The Joys of Outsourcing: It's not all beer and skittles

Episode #95 The Joys of Outsourcing: It's not all beer and skittles

Hey there, and welcome to Episode 95 of the No Bullsh!t Leadership podcast. This week’s episode, The Joys of Outsourcing: It’s not all beer and skittles. Our listener, Geoff asked if we could do an episode on outsourcing, when should we do it? And what are the pitfalls that we need to watch out for? And this is a fun one for me to talk about, given my background as a CIO in some pretty large companies. I’ve conducted a number of large outsourcing processes to assess whether a service should be moved from in house provision to an external supplier. In this episode, we’ll try to pick apart some of the more important steps you’ll have to go through when trying to make an outsourcing decision and a few of the common traps for young players. We’ll start by asking why would you outsource something? We’ll then take a look at how you’d go about making a decision like that. I’ll pause briefly to explore why a lot of outsourcing relationships don’t work out the way we might expect. And I’ll finish by taking a little look into my crystal ball to imagine the future of outsourcing. So let’s get into it!

Let’s start off with why you’d want to outsource something. I’m going to spend a little bit of time on this because it’s really fundamental to achieving the right outcome. Are you considering outsourcing for the right reasons? Because this is so important, I’m going to make it available as a free download for our listener community, which you can get from the Your CEO Mentor website, www.yourceomentor.com/episode95. There’s a lot of good reasons to not do everything that our organisation needs to have done in house. Most organisations outsource something, whether it’s visible to you or not. And you might be able to recognise some of the examples I use in a minute. Now in the ’90’s outsourcing became all the rage, particularly in the IT industry, but the principles behind it go way back to the economic theory of comparative advantage, which was first proposed by David Ricardo over 200 years ago. This basically underpins the whole global trade regime.

Comparative advantage operates at the level of a country or a whole economy, but it can be applied just as easily to the level of an individual business. These decisions are what we call make or buy decisions. Should I make it myself or should I buy it from someone else? There are many things that make a lot of sense to outsource, and here are some of the reasons why. Now I’ve just pulled together seven of these, but I’m sure there are more.

So the first thing is if you’re doing something that is actually a commodity, there’s no value add to it and it can easily be done by someone else without a lot of expertise. For example, accounts payable. Now with all due respect to accounts payable professionals, it doesn’t require high order expertise. It requires diligence, an eye for detail and occasionally some analytical skills. But there are many market providers so the risk of outsourcing is really low. If one supply fails, you can readily find another one. Some of the other advantages of outsourcing commodity style services or products will become obvious shortly.

The second reason you might want to outsource is it often you could buy a product cheaper from an external source. Now, if we look on the global stage, there’s a concept called labour arbitrage. In some places, labour is just a lot cheaper than it is at home. A few decades ago, sweatshops shops in Southeast Asia were manufacturing textiles and the cost of labour in these countries was sometimes an order of magnitude lower than in developed countries. The result was really, really cheap products, which filled our store shelves. But there’s been lots of backlash on this ever since the major brands were outed for exploiting workers in these developing countries, and so they should have been. Now we’re going to have more on this in a minute, but often, this sort of arbitrage sees goods being made markedly cheaper even when you take into account shipping, exchange rate conversions and import tariffs.

The third reason you might want to outsource is that some companies simply do it better than yours can because they have the expertise. Things that aren’t core or fundamental to your business and what you do may be core and fundamental to potential suppliers of those products or services. It’s their day job. It’s almost a given that they can do it more efficiently at high level of quality and more cheaply. They have the expertise. So they’re much more likely to have refined their processes and systems to gain these advantages over a long period of time. I’m going to give you an example and I hope it’s not too circular, but let’s say you want to run an outsourcing process to select a new supplier.

You don’t do that very often. In fact, you may only do it once in a blue moon, so you don’t have any expertise in that area. For the suppliers you’re trying to select, on the other hand, they have deep expertise in this. They respond to tenders all the time. So the very best thing you can do is to get some expertise in to help you with that process. You don’t own it internally. So you have to outsource the expertise that helps you to work out who to outsource to. I said it was a little bit circular, but it is a pretty good example. For me personally, I have a hell of a lot of expertise in the outsourcing process, but I would never attempt to do it myself. I’d always bring in a high order expert to help me with it.

The fourth reason you might want to outsource is that there’s something that you only do very, very infrequently. So a great example is the legal function. Now in most of the organisations I’ve worked in, we’ve had large legal teams and they have a whole lot of generalists legal expertise, but sometimes you’re going to need a deep expert in a particular area. For example, in competition law or contract law or employment law. And when those things arise, you can’t afford to have a top contract lawyer sitting around just waiting to be called to the table. What you need to do is to outsource those things with firms that specialise and hold that deep expertise to offer to a whole range of clients.

Reason number five, to outsource flexibility. Now, classic example of this is overhaul work at power stations. In a modern coal fired power station, you can get by with maybe about a hundred people to run it day to day. A lot of the stuff that you do is actually automated. But every three years or so, you’ve got to do an overhaul on that unit, and then, you need probably 400 or 500 people. Now you’re not going to have 400 or 500 people of excess sitting around for that time when they have to spring into action once every three years. So you have to buy that from an external firm that specialises in providing these types of people. The work increases for a couple of months only by about 400%, and then it goes back to normal. So the flexibility that’s required to do that can only be done by outsourcing to external firms.

Reason number six for outsourcing is scale. And sometimes you just have some suppliers that have advantages of scale over what you can do internally, and this is very common. Classic example is the manufacturer of heavy rail wagons. When I was at Aurizon we used to buy a lot of these things to help us haul coal from a mine to a port. And these things, if they were manufactured locally, used to cost maybe about $280,000 or so. But if we bought them from China, the cost was about 60% of that. When you have scale in manufacturing capacity and capital, as they do in China, you can actually get things a lot cheaper. So outsourcing the production of something to a company or a country that has greater scale is really valuable.

And finally, number seven, sometimes there’s just a need for independence. You can’t do it yourself. For example, you can’t audit your own company’s financial accounts. Well, you could, but it wouldn’t pass the sniff test for regulators and investors. So there’s some of the reasons why you would want to outsource, but why would you not want to outsource something?

Sometimes, even if it passes those tests we’ve just spoken about, there may be strategic reasons not to outsource. The first, and in my view the most important, is that if something is core or fundamental to your business, that you rely upon for your expertise, you cannot outsource that. It doesn’t matter if you can buy cheaper out of the market, you need to retain your core fundamental capability and expertise in house. Sometimes though you have spare in house capacity to utilise. So to utilise that capacity, you do that instead of outsourcing. And occasionally you get into the situation where even though you might like the end product of having something outsourced, the switching and transition costs are simply too high.

But the important rule of thumb is don’t outsource anything that’s core to your business and your ability to compete. Outsourcing specialist legal advice, as we spoke about earlier, may be fine for a bank, but what if you’re in the business of providing legal services to customers? What if it was your actual business? Well you wouldn’t want that knowledge and capability anywhere else, except inside your company. If a supply disappears or a supplier isn’t performing, you’re held to ransom because it’s such a critical function for your business to undertake. There are a bunch of other good reasons why you might not want to outsource. So for example, patriotic reasons. The buy Australian or buy American campaigns that we see appeal to our sense of patriotism, not our sense of economic rationality. It says “pay more than you need to because you’re supporting local jobs and industry”. And this is great because we all get a choice as to whether or not we pay the patriotism premium. Sometimes there are ethical reasons while we may not want to outsource. Investors, and customers are now used to looking through the whole value chain for unethical practises.

Should you be able to pay less for any consumer good if people are being taken advantage of somewhere in that value chain? There’s a fantastic book I want to refer you to it’s called What Money Can’t Buy by Michael J Sandel. And it’s one of the most thought provoking books I’ve read in many, many years. It explores the moral limits of markets. Just because a functioning market can exist, should it exist? Really worth getting into. And finally, sometimes you simply don’t want to take the risk of something being not produced inside your control. We’re going to talk about the illusion of risk transfer shortly.

How would you go about making a decision on outsourcing? Now I’m going to start by talking about larger organisations, but I’ll make some comment shortly on micro businesses. For a start, work out exactly why you want to outsource. What are you trying to achieve? Are you trying to achieve reduce cost, better management focus on your core business, more consistent processes, flexibility of resources, access to expertise you don’t have in your business now? This should frame how you ask the question of the market. So the second thing is to understand your cost structures. Get a really good baseline for how much it’s actually costing you to deliver that service now. So you’ve got to work out the people actually doing the work, and also the people supporting that work, the assets that you’re using for that work, computer equipment, manufacturing facilities, warehouse space, how much management focus is it taking?

How much of that will disappear once you outsource? Because it’s really important that you understand the delta. Then you have to sound out the market, test your hypothesis about whether there would be value. Don’t go full blow and just do your desktop research first. Talk to other similar companies who’ve outsourced that type of service and then go to market with a request for information, just get some ballpark confirmation of your theory about the value of outsourcing a certain function. If that all seems to stack up, then you might want to proceed to a full blown tender process. The very first thing you have to do is establish the selection criteria, and these need to be weighted. In other words, work out what it is you’re going to use as a basis for deciding on which supplier to bring in, and the weighting of the criteria just basically tells you which one is more important than another one.

This is going to stop you from becoming starstruck with those suppliers who salespeople just talk a good game. It’ll help you easily sort out the dogs from the fleas, as you see who really meet your criteria. Then you invite the key players to respond and key players based on their track record and expertise, and based on the guidance you got out of your request for information process that you ran quickly before. If you haven’t done this before, you need to know upfront that analysing the responses from different suppliers is always really, really difficult. Each of them has pros and cons, and you’ve got to build up a cost profile that sometimes doesn’t compare apples and apples. You’ve also got to be able to let them know the potential suppliers or the terms and conditions of the contractor, they need to know what they’re signing up to because very often this affects the price. And from there you interview, you probe and you question those suppliers who have responded. Use every avenue available to separate the marketing spin from the reality. Just remember these suppliers do this every single day and you do it extremely rarely. The gap between the marketing spin and the actual service delivery is always noticeable, but you want to make that gap as small as you possibly can.

Why do outsourcing relationships often not work out as you imagine they would? Well, there’s a range of reasons, but one of the most common ones is a poor understanding of the objective. This leads to poor setting of criteria and then poor selection of a supplier. Misaligned objectives between you and the provider is a recipe for disaster, and it happens really early in the piece. Sometimes, there’s just poor analysis of your cost base. You can’t remove all the costs on your side that you thought you could. For example, in the analytical process, you’ve made some assumptions about removing people or reducing services or pulling out assets, and then you find that when push comes to shove, you can’t actually do that for one reason or another. This is always going to make your cost base higher. Another reason is poor contractual coverage. Now, no contract is ever 100% complete and many suppliers are absolute masters at being able to put variation notices to the contract.

They have to perform a function that is critical that you used to do yourself, but they say, “Oh, hang on a minute. That’s not included. Check the contract.” Before you know it you’re paying over and above what the baseline contract was that you actually did your analysis on when you made the selection. Sometimes there’s just a naive view of the cost to manage. We underestimate the cost of having to keep that provider honest and to manage the interactions between them and your organisation day-to-day. Sometimes there’s an underestimation of the complexity of switching costs. So for example, taking an IT system and outsourcing that. There’s a whole lot of work that has to be done, data cleansing, transfer of that data, reestablishment of the service, disaster recovery provisions, it all has to be seamless to your customers, and so setting that up between you and the external provider is sometimes quite complex.

But the one that I think is the big one is the illusion of risk transfer. We can outsource the function, but we can’t outsource the risk that goes along with that outsourcing. When something goes wrong, the service provider isn’t the one who’s held to account, and we see this over and over again. Here’s a good example. Has anyone ever heard of the company Transocean? Well, you may have. It actually owned and operated the Deepwater Horizon oil rig that blew up in the Gulf of Mexico in 2010. You’ve all heard of Halliburton. Well, Halliburton was the company that was responsible for the capping of the well with cement, the failure of which was the cause of the whole incident. But we all think of it as British Petroleum’s rig because BP had the lease on the actual resource and the output product.

On a much smaller scale, an example I had at CS Energy was with a coal mine that we actually owned, but we outsourced the mining operations to a third party. And when the contract miner was responsible for a technical environmental breach, guess who was responsible for that? It wasn’t them. It was CS Energy. It was a blot on our scorecard, even though we had virtually no control over it. We should have managed the contractor more diligently, because we held the environmental licence, not them. So by all means, outsource it if it makes sense, but don’t kid yourself that you no longer hold the risk because you do.

Alright, let’s take a look into the crystal ball to finish off. What sort of trends are we going to see in outsourcing as time goes on? Well, there are more fragmented working arrangements all the time and COVID-19 has really helped us push into those a bit more strongly. The gig economy is becoming more accessible and it’s becoming more trusted. So for example, at Your CEO Mentor, we have a super lean operation because so much can be outsourced. And we mainly outsource for expertise, but also for scale reasons as well. Everything from bookkeeping and accounting to social media advertising, SEO, right through to colour grading a video content, it’s so easy these days and services are there to help you outsource readily. So, sites like Upwork really give you access to that market of outsource providers. Another real trend that we’re seeing is the ageing population. As expertise is drained from organisations, market players will need to take their place.

Here’s a great example from my days at CS Energy. We had some people who’d been in the organisation for decades. They knew their craft inside out and back to front. They were deep experts in the technical aspects of running the power stations. But as these people got older, it was obvious that we weren’t going to be able to replicate that expertise in any way, shape or form. And because growing that capability internally was no longer possible, we had to look at market players. For example, we have a small handful of power stations, but people like General Electric, Siemens, they have power stations all over the world that they have access to where they can continually build and hone their expertise. Now, interestingly, some would consider this to be CS Energy’s core business, but there’s this principle, right, if you can’t build it in house, it’s either too difficult or expensive to do so you may be forced to the market.

Another trend that pushes us towards outsourcing is cloud computing and software as a service. In the old days, you used to have to buy software and own it yourself and run it on your own computers. But these days, subscription services to software make this super, super easy. So at Your CEO Mentor we use a bunch of subscription services, obviously we use customer relationship management software, we use Gmail, we use chat software, all of this stuff sits in the cloud and we get it for really, really cheap subscription without having the overhead of having to run it and manage it ourselves. Even major businesses are going to the cloud to avoid the cost of owning and managing their own technology infrastructure. It provides more balance sheet capacity for other business related assets, which is just an added bonus. I think we’re going to see a lot more outsourcing as a trend going forward.

So it will be handy for you to really understand the dynamics of when to do it and when not to do it. But don’t just try and outsource something because it’s giving you the shits. Never try to just outsource a problem. If it’s a problem, it’s likely that you don’t fully understand the dynamics. In other words, why is it a problem? So what you’re trying to do is shift it to someone else, but trust me, you’re going to end up paying for it somewhere, somehow. A problem is a problem, and this is definitely one area where out of sight and out of mind, doesn’t solve your problem.

Alright, so that brings us to the end of Episode 95. Thanks so much for joining us, and remember at Your CEO Mentor our purpose is to improve the quality of leaders globally. So please take a few moments to rate and review the podcast, because this is how we get to even more leaders. I look forward to next week’s episode, Performance Reviews.

Until then, I know you’ll take every opportunity you can to be a no bullsh!t leader.