“If you outsource a mess, it’s going to take a while to sort that mess out,” says Graham. “If you’ve got a highly inefficient company I’m not saying you shouldn’t outsource, but I would certainly examine very carefully whether you shouldn’t be trying to sort out a lot of the current inefficiencies before you outsource.”
On the inside
Graham says companies need to be very clear about what they’re outsourcing and to have this stated in their contract with the service provider. “If you don’t understand it you’re putting yourself in a position of some weakness if you’re going to enter into that arrangement without a deep understanding of what you currently have and what you hope to achieve and what improvements might be achieved.”
While it is important to have a legal contract and an established governance system to resolve disputes between the outsourcers and the provider, Graham says it works best when the pair communicate and cooperate well and work with a good spirit of partnership.
After cost reductions and improved business outcomes, a third reason for companies to outsource is for scalability and flexibility of operations. Using outside providers can help a company through the difficult transition phase where they move from being a small enterprise to a large one, Bakhtiari argues in another recent paper, Size Evolution and Outsourcing: Theory and Evidence from Australian Manufacturing.
When companies grow quickly they are forced to take on extra layers of management, but might not yet be profitable enough to justify the additional managers or their cost. For some firms, the best solution is to outsource some non-core functions so they can do away with multiple layers of management and concentrate on their core business instead, says Bakhtiari.
“Firms growing beyond some threshold in size have to use a more complex managerial structure in order to operate without loss of efficiency,” he writes. “The additional overhead cost that stems from this management overhaul can be absorbed by the most efficient firms, whereas firms finding themselves operating close to the threshold outsource service tasks in order to keep their size small and their overhead costs low, while their manufacturing operates at the scale of a large business.”
Don’t lose efficiency
Bakhtiari’s analysis of the Australian Business Longitudinal Survey reveals a paradox in the use of outsourcing – that some manufacturers actually shrink the size of the company in order to produce more. These tend to be the firms not efficient enough to absorb the loss of efficiency that comes with adding extra layers of management.
These firms grow by expanding their networks of suppliers and contractors rather than physically hiring. “The firm is compelled to roll back its size to just below the transition point and outsource the difference in employment,” he writes. “This way, the business keeps its scale of operation at the level of a large business, but internally operates at the level of a small business, hence, saves costs.”
McKinsey’s Champeaux says companies often want the option of having some reserve sourcing from outsourcers, particularly if they are not confident about how long their growth phase will last. “In cases where they didn’t need complete visibility and didn’t want to incur the internal fixed cost base of scaling up their operation they will say, ‘I want to have the flexibility to scale up faster, but I don’t want to be tied into a big cost base internally because I don’t have complete certainty’,” he says.
