Eyes Wide Open: The Pros and Cons of Outsourcing

Consulting on Consulting
By Steven Young

The decision to outsource or not is a fundamental one for most businesses. Firms need to be fully aware of the pros and cons and enter the agreement with their eyes wide open. The appetite for outsourcing traverses the world and most major industries. In 2013, global outsourcing market revenue was $82.9 billion, up from $45.6 billion in 2000. Yet many firms envision greater efficiencies and reduced costs without truly understanding the benefits and pitfalls. For those contemplating outsourcing, here is a brief overview of some of the key points to consider.

MORE FOCUS AND AGILITY

The biggest single advantage of outsourcing is that it provides the firm an increased ability to focus on where it competes by concentrating its management, intellectual capacity, IT spend and corporate energy on its core competencies and the primary goal of making the firm more competitive. The firm can effectively offload all of the business functions where there is no competitive advantage (as its peers all undertake that task in the same manner).

With increased focus, firms generally become more agile. Management is much more attentive to its core competencies and the firm can react to changes in market conditions more readily. A firm can often expand into other sectors and geographies where its outsourcing provider already has a presence. In effect, firms can benefit from leveraging off their outsourcer’s scale and experience.

FASTER TO MARKET
Firms can also derive benefit from outsourcing if the outsourcer has capability or experience that the firm does not possess. If a firm wants to expand its product offering, for example, the third party might provide that capability much faster than if the firm was to establish its own operation.

For example, within the asset management industry, perhaps a firm wishes to move into derivatives. If the asset manager doesn’t have that operational capability but an outsourcer does, then the firm can be faster to market through outsourcing. Indeed, where niche or emerging capabilities or skills are required, it can often make sense to outsource all, or an element of that requirement.

HIGHER LEVELS OF INVESTMENT

If the industry can concentrate certain functions to 3rd party suppliers, this will create a market that can generate significant investment into key areas of the value chain. The outsourcer’s competitive advantage is based upon delivering a good service on what is effectively your ‘commodity’, therefore its investment in the underlying infrastructure and technology will be continuous and substantial. In effect, the outsourced function becomes a profit center, attracting and justifying investment; the same function in-house remains a cost center and will always struggle to justify the requisite investment.

Probably the biggest misconception around outsourcing among those who have not done so before is that it is a ‘cost play’. Costs can be reduced but an outsourced service is not always cheaper. Sometimes the advantage is in changing the cost model, making the costs more predictable and spread over time. Additionally, costs can be directly linked to a business as a variable cost, as opposed to a fixed cost.

The closer a firm gets to a utility model, the greater shared cost benefits it will realize. The more bespoke an operating model is, the higher the cost for the firm.

OVER-RELIANCE ON THE OUTSOURCING PROVIDER
Outsourcing does have one downside: provider risk, particularly where there isn’t a well-established supply-chain. The early adopters are usually ‘lift-outs’ (where their staff effectively leave the firm and go to work for the outsourcer) and these tend to be highly specialized deals.

Lift-outs don’t necessarily create a utility model; they generally create a back-office out of the first operation that is outsourced. In this way the operation may not follow an industry-standard model and therefore be unsuitable as a commodity for other firms to use. This can be a significant problem and commonly arises in industries where they want commodity pricing along with specialized service.

Where an outsourcing arrangement has gone sour, this is usually because the firm either has an unrealistic expectation of what the outsourcer can provide, or when they outsourced, they moved all of the staff to the third party who understood that element of the business. This severely compromises the firm’s ability to provide effective oversight of the outsourcer. The asset management industry is facing that very challenge now, as it seeks to comply with a growing interest from the regulators that have become increasingly aware of the industry’s dependency on outsourcers.

THE NEED FOR MOBILITY
One of the dangers of an outsourced service is that it is much harder to move to another provider once the relationship is solidified. When outsourcers provide unique operating models, firms will have less mobility with their outsourcing agreement. Therefore, firms experience much lower risk when utilizing as standard an operating model as possible, as it will provide the most significant cost advantage but also facilitate the highest level of mobility between providers.

The least optimal situation is where there is ‘zero mobility’—the client is so tightly aligned with an outsourcer that if the client lacks the agility to react to their requirements, in isolation to the suppliers capabilities. Increasingly seen as ‘resilience risk’ this is a growing cause for concern in some markets and sectors.

OUTSOURCING AND RESPONSIBILITY

Most people forget the golden rule of outsourcing, which is that you can’t outsource responsibility. You can outsource the process, but ultimately you are still responsible for that business function.
This is a major threat, as most firms underestimate the amount of expertise that they need to retain in order to conduct effective oversight of their outsourcer.

CULTURAL IMPACT
If a firm has never outsourced before, it is a massive statement of change that can have an immense impact on the culture of the firm. Many firms see this as a negative, but in a fast-moving market, having a culture of change can be a tremendous asset. It can shake up and transform the conservative nature of a firm and can be a substantial contributor to the rapid evolution of the business.

Of course, many people often don’t like or are wary of a change culture, but if a firm can embrace it then it can be a truly positive experience. Losing good people that have been loyal to the company will always be seen as a negative, but in the end senior management needs to do what is best for the business. If change is required, then outsourcing should be seen as a positive step.

If you are considering an outsourced function, proper due diligence is key. You have to bring in experts or consultants who know the market, the suppliers and, most importantly, have been through the same outsourcing process before. In this way you will ensure that you make the best selection and that you enter into the agreement with your eyes open. Firms that conduct effective due diligence upfront will reap a harvest of benefits downstream.

COMPROMISE IS KEY
Fundamental to that due diligence is your willingness to compromise. Understanding that a service provider may undertake a particular task differently from your firm is not necessarily a negative; there is usually a very good reason why the outsourcer works that way. You need to consider whether your current approach actually delivers any tangible competitive advantage: if it does not then you need to follow the outsourcer’s lead. If you want to derive the maximum benefit from the arrangement, willingness to compromise among your operational team is a must.

Steve Young is CEO of Citisoft, a consulting firm dedicated to servicing the investment management industry.

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