Major Risks and Potential Hazards Encountered in Effective Management of Outsourcing Decisions - Term Paper Example

 Table of Contents Introduction......................................................................................................................3 Historical overview of outsourcing..................................................................................4 Why do managers outsource? ..........................................................................................5 Cost cutting...........................................................................................................5 Strategic advantage..............................................................................................5 Underestimated risks and hazards of outsourcing to the outsourcer................................6 Cultural ...............................................................................................................6 Regulatory ...........................................................................................................7 Informational ......................................................................................................9 Organizational ...................................................................................................11 Why and how such limitations and underestimations happen? .....................................13 Lack of a proper procedure and framework .....................................................13 Unreal perception of the core business and competencies...............................13 Putting wrong person on the job.......................................................................14 Conclusion....................................................................................................................14 References....................................................................................................................15 Introduction Globalization has placed immense responsibility and need on the part of organization to devise competitive means of operations. In this sense, organizations now try to focus on their core competencies and get external service providers for their supplementary functions to gain instant access to their expertise, service levels and synergistic benefits from the partnership of the two. This has been termed as ‘outsourcing’ in the business jargon and lately assumed much of significance in business scenario (Winkler 2009:22). Caught in the dilemmatic ‘make-or-buy’ decision, organizations and more importantly the managers often underestimate the risks, possible hazards and hidden costs of their outsourcing decision. Superficially, outsourcing seems to provide cheap labour supply, external expertise, synergies in competencies and perfection of all activities but in-depth analysis of outsourcing decision and related factors reveal serious consequences related to labour enforcements, cultural asymmetries, lack of control and governance over the vendor operations, threat of information leakage and many more which have a direct bearing on the financial, organizational and social viability of the outsourcer’s business. This paper seeks to address this emerging situation with a critical knack. Commencing from an introduction and historical overview of outsourcing and reasons why managers outsource, the main body of the paper comprises major risks and potential hazards encountered in effective management of outsourcing decisions. Discussion of underestimated costs in such happenings and why they happen is also included with a checklist to better the proposition. Examples of insurance, shipping and IT industry have been inserted at appropriate places to anchor the understanding of the concept and provide a practical meaning to the underlying aspects. Historical overview of outsourcing The advent of outsourcing dates back to eighteenth century but actual outsourcing took place in 1980s when companies in United States outsourced their IT functions to specialist IT service providers because IT at that time was a facilitator and it does not found a place in the core business practices of outsourcing firms. The prime objective of outsourcing at that time was to achieve cost savings and responsiveness in adopting latest technology and responding to changing business needs. The service provider also loaned employees to buyer’s site to provide their specialized services. When cost cutting was the main driver behind outsourcing decision, specialized functions like IT, call centre services and like used to take place. Now with the touch of strategy and resource optimization, outsourcing extends beyond cost cutting factors. From entire human resources management to finance and from claims processing to upstream and downstream supply chain activities, outsourcing now finds vent in all of the strategic decisions. Even the service firms are now incorporating outsourcing into their operational as well as tactic decision making practices because of the level of awareness, skill set, capabilities, access to industry and market knowledge and specialized know-how of service aspects and delivery and support functions. Service industry success rests on creating intangible experience for its customers in terms of empathy, responsiveness, care and complaint handling which makes outsourcing the best feasible option for managers (Tho 2005:6). As such, sales, processing, billing, online marketing and various other functions are now being outsourced to specialized service providers. With increased globalization and blurred cross-border activities, remote outsourcing emerged which later on came to be known as ‘offshore outsourcing’ (Krajewski 2008:406). With geographical expansion of outsourcing function, it became all the more complex which calls for more planned, rational and analyzed decisions on the part of managers. Why do managers outsource? As mentioned before, primary reasons for outsourcing were cost cutting and gaining access to specialized services and functions thereby leading to competitive edge. However, many more reasons and factors favour the outsourcing decision taken by managers between these two extremes. Cost cutting Production and manufacturing costs tend to increase if any process or activity is not provided the proportion of requisite and specific resources. Outsourcing provides the benefit of ‘asset specificity’ (Zika 2004) in terms of customized, fully available and monitored resources to the outsourced activity or function. For instance, a firm outsourcing its IT function might not have the state-of-the-art infrastructure, competent and skilled technical professionals, hardware and software systems, technical know-how and other specific assets. Installing these would require added costs on the part of the outsourcing part and since, it does not possess the competency in the required field, and expertise cannot be guaranteed which places a sort of gamble in investing in IT infrastructure and development. Thus, for cost cutting measures, managers usually resort to outsourcing decision for crucial business functions. Strategic advantage Strategically speaking, businesses are now inflicted with greater responsibilities of reduced lag time, enhanced value creation, devising lean and flexible supply chains and overall increased business performance. Undertaking and completing all business activities alone results in longer product development and introduction schedules, enormity of risks, lack of innovation and marginal utilization of resources. As such, to gain strategic positioning in the market and improve upon the brand image, managers seek the help of outsourcing decision to focus on their core competencies and share the risks of business. Figure 1 Verwaal et al. (2009) link the resource based view of an organization under outsourcing decision by matching transaction and resource attributes to that of outsourced decision. Observations reveal that outsourcing results in an overall production efficiency and access to better technology capabilities. On the other hand, switching costs and environmental uncertainty are negatively related to the favourable outcome of outsourcing decision (Figure 1 above). Thus the entire process of outsourcing is based on how well these resource and transaction attributes are aligned to arrive at a combined fruitful result. Underestimated risks and hazards of outsourcing to the outsourcer Cultural Outsourcing might take place in domestic or foreign setting. In case of domestic outsourcing, partners are believed to carry the same set of principles, norms and beliefs. There might be a different corporate culture, but the national culture remains the same. Problems arise when outsourcing takes place between partners of two different cultural backgrounds. Managers generally prefer foreign partners on the basis of their merit and other hard factors but soft issues of cultural aspects namely communication, commitment level, governance structure, flexibility, innovation, religious values and such inherent traits are usually ignored by them (Figure 2). This leads to a misalignment in the cultural binding of the two partners and often results in frequent conflicts, complaints from customers, project cost and time overruns, low quality and savings and such other repercussions. Figure 2 Clashes in cultural aspects add on to the monetary losses for the outsourcer. This is because when matching up with the foreign partner, arrangements have to be made regarding communication channels, meetings, performance reviews and others which if not planned properly in advance, burdens the financial state of the project and thus makes the outsourcing decision unviable (Kvederaviciene & Boguslauskas 2010). Cohen & Stonich (2006) highlight the hidden costs of such misalignments and asymmetries in cultural, organizational and distanced relationships taking the example of China as the manufacturing service provider. The drawbacks in Chinese economy amount to less skilled and educated workforce, surmounting language barrier, low supply chain and operations efficiency levels and such marked differences which managers actually observe much later traversing the path of outsourcing. A coin has two sides. In the outsourcing decision, the other side of the coin has loss of control over the operations, rules and practices of the service provider firm. This is because only certain things are specified in Service Level Agreement (SLA) but differences in culture, size, corporate objectives, motivation levels and others cannot be written in black and white. Thus there always remains an arm’s length relationship between the two entities in terms of these dimensions which make certain costs of outsourcing unobvious for the managers (RealFD n.d). Regulatory When outsourcing a function, there arises the requirement of quality people who are skilled, competent and trained enough. Taking the example of shipping industry, the ship operators outsource the recruitment function to other agencies. In outsourcing the recruitment function to crewing agencies, the actual organization has no control or awareness of the practices and standards adhered to when hiring and training the seafarer labour (Bloor & Sampson 2009). As such, many of the global labour standards and training needs are overlooked. Future concerns also arise from labour quality and audit examinations when actual labour is examined and checked against the expected training levels. For managers, serious repercussions arise out of non-adherence to labour standards and low efficiency of labour because the onus of recruitment and responsibility falls on the actual organization which outsourced the recruitment function (Edwards 1995). Thus, costs of recruitment get wasted and no returns in the form of efficiency and quality are received. Service quality is measured by the components of tangibles, empathy, responsiveness, assurance and reliability (Sureshchandar, Rajendran and Anantharaman 2002). However, SLAs with service providers do not guarantee the adherence to explicitly devised SLA rules and policies and if they deviate from such practices, the loss of customer or unsatisfactory complaint from customer results in a direct loss for the firm. Figure 3 demonstrates the conflicts in the service objectives of customer and service providers which lead to outcomes opposed to what had been actually perceived. Such altercations in goal setting affect the cost per unit, control mechanism, quality as well as the viability of operations for both the partners. Figure 3 Information based In an outsourcing decision, information and data exchange takes place between the two parties. Though rules and regulations are charted as to who will handle the data, ownership rights, validation, authenticity and other concerns but the outsourcer cannot ensure that the customer data or sensitive information is in right hands. For example, in healthcare provider firms, there is still no confirmation or assurance of confidentiality or validity of medical and health data of patients after the introduction of HITECH Act and Electronic Health Records (EHR). Initially certifications and regulations might impose obligations on the service provider and third parties to comply with information exchange rules; it only increases the cost of outsourcing and might take a grave situation if such rules are not complied with. Figure 4 Trust in business relationships arises when components of shared motives, congruence, honesty and combined professionalism are present (Figure 4). Outsourcing decisions suffer from anomalies of trust and distrust because environment uncertainty makes the fact uncertain as to whether the service provider is also working for a competitor (Adler 2005). Also, concerns regarding security and information system management and protection of sensitive business data make outsourcing a daunting challenge for managers in terms of in-depth analysis and rational decision making. In the case of BPO, concerns arise because of the constraints of contract type- fixed price and time and materials. Such time and price limitations impose trade-off urgencies for outsourcing firms because service provider firms deliver such services on the basis of billing cycle and other details (Bakos and Brynjolfsson 1993). Thus, alignment issues between time period, contractual and information sharing and structural systems might crop up. Organization dependent Muehlberger (2007) explain the concept of creation of dependency in outsourcing by hierarchical governance and work structures with the help of insurance company. An insurance company hires both direct sales agent and tied agents. Tied agents are those who are outsourced a part of the insurance selling function. With tied agents, insurance companies specifically exercise more of monitoring and control mechanisms. The tied agent so hired has to depend upon the resources supplied by the company because he is entitled only to the commissions accruing on insurance policies given. In such circumstance, tied agents have to rely on funding and business capital supplied by the company. Also, the firm exercises greater control on the work activities, authority relations, customer service and use of other resources by the agent. This in one or the other manner restricts the flexibility and innovation of the agent and results in creation of dependency of agent on the company which is not as fruitful as when agents are empowered and free to exercise their own control over the functions and their work. Hong and Fiona (2009) highlight the conflict in identities and asymmetric power distribution between the in-house staff and the outsourcing staff especially in the case of IT outsourcing. When an organization outsources IT function, there happens to be a perception gap in the roles assumed by the two entities. On one hand, the in-house staffs consider the outsourcing staff as ‘cheap’ and low hierarchy placed members. On the other hand, the outsourcing staffs consider themselves more of professional and competent than the in-house staff. The managers generally fail to resolve this conflict as both the teams have their own assumptions of work related behaviors and confusion remains as to who will gain the position of principal lead. Roles and duties of both the staff members remain ambiguous which often result in delays, conflicts, identity gaps and low commitment and morale. Organizational learning is also hampered this way because no decision is taken with a consensus. Generally the internal staffs are resistant towards outsourcing the functions of the firm to an external service provider. However, in order to extract the best synergies out of the talent of both in-house and external employees, knowledge management and transfer capabilities have to be developed. In the absence of such practices, internal employees do not feel encouraged to work in tandem with their external counterparts, the costs of which are enormous for the firm in terms of lost productivity, efficiency, time and money wasted on grievance handling and chances of moving to another service provider. Change is inevitable. However, when going into outsourcing decision, renegotiations of agreement clauses and customization freedom is not that easy because the service provider might allow the outsourcer to enhance or modify the elements so frequently. Thus, for the outsourcer, the market forces and customer demands will change but non-approval from the part of service provider might lead to discrepancies and conflicts. Barua et al. (2009) assert that in the short run, outsourcing provides cost advantage, access to better technology and service capabilities, allows firms to focus on their core competencies and furnishes synergies of operations. However, in the long run, outsourcing decision may turn lethal and lead to destruction of the value chain of outsourcing firm if the service provider is not selected judiciously. This is because when contracting, he will get acquainted with the practices, culture, information and skill set of the people of the firm. In case the firm depends on its service provider for the function outsourced and does not provide for proper training of its in-house employees to keep them abreast of latest happenings, such dependency can lead to slipping out of the value added activity of the firm entirely in the hands of service provider. Why and how such limitations and underestimations happen? After going through the above mentioned hidden risks and hazards of outsourcing, one must be scratching his head as to why do such underestimations happen. The reasons behind this limitation are numerous- some arise out of lack of senior management commitment and some are attributed to absence of proper framework and analysis techniques to be applied while chalking out the outsourcing decision. An overview of such reasons goes as below: Lack of a proper procedure and framework Generally decisions come intact with a well defined procedure of diagnosis, seeking alternatives, comparing and contrasting the benefits and disadvantages of each and then selecting the best course of action. However, outsourcing decision is devoid of any such process or framework which can be applied and the potential hazards to do away with. Most of the times, managers rely on their intuition and experience element and select the service provider which account to maximum cost reductions. Thus, other crucial elements of managerial and organizational implications are ignored (Zika 2004). Transaction costs of the nature of information and communication also give rise to greater uncertainties in terms of delivery times, costs of safety and inventory and overall governance structure of the two partner firms. If not chalked out properly in the beginning, these transaction costs can lead to damaged cooperation and sour relationships between the partners. Unreal perception of the core business and competencies Some outsourcers fail to identify their own core competencies and process in supply chain which should be contracted out to add value. In this misunderstanding, they sometimes outsource wrong process to a service provider or a correct process to a wrong service provider. In either case, the unfortunate party is the outsourcer himself because of added costs, absence of any results and lost efficiency of employees and resources in this change process. Especially in international outsourcing where a big firm enters into a market with cheap labour availability, its reputation and brand image sometimes get hampered. Example are footwear and garment companies like Nike and M&S which have frequently been engaged in abusive labour practices and faced the vulnerabilities of reputation risk in cheap labour markets. Putting wrong person on the job Even this might be one of the reasons behind unsuccessful achievement of outsourcing objectives if the firm places wrong person or team on deciding upon the outsourcing decision (Zika 2004). If the person himself is not well equipped of this process methodology, inherent factors, risk elements and other essential details, he is definitely going to misinterpret the pros and cons of outsourcing and as such, there will remain many costs and constituents not addressed to. Conclusion Analyzing the pros and cons of outsourcing, it can be said that in the absence of frameworks, processes and tools, managers commit mistakes in estimating the true worth of their outsourcing decision and realize later the hidden costs and repercussions. The prime culprit is the cultural mismatch which actually brings in all other worries of recruitment, labour standards, inefficiencies, clashes and incorrect estimation of core competencies. In order to do away with these limitations, setting of clear and pre-defined goal is a necessity along with shared vision, regular training of staff members, modifications in the contract and element of trust intact in the relationship. Regular meetings and clear understandings of the inherent intricacies in all the clauses of outsourcing can help both the partners in eliminating vulnerabilities of all kinds. References Adler, T.R. (2005). 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