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What is Sourcing Risk?

Posted by Protiviti KnowledgeLeader on Thu, Jul 26, 2018 @ 09:33 AM

outsourcingOutsourcing has become a keystone of major business operations to the point that it’s almost a given that large companies will move certain expensive business processes and labor-intensive activities to a third-party. Is this always the best option?

What is Outsourcing?

Outsourcing is so common today that we might assume that the concept has always been used in business. In reality, the term was not formally identified as a business strategy until 1989, following the global business push in the 1970’s and 80’s to reduce bloated infrastructure and increase agility. One well-known example is Eastman Kodak’s move to outsource its information technology infrastructure in order to focus on its primary business. The decision was made that a business process didn’t need to be “owned” in order to be access and many major corporations quickly followed suit.

Tasking an outside outsource to handle its non-core operations allows a company to focus on its core business by transferring the ownership of a business process to a supplier. The key to this definition is the aspect of transfer of control. This is different from business relationships in which the buyer retains control of the process or, in other words, tells the supplier how to do the work. It is this transfer of ownership that defines outsourcing, and often makes it such a challenging process.

There are some obvious benefits to outsourcing, including:

  • Lower cost
  • Process simplification
  • Predictable cost and results
  • Greater agility and ability to pivot
  • Value of a strong vendor reputation
  • Ability to produce or procure technology not available in-house

Unfortunately, like anything that has benefits, outsourcing also comes with risks.

Are We Ready to Outsource?

When outsourcing brings so many benefits to the table, the urge to jump in quickly in understandable. But is your company actually ready to outsource? Often we’ll begin writing an outsourcing request for proposal (RFP) and begin contract negotiation before the move has been thoroughly vetted. While agility and quick decision-making is certainly a goal of outsourcing, moving too fast can potentially cause many problems.

One consideration is the ramp up time involved. The process of RFP, proposal and negotiation is very time-consuming and expensive, for both the outsourcing company and the vendor providing the outsourced services. Because of this, qualified outsourcers are hesitant to begin negotiations without evaluating if the client company has done due-diligence and is serious about proceeding in good faith with the RFP process.

Secondly, we’ll always want to remember that intelligent negotiation of an outsourcing deal requires gathering and providing extensive, validated internal data to the vendor. Nothing is worse than rushing around in the eleventh hour to find requested data when serious pricing and service level questions arise. It’s best to remember that the vendor is making a business decision to work with us as much as we are with them, so we need to cultivate confidence in our capabilities and strong information data-driven responses to their requests. When internal data is not available or is of questionable validity, the outsourcer will not be willing to commit and the we’ll end up with a non-binding “agree to agree” which is of minimal benefit for either party.

Time for the Process

Along with determining outsourcing readiness, we should guard against trying to compress the RFP, due diligence, and contract negotiation periods unrealistically. Outsourcing deals are time consuming. They are complex and require a great deal of iterative discussion among the negotiation team members for the outsourcers, customers, and their professional representatives (e.g., consultants and lawyers) to agree upon and document clear understandings. There is no cookie-cutter approach to outsourcing that will work in every situation. The parties must take the time to get the fundamentals right, and that includes adequate time for due diligence, discussions, and negotiations.

There is no rule of thumb for how long completion of an outsourcing deal should take after the RFP proposals are received from outsourcers. Much will depend on how motivated and how well prepared we are for the process. One rule is clear, however, and that is that the process generally will take longer than we estimate in the beginning, so some cushion should be built into the timeline for the deal. Invariably, issues that no one anticipates will come up during the process and will require additional time for resolution. If an arbitrary deadline is pressing, the temptation will be to postpone the issue to the post-contract period when business disputes can be difficult to resolve.

Obviously, disputes should be avoided as much as possible, and having a good legal team ready and able to commit time and resources to the process is extremely important. We must be prepared to use legal counsel effectively. An outsourcing lawyer can be most effective in guiding the client around common pitfalls if the lawyer is brought into the deal early as an integral part of the RFP development, evaluation, and negotiation phases.

BUSINESS RISKS RELATED TO SOURCING

Failure to manage outsourcing risk can have the following impact:

  • Reliance on third parties whose objectives run counter to the entity’s plans
  • Reliance on third parties whose performance runs counter to the entity’s plans
  • Reliance on startups or other vendors that may not be in existence by project completion
  • Reliance on vendors with immature infrastructure may be unable to provide service, impacting its customers

Outsourcing is based upon fundamental principles, that when applied at the outset, result in an effective, successful relationship. The first of these basic principles is for the buyer to determine the scope of services and the metrics (for the performance levels) it wants from the supplier. This is the only way a buyer can comfortably turn over its process to the supplier and ensure value generation, which also ensures accountability from the supplier. It must be done upfront, before the contract is signed.

A sure cause of failure in an outsourcing relationship is for the buyer to let the supplier dictate services and performance levels as well as inadequate description of scope and boundaries for component of the service. This can lead to a supplier providing something that was not agreed upon and then charging a premium for it, or the supplier not providing something the buyer assumed it would be getting for the price it is paying. For example, in an outsourced human resources (HR) function, the buyer must adequately describe the scope of services the supplier is to provide (does it include payroll, administration of benefits, procurement of new benefit options, recruiting, retirement benefits?).

Recently the pendulum of corporate identity has swung away from vertically integrated mega-corporations to agile, heavily outsourced entrepreneurial organizations. As with any business strategy, however, what works for one company does not necessarily work for another. A decision to outsource more of a company's business processes should reflect the long-term goals of the company, not the latest trends in the business community.

The general idea behind outsourcing is for a company to do what it does best and let the experts do the rest. Few companies take this radical of an approach, choosing instead to outsource only the nonessential processes. Essential non-core processes, then, stay in-house, unless outsourcing offers a strategic advantage. Generally, cost savings alone is not reason enough to begin outsourcing a service. Sound reasons include one or more of the following:

  • A change or expected change in market conditions that increase the need to concentrate management efforts and resources on core competencies.
  • A well-developed outsourcer market that offers advanced technology, specialized professional expertise, significant capital investments, or innovative solutions and techniques that the company cannot match.
  • The opportunity to shorten cycle times for such things as product development, production or customer response.

Looking to avoid Outsourcing Disasters?

Deciding to outsource a process or service usually results in considerable change, employees will be affected, overhead costs will change, management focus will shift, and cycle times will shrink. Without a cohesive strategy that recognizes the potential for change, fragmented outsourcing activities can lead to problems that snowball into customer dissatisfaction or business complications.

To avoid complications and for further guidance, check the Sourcing Key Performance Indicators document on KnowledgeLeader.

Make sure the right questions are being asked at the right time before the outsourcing process drains more time and money than it saves.

In addition, these related resources can also be helpful:

Service-Level Agreement Sample

Channel Effectiveness Risk Questionnaire

Protiviti Risk Model

And there is also a full topic page for Outsourcing/Co-sourcing/Shared Services with relevant articles, tools checklists and templates.

 

Topics: internal audit, supply chain, purchasing & accounts payable, vendor management, performance management/measurement, outsourcing/co-sourcing/shared services, sas 70

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