of outsourcing. An important message of this article is that some outsourcing efforts are doomed to fail even before the relationship with the vendor has actually started. When a firm has outsourced activities that should not be out- sourced, selected the wrong vendor, and written a poor contract, the likelihood of success is close to zero.

96 Academy of Management Executive May

To be successful with outsourcing, iirms need to accumulate the expertise required to avoid the seven deadly sins of outsourcing. Such a process is unfortunate both time consuming and costly. Throughout this research, I noticed that this exper- tise was rarely capitalized at the company level. This is unfortunate as my research suggests that the seven deadly sins are very similar from one outsourced activity to the other. Hence, I strongly believe that firms using substantial outsourcing could gain a lot from setting up a department de- voted to capitalizing outsourcing management ex- pertise.'*^ Such a department may be charged with sharing and leveraging prior outsourcing experi- ence and knowledge throughout the company. Set- ting up a dedicated outsourcing function may be a luxury for small firms or firms that do little outsourc- ing. In that case, outsourcing-related information may be collected at the purchasing department level.

Outsourcing is a way for firms to cut costs, im- prove performance, and focus their limited re- sources on their core business. However, outsourc- ing can also be dangerous when it is not properly implemented. Firms must think seriously about how they will manage the deadly sins before mak- ing their actual outsourcing decisions.

Appendix: Information on Companies and Outsourcing Operations Profiles

My findings are based on an extensive analysis of the aca- demic literature and an in-depth study of 91 outsourcing cases with various characteristics (see "Company profiles" and "Out- sourcing operations profiles"). Primary data were collected through detailed questionnaires and interviews. There are two broad types of outsourcing; (1) outsourcing a s an alternative to vertical integration and (2) outsourcing a s a means to vertically disintegrate {i.e., outsourcing activities that were performed in-house). In this article, I focus on the second type of outsourc- ing. To detect announcements for outsourcing contracts, I con- ducted an exhaustive electronic search of two major databases: ABI/INFORM-GLOBAL and REUTERS. I was able to compile an initial sample of 816 "vertical disintegration" outsourcing cases. Questionnaires were then obtained for 91 cases (yielding an 11 percent response rate). Each questionnaire came irom a different iirm. The respondents were senior executives respon- sible for outsourced activities. Due to financial constraints, I could only conduct interviews for approximately half the cases. Unless otherwise noted, all presented data and illustrations are irom this research project.

To assess whether outsourcing efforts were successes or fail- ures, I used a five-point Likert scale (Irom "not satisfied at all" to "totally satisfied"). Outsourcing efforts were considered suc-

cesses when managers were "very satisfied" or "totally satis- fied." They were considered failures when managers were "not satisfied at all," "not satisfied," or "moderately satisfied." Using this methodology, 63 per cent of the outsourcing efforts were considered successes and 37 per cent were considered failures. To check the reliability of my measure, I developed an objective indicator oi outsourcing success using nine binary items: (1) cost reduction. (2) ability to turn ilxed costs into variable ones, (3) control of expenses, (4) personnel management, (5) overall performance, (6) access to better competencies, (7) access to better skilled personnel, (8) improved service quality, and (9) reallocation of resources to the core business. The average number of objectives met was respectively 3.2 for outsourcing failures and 6.8 for outsourcing successes. Results from an ANOVA analysis suggests that this difference is statistically significant (F - 16.1; p < 0.01).

The table below lists each sin in the first column, the number (and percentage) of failed efforts that committed the sin in the second column, and the number (and percentage) of successful efforts that committed the sin in the third column.

Company profiles

Geographical origin

Europe North America Industries Raw materials and utilities Manufacturing Services Finance and banking

Number of employees < 1,000 1,000-10,000 > 10,000

Outsourcing operations profiles

Type of activity oufsourceci

Information Technology Telecommunications Logistics Finance Others

Contract amount

<S10 million $10-100 million >$100 million

Percenfage o/ budget outsourced 0-20% 21%-40% 41%-60% 61%-80% 81%-100%

Percentage of sample

76 24

22 41 24 13

24 38 38

Percentage of sample

54 7

17 7

15

38 30 24

11 12 11 23 43

2003 BarthSlemy 87

Deadly sin

Number (and percentage) of failed efforts that committed the sin

Number (and percentage) of successful efforts that

committed the sin

26 (28%) 8 (9%)

21 (23%) 19 (20%) 5 (6%) 4 (4%)

33 (36%)

Results of chi-square

test

/ = 5.46" ) ^ = 5.58" ) ^ = 16.40" i^ = 2.99* ) ^ = 12.82" ) ^ = 2.60' y" = 0.70

Outsourcing activities thai should not be outsourced Selecting the wrong vendor Writing a poor contract Overlooking personnel issues Losing control over the outsourced activity Overlooking the hidden costs of outsourcing Failing to plan an exit strategy

50 (55%) 27 (30%) 63 (69%) 35 (38%) 34 (37%) 13 (14%) 41 (46%)

' p < 0.10, " p < 0.05, ' " p < 0.01.

Endnotes

' The Economist Intelligence Unit. 1999. Designing fomor- row's oiganisation. London.

-̂ Gilley. K., & Rasheed, A. 2000. Making more by doing less; An analysis oi outsourcing and iis effects on firm performance. Jouinai oi Management, 26(4): 736-790.

^ Quinn, J. B., & Hilmer, F. 1994. Strategic outsourcing. SJoan Management Review, Summer: 43-55.

•̂ Jennings, D, 1996. Outsourcing opportunities for financial services. Long flange Pianning. 29(3): 393-404.

^ Bryce. D., & Useem, M. 1998. The impact of corporate out- sourcing on company value. European Management Joutnal, 16(6): 635-643.

^ See for instance Huber, R. 1993. How Continental Bank out- sourced its "crown jewels." Harvard Business Reviuw, January- February: 121-129; Cross, J. 1995. IT outsourcing: British Petro- leum's competitive approach. Harvard Business Review, May- June: 94-102; and McFarlan, F.. & Nolan, R. 1995. How io manage an IT outsourcing alliance. Sloan Management Review. Winter: 9-23. However, there are exceptions such as Ang, S., & Toh, S. 1998. Failure in software outsourcing: A case analysis. In Will- cocks, L., & Lacity, M. (Eds.), S(ralegic sourcing of in/ormalion systems.' Perspectives and practices. Chlchester: John Wiley. 351-368.

' Sitkin, S. 1992. Learning through failure: Tbe strategy oi small losses. In Cummings, L., & Staw, B. (Ekls.), Research in organizational behavior. Greenwich: JAI Press,

® Lacity. M.. & Hlrschheim, R. 1993. Thj information systems outsourcing bandwagon. Shan Management Review, Fall: 73- 86; Loh, L., & Venkatraman, N. 1992, Diffusion of information technology outsourcing: Influence sources and the Kodak effeci. /nformafion Systems Research, 3(4): 334-358; and Ang, S., 8f Cummings, L. 1997. Sirateglc response to institutional influ- ences on information systems outsourcing. Organizafion Sci- ence, 8(3): 235-255.

^Barney, J. 1991, Firm resources and sustained competitive advantage, journal ol Management, 17(1): 99-120. Classic refer- ences regarding the resource-based view of ihe firm include Amit, R., & Schoemaker, P. 1993. Strategic assets and organiza- tional rent. Strategic Management Journal, 14(1): 33-46; Dierickx, I., & Cool, K. 1989. Asset siock accumulation and sus- tainability of competitive advantage. Management Science, 35(12): 1504-1511; and Teece, D., Pisano, G., & Shuen, A. 1997. Dynamic capabilities and strategic management. Strategic Management JournaJ, 18(7): 509-533.

'" The case of the U.S. consumer electronics industry is a classic one. Poorly performing business units started outsourc- ing components manufacturing to Asian suppliers. Ai that time, mosi of them even had to teach their suppliers how to build the components. As outsourcing resulted in lower cosis, it quickly

spread through the entire U.S. consumer electronics industry. Later, some U.S. manufacturers found out that their suppliers were unable or unwilling io supply them as requested. How- ever, ihe U.S. firms had losi their manufacturing skills and could noi preveni the suppliers from entering downstream mar- kets on their own. See Beitis, R., Bradley, S., & Hamel, G., 1992. Outsourcing and industrial decline. The Academy oi Manage- ment Executive. 6(1): 7-22.

" Dess, G., et al. 1995. The new corporate archiieciure. The Academy oi Management Executive. 5(3): 7-20; Markides, C. 1992. Consequences of corporaie refocusing: Ex anie evidence. Academy oi Management Journal. 35: 398-412; and D'Aveni, R., & Ravenscraft, D. 1994. Economies of integration versus bureau- cracy costs: Does vertical integration improve performance? Academy of Management Jouinal, 37(5); 1167-1206.

'̂ Leiblein, M., Reuer, J., & Dalsace, F. 2002. Do make or buy decisions matter? The influence of organizational governance on technological performance. Strategic Management Journal, 23(9): 817-833; Poppo, L., & Zenger, T. 1998. Testing alternative theories oi the firm: Transaction cost, knowledge-based and measurement explanations for make-or-buy in information ser- vices. Strategic Management Journal. 19(9): 853-877; and Silver- man, B., Nickerson, J., & Freeman, J. 1997, Profitability, transac- tional alignment and organizational mortality in ihe U.S. trucking industry. Strategic Management Journal, Summer Spe- cial Issue: 31-52.

'^Lacity, M., Willcocks, L., & Feeny, D. 1996. The value of selective IT outsourcing. Sioan Management Review. Spring: 13-25.

'•* Though transporiaiion had been ouisourced for a long time, logistics was largely iniernalized in this firm.

'̂ For a thorough review, see Razzaque, M., & Sheng, C. 1998. Outsourcing the logistics function: A literature review. Interna- tional Journal oi Physical Distribution and Logistics Manage- ment. 28(2): 89-107.

'̂ Rabinovitch, E., ei al. 1999. Outsourcing of integrated logis- tics functions: An examination of industry practices. Interna- tional Journal of Physical Distribution & Logistics Management, 29(6): 353-373.

" I am grateful to an anonymous reviewer for suggesting this example.

'̂ Trusiworihiness can be defined a s the expectation ihat the vendor will not take advantage of ihe clieni even when the opportunity is available. See Zaheer. A., McEvily, B., 8E Perrone, V. 1998. Does trusi maiter? Exploring ihe effects of interorgani- zaiional and interpersonal trust on performance. Organization Science, 9(2): 141-159.

'̂ Mohr, J., & Spekman, R. 1994. Characteristics of partnership success: Partnership attributes, communication behavior and conflict resolution techniques, Strategic Management Journal, 15(2): I3&-152.

98 Academy of Management Executive May

™ At the beginning of the contract, the client receives a one- time capital payment and shifts the problems to the vendor.

^'Ring, P., & Van de Ven, A. 1992. Structuring cooperative relationships between organizations. Strategic Management Journal, 13(7): 483-498.

^̂ Barney, J.. & Hansen, M. 1994. Trustworthiness as a source of competitive advantage. Sirafegic Management jouinal. 15(2): 175-190.

^̂ Lambert, D., Emmelhainz, M.. & Gardner. J. 1999. Building successful logistics partnerships. Journal of Business Logistics, 20(1): 165-181; and Anderson, J.. & Narus, J. 1990. A model of distributor firm and manufacturer firm working partnerships. Journal of Marketing, 54(1): 42-58.

*̂ Ackerman, K. 1996. Pitfalls in logistics partnerships. Intei- national Journal of Physical Distribution and Logistics Manage- ment, 26(3): 35-37; and Lambert, Emmelhainz, & Gardner, op. cit.

" Saunders. C , Gebelt. M., & Hu, Q. 1997. Achieving success in information systems outsourcing. California Management Review, 39(2): 63-79.

^̂ Willcocks, L., & Choi, C. 1995. Co-operative partnership and "total" IT outsourcing: From contractual obligation to strategic alliance. European Management 7oLjrnaJ, 13(1): 67-78.

" Realistic measurement af outsourcing success is never easy. Indeed, the most Important measures of outsourcing suc- cess are often intangible.

^̂ Parkhe, A. 1993. Strategic alliances structuring: A game theoretic and transaction cost examination of interfirm cooper- ation. Academy of Management Journal, 36(4): 794-829.

^̂ Harris, A., Giunipero, L., & Hult, G. 1998. Impact of organi- zational and contract flexibility on outsourcing contracts. Indus- trial Marketing Management, 27{5): 373-384.

^ See Henderson, M. 1997. Ethical outsourcing in the UK financial services: Employees rights. Business Ethics, 6(2): 110- 124. According to this article, outsourced employees have the following rights: right lo information, right to fair pay, right not to be fired, and right not to be discriminated against.

'̂ Alexander, M., & Young, D. 1996. Outsourcing: Where's the value? Long flange Planning, 29(5): 728-730.

^̂ Poppo, L. 1995. Influence activities and strategic coordina- tion: Two distinctions oi internal and external markets, Man- agement Science, 41(12): 1845-1859.

^ Useem, M., & Harder, I. 2000. Leading laterally in company outsourcing. Sioan Management Review. Winter: 25-36.

^* Maltz, A., & Ellram, L. 1997. Total cost of relationship: An analytical framework for the logistics outsourcing decision. Journal of Business Logistics, 18(1): 45-65.

^Williamson, O. E. 1985. The economic institutions of capi- talism. New York: Free Press; Williamson, O. E. 1975. MarJtef and hierarchies: Analysis and antitrust impiications. New York: Free Press; Masten. S., Meehan, J., & Snyder, E. 1991. The costs of organizations. Journal of Law, Economics and Organization, 7(1): 1-25; Dyer, J. 1997. Effective interfirm collaboration: How firms minimize transaction costs and maximize transaction value. Strategic Management Journal, 18(7): 535-556; Ang, S., & Straub, D. 1998. Production and transaction economies and IT outsourcing: A study of the US banking industry. MIS Quarterly, 22(4): 535-548; and Barthelemy. J. 2001. The hidden costs of IT outsourcing. Sloan Management fleview. Spring: 60-69.

^̂ In the transaction cost economics (TCE) literature, vendor search and contracting costs are termed ex ante transaction costs, and vendor management costs are termed ex post trans- action costs.

^̂ Williamson, O. E. 1991. Comparative economic organiza- tion: The analysis of discrete structural alternatives. Adminis- trative Science Quarterly, 36(2): 269-296; and loskow, P. 1988. Asset specificity and the siruclure of critical relationships: Em- pirical evidence. Journal of Law, Economics and Organization, 4(1): 95-117.

^̂ Klein, B., Crawford, R., & Alchian. A. 1978. Vertical integra- tion, appropriable rents and the competitive contracting pro- cess. Journal of Law and Economics, 21(2): 297-326.

^^This difference is all the more significant a s the hidden costs of outsourcing are largely fixed. In other words, they are very sensitive to scale economies. See Dyer, J. 1996. Specialized supplier networks as a source of competitive advantage: Evi- dence from the auto industry. Strategic Management Journal, 17(4): 271-291.

'^''Dyer, J., Cho. D., & Chu, W. 1998. Strategic supplier seg- mentation: The next "best practice" in supply chain manage- ment. California Management Review, 40(2): 57-77; Weiss, A., & Anderson, E. 1992. Converting from independent to employee salesforce: The role of perceived switching costs. Journal of Marketing Research, 29(1): 101-115; Klemperer, P. The competi- tiveness of markets with switching costs, fland 7ournai of Eco- nomics, 18(1): 138-150; and Porter, M. 1980. Competitive strategy: Techniques for analyzing industries and competitors. New York: The Free Press.

"' Greer, C , Youngblood. S.. & Gray. D. 1999. Human resource management outsourcing: The make or buy decision. The Acad- emy of Management Executive, 13(3): 85-96.

•"̂ I am grateful to an anonymous reviewer for pointing to this important trend. A discussion of the relationship between Menlo Logistics and General Motors can be iound on www. vectors CM. com.

^̂ On a related topic, it has been recently shown that firms having a dedicated alliance function generate more alliance value than others. See Kale, P., Dyer, I., & Singh, H. 2002. Capa- bility, stock market response, and long term alliance success: The role of the alliance function. Strategic Management Jour- nal, 23(8): 747-768.

lerome Barthelemy is assistant professor of strategic manage- ment at ESSEC Business School (France). He holds a Ph.D from HEC (France) and has been a visiting research scholar at the University of California of Berkeley. His research on out- sourcing has appeared in jour- nals such as MIT Sloan Man- agement fleview and European Management Journal. Contact: