The Use Of Outsourcing To External Parties Commerce Essay

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The use of outsourcing and external parties is becoming more and more common in business life. Making a decision to outsource an operation is a strategic decision where several levels of interest need to be balanced. Implementing and making the outsourcing partnership a success is crucial if strategic and operational success is to be achieved by the company.

Today's outsourcing business is one of the fastest growing aspects of the world economy. According to a survey from Duke University's Offshoring Research Network and PricewaterhouseCoopers. Despite a slow economic recovery in 2010, USD 15 billion worth of outsourcing contract is being negotiated as companies seek to reduce their cost and stream line their operations. (PricewaterhouseCoopers, 2010)

Drucker quoted in Clott (2004 p. 153) calls outsourcing "one of the greatest organisational and industry structure shifts of century" with the potential to transform the way business is conducted. They argue that this move towards outsourcing is the result of globalisation of commerce on a worldwide level and at the same time a technological development within the communication area allowing service and production is moved outside of the factories and companies.

However outsourcing brings strategic risks that companies need to counter. One way of trying to reduce the risk is to use intercompany agreements.

2. Literature review

This literature review is divided in three parts, the first part describes outsourcing and the advantage it can bring to a company. The second part describes the risk that outsourcing brings to a company. The third part is about agreements and how they are used as a tool used to minimise strategic risk. The author has chosen this division based on the research question and research objectives.

Latcity et al (2008) conducted a twenty year research program into outsourcing covering over 1400 interviews in 500 companies on five continents, which broke down outsourcing into two main types; Information Technologies Outsourcing (ITO) and Business Process Outsourcing (BPO). ITO is when a company decides to outsource computer or Internet related work, such as programming, data storage, hosting and back up service to vendor companies. BPO is outsourcing that involves a whole operation or responsibilities of a specific business functions to a vendor companies. BPO is further broken down into two subparts; back office and front office. Back office includes internal business functions such as human resources, finance and accounting where as front office is customer focused services including, customer support, helpdesks and sales services. Offshore outsourcing is when ITO or BPO is moved outside the client's company´s domestic county.

Based on interviewing more than 100 senior managers who were involved in the outsourcing decision process for extended period of three to over ten years, Lacity and Hircheim (1994) concluded that there had been a change in the mindset among mangers and they now looked at outsourcing in new, strategic way, an example of this change is how strategic theorists like Michael E. Porter have since the mid 1980s been teaching business leaders that a company should focus on core commences or primary business actives. This change in business theory has clearly changed how companies operate. During the 1990's companies started to change directions and abandon their diversification strategy to focus on core capabilities. Part of this change was the decision to outsource non-core BPO/ITO. (Lacity et al., 2008)

2.1. Outsourcing Advantage

This research was followed up by Lacity and Rottman (2009) where they noted how senior managers are struggling with calculating the return on investment for some departments as they are not able to measure the impact, just the cost on those departments. This problem with assessing the value of a department, function or process made it desirable for the senior management to add a business value to be able reduce cost.

Chapter two noted that managers outsource what they consider to be non-strategic activities as way for them focus on the core business. Porter (1985) argues that a company can only have one of two generic strategies to gain a competitive advance, cost or diversification. To achieve the first a company must deliver more benefits at a lower cost than their competitors. To do this, outsourcing become attractive options as it allows for a reduction in fixed costs and increased flexibility should production volumes change.

2.1.1. Cost reduction

Clott´s (2004) research supports Porter's and describes how reducing cost still is the primary driver for companies to outsource. By using an external vendor the company can reduce cost overheads within staffing and increase their flexibility. External vendors can leverage economics of scale as they manage similar projects for other clients. Depending on the location of the vendor the labour cost may also be significantly lower. A second financial aspect which motivates outsourcing is increasing control over costs, since a company can predict costs as it is defined in the contract.

2.1.2. Flexibility

By using a vendor company the client company can focus on its core competencies, but it also allows the client company to source the best resource for each part of their value chain. Nike, Inc. is the largest supplier of athletic shoes in the world. They outsource 100 percent of their manufacturing. This way Nike can focus on what they do best; research and development, marketing, distribution, and sales. By having the whole manufacturing process outsourced, they stay flexible and can meet any change in market quickly and effectively without extra overhead cost. (Quinn and Hilmer, 1995)

2.1.3. Knowledge /Technical access

The other main reason for outsourcing is to get access to the latest technology or know-how, as the vendor company´s core competence is within the area that is being outsourced it. Unlike the client company, the vendor companies are able to leverage best practice and maintain investment levels. Lancity and Rottman (2009) conducted 67 interviews in 25 organisations and concluded that using an outsourcing vendor company does not only enable the client to focus on its special core activities but also allows the firm to get access to cutting edge technology and knowhow. In many cases this knowledge has been built up by the vendor company over many years and represents a significant investment.

2.2. Outsourcing Risks

Outsourcing may seem like a simple and logical decision, but Barthelemy (2001) outlined five main hidden costs that can turn an outsourcing project into to a loss.

Figure 1: Cost during outsourcing project

Source: Barthelemy, 2001 p.63

From their research Barhelemy and Quelin (2006) concluded that outsourcing risks can be divided into two main types; ex ante or before risk that includes the searching for a vendor, selecting a vendor and negotiation contract. This second is ex post or after risk cover the implementation and monitoring of the outsourcing. The ex post risk is much more complex as it includes the initial transition of operation to vendor, training and ongoing management of vendor performance.

2.2.1. Ex ante risks

Companies that decide to outsource need to be aware that they are going to be handing over a substantial part of its control to an external party. Aron et al (2005) state the conclusion on interviews with senior executives that made the decision to outsource, and on site visits to companies providing outsourcing services.

Obvious ex ante risk that a company need take into considerations is the search, selection negotiation, legal and migration and coordination costs, this can in some cases can be substantial and have nock on effects that last for an extended period of time. For example, the selection may lead to a bidding war between different vendors over an attractive contract. This situation, that may seem positive, will in worst case result in vendors making unrealistic bid offers. Sometimes the vendor already knows or discovers by hand that they are unable to recover their business results and operational costs for the near future. Known as, "winner's curse", it can lead to additional costs, poor service, or considerable switching costs for the client company. It can particularly become an issue when handling new technologies as the vendor's capability may not be fully developed. (Kern et al., 2002).

Secondly, back office BPO and ITO are relative easy to migrate as they are of low strategy impact to a company, where as front end BPO brings much more strategic risk. Beasley et al (2004) surveyed 300 outsourcing agreements from 300 American firms between 1997 and 2003. They conclude that any BPO cost savings are initially counter balanced by transition costs of finding and transferring the operation to the vendor company. Therefore, it is important not to underestimated the time and money needed during the transition phase. If not calculated correctly these additional costs can easily turn the positive margin of the outsourcing deal into negative.

When outsourcing both client and vendor companies should realize that the situation they are in today may well change and be different in the end of the contractual period. Inevitable any selection of a vendor company in another country brings new strategic risks. Now the client company needs to take into consideration geo-political and environmental factors as well as languages and cultural differences. This makes any decision to move a process offshore much more complex. Technological changes create new opportunities but it may also create new challenges and therefore client companies needs build in upgrades into the contract. As it is almost impossible to predict these changes, the client company always takes a risk when signing a contract with a vendor company a risk that should be taken seriously, particularly when signing long term contracts. (Kern et al., 2002).

Another major strategic risk is determining how and what information to allow (if any at all) vendor company access to, as this may form the base for the company's competitive advantage. Aron et al (2005) recommends that a risk assessment need to be carried out by the client company to assess what information is strategic confidential information and what information can be shared with vendor. For strategically sensitive operation, companies should divide up the process on several partners thereby reducing the overall risk. This makes each piece of information useless, preventing sensitive information from leaking to competitors. Clear contracts that specifies penalties for breaches by the vendor also needs to be put in place, finally the researchers recommend that the most sensitive and vital parts should be kept in-house to ensure that in case there is need to reintegrate the process, this can be done swiftly.

Falling up on this Shi (2007) argues that companies need to have agreements in place to control the knowledge that builds up within the external vendor. Here there is a clear conflict of interest as the vendor want to keep the knowledge and tacit skill, where as the client company wants to move this to their company. Client companies are worried that vendors may have other customers that can benefit from this knowledge and take advance of this spill over since they want to protect their strategic assets.

Contrary to Shi (2007) and Aron et al (2005), Spenser (2003) argues that companies should share some of their strategic information to external parties as it will allow them to have higher innovation rate. He notes that one of the costs for any company is the repletion of finding and leaning knowledge, if a company is more open and share knowledge they can reduce the time it takes for vendor company to become effective. This sharing also builds trust between the two companies leading to improved information sharing, allowing the client company gain information to deliver better products and services.

2.2.2. Ex post risks

Once an operation has started, new risks, emerges. One of the most common problems is the agent-principle problem, which occurs when the vendors goal are not aligned with that of the client company. To avoid inconsistencies, the client company needs to monitor the behaviour of agents and then influence this behaviour. Roth and O'Donnel's (1996) study which examined the agent-principle theory in 100 subsidiaries, in five countries indicates how compensation strategy influences the agency problem. The researchers notes three main factors that amplify the risk for misalignment and creation of a agent-principle problems; the cultural difference, operational and strategic role of the companies, the degree of psychological alignment of individuals agents at the vendor company to client company goals. The researchers suggest that the agency principle problem can be reduced if the goals and compensation are aligned to common goals, which can be done either through increased informal or formal control mechanisms.

Another where were BPO/ITO will make an impact is the human resources department. They can reduce their overhead and free client company from deal with physical safety, pension plans, health and life insurance, sexual harassment issues, wages, taxes, etc. For a small and medium size companies, this is a major benefit of outsourcing. As the outsourcing market grows and matures, the workforce will grow and start coming under more and more scrutiny from external parties labour unions, NGO and lawmakers. Therefore Beasley et al, (2004) recommends that the client company still stay involved and make regular onsite visits as well as have the vendor company provide updates on affirmative action plans, employee grievances, terminations, etc. As it can have serious negative consequences if the vendor company is found having bad HR practise. One example is how New Jersey Senate is considering making it illegal for any government contract to pay a lower salary than the state average. This will not ban outsourcing, but it will take away one it its major incentive.

2.3. Agreements in Outsourcing

Bathelemy (2003) outlines how there are two fundamental sides to the outsource management. The first is a hard side that is covered by contract and Service Level Agreement (SLA). The second is the softer side, the trust between the parties. Barthelemy conducted 50 in-depth studies of IT outsourcing cases, obtained via a survey of both American and European companies. The survey was followed up with interviews of approximately half of the respondents. Based on this, Bathelemy like Beaumont (2006) and Goo et al (2009) acknowledge the need for good contracts in any outsourcing agreement and that the goal for any company that decides on outsourcing is to use both the hard and the soft side of management. This creates a powerful management mode that enhances the client-vendor relationship and makes it more effective.

In their research into agreement in outsourcing, Barhelemy and Quelin (2006)´s research of 816 outsourcing contracts in America and Europe from 1992 to 1997 shows how SLA are used as a compliment to the formal contract between a client company and vendor company. To complicate matters, contracts between a vendor company and client company are often incorrectly referred to as SLAs. They reduce the impact of risk and making outsourcing venture more successful. SLA are result focused and aim to drive behaviour and results by using bonus and penalties. SLAs can take the shape of a legally binding and formal contract or more flexible Service Level Clauses (SLC) that outline goals and targets that vendor company need to reach. Researchers found that it is important for companies to stay flexible and not only rely on contract and SLAs, but also imperative to utilize other forms of governance such as trust, reputation, or even technology lock-in.

After survey of 92 senior managers in South Korean, Goo et al (2009) found that all had managed outsourcing businesses and negotiations in the last five years. They confirmed the prevailing academic research on international organisational management, that there are two forms of governance, formal contracts and realisation governance. A formal contract is a written document that contractually binds the two parties together. Most of the time this is negotiated and agreed by senior management and may only work as a guide for overall behaviour and what key objectives shall be reached. The relations governed are different as it is unwritten, based on trust and most of the time is between the employees of the two companies.

Beaumont (2006) conducted nine in-depth interviews with senior managers in outsourcing vendors and three senior client executives. To compliment his primary research the author had numerous informal conversations with the vendor's executives. The conclusion is that a well designed SLA will form the foundation for an outsourcing relationship. In some cases the relationship is at arm's length and very straight forward. In other cases, SLA's are highly complicated with high levels of trust on both sides. Consistently it was found that a good SLA can help remove some of the trust and measurement problems that otherwise occur. Beaumont also outlines a methodology for creating and negotiating SLA's. This is very labour intensive, and sometimes forces the company to hire external consultants which drives up the cost, but the effect of a well structured SLA will be necessary and beneficial as critical process are transferred to another organisation. Well structured SLAs will happen if companies look beyond the simple cost savings and focus on implementation monitoring during the negotiation process.

3. Research Methodology

3.1. Research Philosophy

Generally speaking there are two broad methodological positions, positivism and interpretivism also know as phenomenology. In positivism the underlying assumptions are that any results needs to be grounded in observable facts that can be replicated. This form of methodology is most commonly found in the natural sciences - physics, chemistry, biology, etc. Interpretivism, can be defined as observed phenomena, therefore phenomenology mostly works within the social sciences - anthropology, archaeology, economics, history, ect. The assumption here is that results can only be understood through social constructions such as language, consciousness and shared meanings. (Saunders, et al., 2003)

Figure 2: The research onion

Source: Saunders, et al, 2003 p. 82

3.2. Research Approaches

According to Saunders et al. (2003) as outlined in figure 2, the "research onion" there are two opposite research approaches. In the first, the inductive approach, the researcher collects data and develops theories as result of the data. In the opposite, the deductive approach, the researcher tries to develop an already exiting theory using hypothesis.

Remenyi, et al (1998) takes a slightly different approach and instead follows the data collection where there are two commonly used methods, the quantitative and qualitative. In a quantitative research the goal is to collect a set of facts and then compare the fact with another set of facts, from this conclusion can be made. Qualitative research methods are designed to understand the social and cultural contexts within which people operate. Qualitative methods' gather evidence by means other than counting and, normally, textual information constitutes the core of the data, whether it is the transcriptions of interview records, surveys, field observations, or official organisational documents.

3.3. Research Strategies

Yin (1989) argues that case study is a sophisticated research method that has been used for many years and regards it in much the same way as a natural scientist regards a laboratory experiment. Cases studies are particularly good at answering question around decisions: why they were taken, how they were implemented, and with what result as it allows researchers to investigate contemporary phenomenon within its real life context while using multiple sources of evidence.

Gunmmesson (in Remenyi, et al., 1998), states that it's no longer obvious that limed observation can't be used as basis for generalisation. Nor does it appears obvious that properly devised statistical numbers of observations will lead to meaningful generalisation.

Like any other research method, case studies can become biases, due to the influence of the supplier or the recipient of the information. Unlike pure qualitative research case studies are more susceptible to bias as the researcher is closely involved with the supplier. That said bias's can be found everywhere, and attempts should be made to minimise it, in collecting and analysing data. It is vital for a test to be valid in order for the results to be accurately applied and interpreted. In the suggested case study reliability and validity will be obtained by acquiring data from many sources, a process referred to as triangulation. Using triangulation, any data will be crosschecked against other data. (Tellis, 1997)

For the suggested dissertation, the author has chosen to use a single case company that have multiple outsourcing agreements within different departments. This will allow the author to compare different methods of managing strategic risks when outsoaring.

3.2. Data Collection

The author is planning to use semi structured interviews to collect data, due to the ability to avail them which can develop during interviews. Furthermore this method supports the inductive approach allowing one to probe respondent's answers.

According to Bryman and Bell, (2007) a semi structured interview approach is to be recommend when:

• There are a large number of questions to be answered

• Where the questions are complex or open ended

• Where order and logic of questions may need to be varied.

The information gathered from the interview will be of key importance to the outcome of the research an interview template was constructed and aligned with the research objectives therefore interview questions are created and divided into groups based on themes. Questions will be predominately asked in an open-ended manner to enlist as much information out of the interview as possible. Only a few control questions will be asked in the form of specific (closed) questions. Bryman and Bell (2007) argues that for qualitative studies personal interview are more suitable than a questionnaire as it offer the researcher, flexibility, control over the interview situation, high response rate and ability to collection supplementary information if needed.

The personal nature of interviews also ensures that all the queries are responded to in a direct and indirect manner, such a response rate could is not guaranteed by quantitative analysis. All interviews will be recorded and each interviewee will be offered a copy of the interview and summary transcript of the interview to verify that information has been interpreted correctly. All interviewees are also informed that all material is treated with the highest confidently and no names will be made publish. (Bryman and Bell, 2007)

The criterion for selecting interviews is that the candidates must have relevant experience in selecting or managing outsourcing vendor using agreements. One of the most difficult challenges for researchers is to identifying key object to interview and that can share relevant information. In addressing this challenge the author have arranged pre-meeting with a senior manager in the case company to assist in identifying and booking meetings with key interview objects. These managers are only given basic background information about the research question, to be better able to identify appropriate personnel who could provide the necessary information. (Bryman and Bell, 2007)

4. Research idea, problem and hypothesis

Having a clearly defined one research problem a researcher can focus his/her research on obtaining the best data. Crucially the research problem will dictate the methodology used to collect the data. Remenyi, et al (1998) places the research problem at the centre of the whole research process. As a researcher start approaching the process of research it is recommended that he/she break down the process into eight steps, starting with the literature review from this a correct formulation of the research question is possible that will then lead to establishing a research methodology.

Figure 3: Steps in research

Source: Remenyi et al (1998, p. 64)

For this dissertation proposal the author initial research area was around outsourcing, from this a research area the research idea develop as the initial literature review was conducted. In chapter 1 introduction, outsourcing is a growing business phenomena but it comes with strategic risk involved with assuring a process is successfully migrated to eternal vendor. The question is if companies can reduce strategic risk that is involved with outsourcing a business process? The question form the based for a deeper literature review into if companies use agreements to reduce strategic risk.

A research question should not be too broad or too narrow as this can limit or make it impossible to research. During most of the research the research should continue to redefining the research question, allowing it to accurately and making any conclusions from the research relevant and significant. By keeping the research question in his/her mind during the collection of data researcher keep in his/her mind on the purpose of the research study. The goal should always be that theory comes first and that research validates or contradicts theory. As a result the researcher conceives from the theory what to look for; the relevant concepts, the relevant factors and hypothesis to be tested empirically. (Ghauri et al., 1995)

Based on the literature review the research question was too abstract to solve by itself, therefore the research question was broken down into a few smaller sub question so that research can answer the research question. The research objectives include both the primary research question and also the secondary objectives. To support and develop the results of the primary research question and secondary objectives where compiled. The research objectives influence all other parts of the research process, such as structure, method, sample, measurements, analysis and even conclusion. This is the research objectives, each one of them build towards answering the research question. (Remenyi et al., 1998)

Based on the figure 2 and the research question a hypothesis was created to be tested during the cases study:

Hypothesis: Is the strategic risk involved with outsourcing being reduced by intercompany agreements?

From this three sub hypothesis where derived;

Sub-hypothesis I: Is there a strategic advantage by outsourcing?

Sub-hypothesis II: Is there a strategic risk when outsourcing?

Sub-hypothesis III: Is it possible to reduce the strategic risk with intercompany agreements?

5. Research Justification

Decisions to outsource an activity to external vendor are usually taken at the senior level within the company, making it a strategic decision of the firm. A critical decision as to outsource still in too many cases fail to deliver what it was it achieve. According to Duke University's Offshoring Research Network and PricewaterhouseCoopers (2010) the two most common reasons for failure was that the client company had unrealistic expectations and the lack of a outsourcing strategy were the two top reasons for contract terminations.

With this in mind and as noted in the literature review theirs is a growing literature on the outsourcing and intercompany agreements that argues that agreement will reduce the risk (see, e.g., Latcity et al (2008); Beaumont (2006); Bathelemy (2003); Barthelemy (2001); Barhelemy and Quelin (2006); Aron et al. (2006); Roth and O'Donnel's (1996)) The goal of this dissertation is to put this into a hypotheses. This dissertation will contribute to the base of knowing in three areas;

1. The work will build on the already exciting work on usage of intercompany agreements in outscoring. The research hypothesis aim at strengthen the currently exciting research finding.

2. Give empirical evidence to the theory that a service level agreement and contract in outsourcing are reducing strategic risk as outlined in the literature review.

3. Assist decision makers in formulating better informed decision as to how to use agreements to reduce the strategic risk and achieve better performance.

6. Timeline

Unlike an undergraduate thesis, a master dissertation is a lengthy piece of academic writing that demands time to collect and then analyse each of the findings and then the overall findings. Therefore the author has broken down the timeline into three main blocks, fall, spring and summer. This will allow the author time to achieve the research objectives (as specified in chapter 2) to meet the goal of handing in the completed work by September 2011.

6.1. Fall 2010

6.2. Spring 2011

6.3. Summer 2011