Structuring a new business venture

Risks Associated With Outsourcing

Outsourcing can have significant benefits but is not without risk. Some risks, such as potentially higher offshoring costs due to the eroding value of the US dollar, can be anticipated and addressed through contracts by employing financial hedging strategies. Others, however, are harder to anticipate or deal with.

As a general principle, functions that have the potential to interrupt the flow of product or service between a company and its customers are the riskiest to outsource. For example, delegating control of the distribution process to an online retailer can result in customers not receiving goods promptly; outsourcing call-center responsibilities can result in customers being dissatisfied with the product or service and, thus, in higher product returns, lower repurchases, or complaints that could endanger the company’s reputation.

The second-riskiest type of activity to outsource is one that affects the relationship between a company and its employees. Outsourcing the human resources function, for example, can affect the quality of employee hiring; outsourcing payroll and benefits processing can result in information breaches that generate identity theft issues and resultant legal issues; and outsourcing software design can generate a decline in organizational innovation. By contrast, support functions such as accounts payable and maintenance are less risky to outsource because they have few direct links to customers or internal organizational processes.

More formally, risks associated with outsourcing typically fall into four general categories:

· loss of control

· loss of innovation

· loss of organizational trust

· higher-than-expected transaction costs

Loss of Control 

Managers often complain about loss of control over their own process technologies and quality standards when specific processes or services are outsourced. The consequences can be severe. When tasks previously performed by company personnel are given to outsiders, over whom the firm has little or no control, quality may suffer, production schedules may be disrupted, or contractual disagreements may develop. If outsourcing contracts inappropriately or incorrectly detail work specifications, outsourcers may be tempted to behave opportunistically—for example, by using subcontractors or by charging unforeseen or unwarranted price increases to exploit the company’s dependency. Control issues can also be exacerbated by geographic distance, particularly when the vendor is offshore. Monitoring performance and productivity can be challenging, and coordination and communication maybe difficult with offshore vendors. The inability to engage in face-to-face discussions, brainstorm, or explore nuances of obstacles could cripple a project’s flow. Distance, too, can increase the likelihood of outages disabling the communication infrastructure between the vendor and the outsourcing firm. Depending on where the outsourced work is performed, there can be critical cultural or language-related differences between the outsourcing company and the vendor. Such differences can have important customer implications. For example, if customer call centers are outsourced, the manner in which an agent answers, interprets, and reacts to customer telephone calls (especially complaints) may be affected by local culture and language.

Loss of Innovation

Companies pursuing innovation strategies recognize the need to recruit and hire highly qualified individuals, provide them with a long-term focus and minimal control, and appraise their performance for positive long-run impact. When certain support services—such as IT, software development, or materials management—are outsourced, innovation may be impaired. Moreover, when external providers are hired for the purposes of cutting costs, gaining labor pool flexibility, or adjusting to market fluctuations, long-standing cooperative work patterns are interrupted, which may adversely affect the company’s corporate culture.

Loss of Organizational Trust

For many firms, a significant nonquantifiable risk occurs because outsourcing, especially of services, can be perceived as a breach in the employer-employee relationship. Employees may wonder which group or what function will be the next to be outsourced. Workers displaced into an outsourced organization often feel conflicted as to who their real boss is: the new external service contractor or the client company by which they were previously employed?

Higher-Than-Expected Transaction Costs 

Some outsourcing costs and benefits are easily identified and quantified because they are captured by the accounting system. Other costs and benefits are decision relevant but not part of the accounting system. Such factors cannot be ignored simply because they are difficult to obtain or because they require the use of estimates. One of the most important and least understood considerations in the make-or-buy decision is the cost of outsourcing risk.

There are many other factors to consider in selecting the right level of participation in the value chain and the location for key value-added activities. Factor conditions, the presence of supporting industrial activity, the nature and location of the demand for the product, and industry rivalry should all be considered. In addition, such issues as tax consequences, the ability to repatriate profits, currency and political risk, the ability to manage and coordinate in different locations, and synergies with other elements of the company’s overall strategy should be factored in.