New Trends in Organizations Flexibility: Outsourcing


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New Trends in Organizations Flexibility: Outsourcing

  1. 1. NEW TRENDS IN ORGANIZATIONAL FLEXIBILITY: OUTSOURCING Fernando Casani Fernández-Navarrete MaÁngeles Luque de la Torre Jesús Rodríguez Pomeda Pilar Soria Lambán UNIVERSIDAD AUTÓNOMA DE MADRID Madrid, April 1996 INTRODUCTION In recent years, the need for flexibility which has been forced on management by the new competitive environment has given rise to the development and the spread of outsourcing. In spite of its general use, we think that on occasion it has been used incorrectly and to a lesser degree as a simplistic tool for reducing staff. The object of this paper is to have a critical look at outsourcing along the following lines. Firstly, we look at the effect of technological change and of the globalization of markets on the new competitive environment and the reaction of firms adopting a more flexible organizational structure. From this base, we develop the concept of outsourcing and its process of implementation and its treatment in the literature. Our study is a critical analysis of the series of internal and external problems posed by outsourcing in firms which have introduced it but have not up to now taken advantage of its full scope. The final section gives a summary of main conclusions of the paper. 1. TECHNOLOGICAL CHANGE AND THE NEW COMPETITIVE ENVIRONMENT Technological development induces and subsequently is affected by changes in the economic environment. As history has shown, technology is the key factor in the creation or disappearance of a business, as a result of new products replacing older ones, the opening of new markets, and radical changes in production, sales and consumption; in other words, significant changes in the process of added value. Therefore, technological change appears as a social process, whose sphere of influence is as much within the firm (acquisition and development of know-how, learning patterns or management models), as it is on the environment in which its business activities take place (institutional changes which affect market regulation, tangible and intangible public infrastructure, etc.) Presently, technology is changing the competitive environment. It is characterized by two sets of interrelated factors. On the one hand, technological and organizational innovations foster cost reductions in communications and transportation permitting decentralization; while on the other, institutional changes facilitate liberalization of financial and commercial markets (Papaconstantinou, 1993, p.7). Firms try to respond to this complex situation by using a growing ability to adapt. The increase in commercial deregulation places a premium on rapid response to these changes because of greater ease of entry to wider markets and the shorter time frame in which to take advantage of the resulting competitive edge. The outcome is a qualitative change in the manner in which the firm carries out its activities. A consequence is the appearance of new production models based on the interaction of their components, which include the development of differentiated products, anticipated responses to the market, a multi-faceted workforce, and flexible organizational schemes which yield cost reductions while maintaining levels of quality (Boyer, 1995, p.107). In the new competitive environment, flexibility becomes a key factor in defining the strategy and the structure of the organization. The rapid changes in technology and the speed with which new products are introduced into the market force on firms a process of adaptation in order to be able to respond to the strategic moves of their competitors. Therefore, firms must have not only strategic management, but a flexible organizational structure. 1
  2. 2. 2.ADAPTATION OF ORGANIZATIONAL STRUCTURES In this context, the classical organizational structures based on vertical and hierarchical structure are giving way to horizontal organizations, broader and less hierarchical. Generally, it is alleged that the traditional vertical structure slows decision-making and the implementation of processes, while the horizontal structures, with the decision-making process decentralized to inter-functional teams, permit the development of creative forces within the organization, fostering their learning abilities, and, therefore, allowing the firm to better adapt to the new competitive environment, in which organizational learning is becoming ever more important. Nevertheless, as we will show throughout this study, creating horizontal structures does not eliminate the problems of the organizations, but on the contrary, they simply exchanged for others. As a result, smaller, more responsive and more dynamic organizations (learning organizations) arise with staff who assume more responsibility and, therefore, are more committed to the goals of the firm (loyalty). Firms are more customers satisfaction oriented, with special emphasis given to processes rather than functions, focused on the analysis of the value given to the customer by each of the activities. On the other hand, new trends in the organization of the firm tend to blur its limits when developing structures bases on strategic flexibility and on co-operation between competitors, while at the same time continuing to compete in the traditional way in other fields or sectors of activity. Similarly, technology has eroded the barriers to co-operation between firms, by permitting easier co-ordination of the activities of organizations which work together, reducing the transaction costs, especially in customer-supplier relationships (Halal,1994). As a result in some cases, internalization of activities by firms makes less sense, often resulting in a process of spinning off organizational units and causing a reduction in size of the firms resulting in smaller, more rationalized organizations, i.e. a learning organizations, with a variety of co-operation and outsourcing agreements with other firms.1 The process of down-sizing organizations, which occurred mainly during the period of economic crisis in the early 1990's, put special emphasis on the areas of cost reductions, concentrating primarily on staff reduction and process re-engineering (Hammer and Champy,1993) with the aim of re-directing activities towards the customer. Since the mid-80's, the so-called Theory of Resources and Capabilities has gained increasing importance in strategic management (Giget, 1984 and 1986; Grant, 1991 and 1992; Peteraf,1993; Prahalad and Hamel, 1990 and 1994; Penrose, 1958; Selznick, 1957; Wernerfelt, 1984). One of the fundamental concepts of this trend is that of core competence. In its most recent form, it consists of three inter-related factors (Bueno, Morcillo and Rodríguez, 1995, pp.3).: -intent, what the organization wants to do in response to their future strategic vision of the business. -know-how, what the firm knows how to do as a result of accumulated experience derived for internal as well specific external sources. -capabilities, what the firm is able to do based on the professional skills and abilities it possesses. Management by competences consists in identifying what the firm knows how to do best (with respect to its competitors) based on its key organizational capacities and concentrate on preforming these 1 A flexible structure would be, for example, the so-called Irish Shamrock, proposed by Handy (1989) 2
  3. 3. activities. Starting from Porter's concept of the chain of value, each of the core and support activities of the organization are analyzed to determine those which generate low value or do not create core competence and which can be performed by other companies through contractual agreements or by means of a co-operative process (Bueno, 1996, p.233). It may even be assumed that each firm competes not only with its direct competitors, but with all its possible suppliers for each activity in its chain of value. Therefore, if an internal activity of the firm can be carried out more efficiently by a supplier, it may be preferable to sub-contract the activity and concentrate on those at which it is more efficient. In practice, therefore, the firm may analyze each task that it performs and concentrate on its core competence and critical strengths. Concentration by the firm in developing its core competence makes it worthwhile to co-operate with other firms to perform its non-basic activities (strategic outsourcing). As shown in Figure 1., the outsourcing process begins with the external sub-contracting of simple activities for which there are many suppliers, such as, security and building maintenance. Later, sub-contracting can de done of more strategic activities which require a closer relationship with the supplier, such as, logistics, distrubution and even product design. At the limit is the concept of the virtual corporation where the firm offering the product to the customer is perceived as a single highly-integrated company, when in reality it is an organization formed by multiple companies involved in the production of specific goods or services. Each of the companies focuses on its core competence and takes part in some of the necessary phases to produce a final product which meets the needs of the customer. Thus, maximum efficiency is achieved as each task in the chain of value is carried out by a specialist in that area. FIGURE 1.- THE EVOLUTION OF OUTSOURCING VIRTUAL PERCEIVED COMPANIES PROXIMITY TO PRODUCT “CORE” DEVELOPMENT DESIGN DE FINANCE MANUFACTURING PRODUCTOS FUNCTIONS MARKETING LYBRARY INFORMATION SYSTEMS DISTRIBUCION PHOTOCOPYING TRANSPORTATION SECURITY MESSENGERS CATERING RIA CLEANING TIME VERTICALLY/HORIZONT ALLY INTEGRATED COMPANIES Source: Arthur Andersen, EIU (1995) In the following sections we will make a detailed study of the characteristics that outsourcing exhibits in this process leading to the virtualization of the firm, and the internal and external problems associated with its implementation. 3. OUTSOURCING: CONCEPT AND PROCESS 3
  4. 4. 3.1 CONCEPT There are two basic types of outsourcing: a) The first type is defined as the process by which a task or activity traditionally performed within the firm is transfer out to an external supplier. b) The second type, used more in practice and which may cause confusion, defines the process as any activity carried out outside the firm regardless of whether this activity had previously been carried out by the firm. Nevertheless, and independent of the interpretation that is adopted, one must keep in mind that the process of outsourcing is not a mere service of classical sub-contracting, but implies a much deeper relationship between the client and the supplier. Outsourcing is a long-term link tied to the performance of certain essential tasks by specialists -but not in the area of its core competences- who over time become strategic partners. For the relationship to work efficiently, both organizations must accept the fact that each one has to share with the other certain strategic decisions. The financial remuneration received by the supplier may even depend on the results obtained, in such a way that both share in the risks and the profits of their co- operation. The fundamental characteristic which differentiates tactical outsourcing (or merely sub- contracting) from strategic outsourcing is the establishment of a co-operative relationship which grows proportionally with the interrelationship between the externalized function and the rest of the business process. However, in practice, it is not always easy to identify the boundary between sub-contracting and strategic outsourcing2. In parallel with outsourcing, and also in response to the need to modernize organizations, the concept of re-engineering has emerged. Both concepts may be considered instruments to use in response to the rapid changes in the business environment, with the aim of obtaining a clear improvement not only in one's competitive position but also in business profits through the management of business processes. Re-engineering is a radical internal re-structuring; while outsourcing is co-operation with external suppliers. According to Rueda and Molina (1995), the difference between these two terms from a conceptual point of view is to be found more in the temporal environment and the ability to control resources than in the content (see Figure 2.). FIGURE 2. EVOLUTION OF CO-OPERATION MODELS COOPERATION MODELS TRENDS internal INSOURCING actions for improvement ALlIANCE reengineering internal filiation RESOURCES erna strategic CONTROL alliance external filiation OUTSOURCING with a partner outsourcing agreement Source: Rueda y Molina (1995) CAPABILITY & FLEXIBILITY TO REACH THE OBJECTIVES 2 From here on, the term outsourcing will be used exclusively to mean strategic outsourcing. 4
  5. 5. 3.1.1. SOME DATA ON THE USE OF OUTSOURCING No precise data exists which would permit us to accurately quantify the volume of economic activity that outsourcing operations have reached, nor the sectors nor principal activities in which it is being used. Nevertheless, a few studies and some partial estimates permit us to see the main trends. An empirical study published in the Economist Intelligence Unit in co-operation with Arthur Andersen (1995) contains the conclusions of a survey of 303 senior executives from global businesses throughout North America and Europe. The results (see Figure 3.) show that outsourcing is widely used in an extensive range of activities by major American and European companies, especially the later. FIGURE 3. A COMPARISON OF OUTSOURCING IN EUROPE AND NORTH AMERICA WAREHOUSING 34% 17% FINANCIAL 32% FUNCTIONS 21 % 50% PRODUCTION 21% 51% INFORMATION SYSTEMS 27% 66% TRANSPORTION & SHIPPING 24% 63% LEGAL 56% Europe North-America Source: EIU (1995) It is worth pointing out that in the telecommunications sector, the objective of the large consortiums which are being formed is to externally manage the communications of the major companies in the world. CONCERT, a global company formed by BCT and MCI, estimates that the outsourcing services in the sector today represent a $69,000m. business and that this figure will reach $156,000m. by the year 2000. Meanwhile in the financial sector, a study done at a world level by Ernst & Young (1995) shows that the evolution of outsourcing has not only stablized, but that its rate of growth is quite high (see Figure 4.). FIGURE 4. THE EVOLUTION OF OUTSOURCING IN FINANCIAL INSTITUTIONS 60% 50% outsourcing developed 40% outsourcing in 30% process 20% 10% 0% MORTGAGES CREDITS CREDIT CARD RETAIL RETAIL LOCKBOX SOFTWARE CHEQUE PROCESSING TREATEMENT NETWORK MANAGEMENT DATABASE CARDS ISSUES BALANCE STUDENS CREDITS CREDITS SCORING 5
  6. 6. INSURANCES Fuente: Ernst & Young (1995) ATM DRIVING & SWITCHING SEGUROS Por su parte, EDS, principal proveedor mundial de servicios informáticos con más de un 25% del EDS, the world's leading supplier of data processing services with more than a 25% share of the market, estimated that in 1995 the European outsourcing market for computer services was $250,000m., which represents 6% of total expenditures in Europe on computer services. In Spain where outsourcing is not so extensive, expenditures are estimated to be about $540m., 2.7% of total expenditures for all computer services. However, it should be pointed out that the outsourcing contract recently signed by LA CAIXA with the same EDS could reach a value of $1,000m. over its 10-year life. EDS is presently negotiating a similar agreement with CAJAMADRID. In addition, Banco Urquijo announced a 10-year contract with IBM ISS valued at an estimated 10,000m.Pta. The CRANFIELD project3 shows that 41% of the Spanish companies surveyed, which represent a variety of sectors of activity, have increased their use of sub-contracting in the last three years. This conscious decision by businessmen confirms the great future to be seen in this activity. In 1995, 72% of companies used sub-contracting to a greater or lesser extent. Forecasts indicate a continuation, if not an acceleration, of this trend, which is appearing in the rest of Europe as well. 3.1.2. ADVANTAGES AND DISADVANTAGES OF OUTSOURCING Many papers on outsourcing are to be found in the literature. They make reference to the advantages and disadvantage associated with the use of outsourcing. Nevertheless, we believe it is advisable to divide them into two basic categories: advantages and disadvantages of a strategic nature and those of an operational nature (see Figure 5.). This classification will permit us to simplify our study of them and to obtain some empirical evidence of businessmen´s reaction to them. FIGURE 5. THE ADVANTAGES AND DISADVANTAGES OF OUTSOURCING ADVANTAGES DISADVANTAGES STRATEGIC OPERATIONAL STRATEGIC OPERATIONAL Competitive Eficiency Lost of Contract problems advantages increase control with supplier generation Possible Reduction of further Risks labor cost increase of Problems with reduction cost internal human Cost reduction in the Different resources long term quality to Organizational final consumer flexibility increase Source: Own elaboration 3 Annual report leaded by ESADE and by Formación Continuada Les Heures of Universidad de Barcelona which studies trends in the Strategic Management in Human Resources in Europe. 6
  7. 7. Strategic Advantages a) Generating competitive advantages: The use of outsourcing in a specific activity does not necessarily mean a competitive advantage will be gained in that activity, even though it is being performed in the most efficient manner by a specialist. As the specialist may be supplying the same service to a number of competitors and all things being equal, every user of the service essentially maintains its same relative competitive position. The basic advantage of outsourcing is that it allows managers to concentrate on the core areas of their business giving them more time for key activities and freeing human, capital and management resources to be focused on activities which form the basis of their business. The following are some of the main competitive advantages to be obtained: a.1) the formation of barriers to entry, as a direct result of developing core competences. a.2) the quickest access to autonomous innovation (Chesbrough and Teece, 1996), that is, innovation which can be introduced independently of other innovations. The supplier, in the capacity of a technological partner, may be able to provide innovation more quickly that the firm could develop it itself resulting in shorter development times, quicker response times, greater flexibility and better quality of service. b) The cost reductions basically obtained through: b.1) an extensive utilization of investment, innovation and abilities of the external suppliers of outsourcing that cannot be duplicated internally (or if they can, at a much higher cost). b.2) a modification of the cost structure, reducing fixed costs and making variable costs more predictable. There is a reduction in the fixed costs of maintaining capital assets and their associated labor costs. c) Risk reduction: c.1) with rapidly changing technologies and markets, the joint strategy presupposed by the use of the process of outsourcing reduces risks, shortens life cycles, reduces investment requirements and allows better response to final customer demands. c.2)in addition to the above, part of the risk that the customer assumes is transferred to the supplier, since he now also has an investment. For example, Gallo, a major producer and distributor of wines in the United States, purchases most of its grapes from outside sources, shifting to its suppliers the cost of land, labor problems and the risks associated with the weather (Quinn and Hilmer, 1995, p.66). d) Finally, outsourcing increases the organizational flexibility which allows the firm to design a smaller more responsive organization, which is able to react more quickly to the changing business environment, as well as providing easier access to the resources and experts needed for growth. Operational Advantages a) Firstly, an increase in performance of the factors used can be obtained since they are managed by specialists in each activity. b) Furthermore, reductions in permanent staff can be achieved. (Depending on the specific legislation in each country, outsourcing may be a way of achieving greater staff flexibility). In spite of the supposed strategic advantages emphasized by the theory; in various empirical studies (i.e. Oraa, 1994), it can be observed that the advantages perceived by the client as a consequence of outsourcing paradoxically are more related to operational than strategic considerations (see Figure 6.). 7
  8. 8. FIGURE 6. THE ADVANTAGES PERCEIVED BY THE CLIENTS 25 operational advantages 20 15 strategic advantages estratégicas 10 5 To decrease the management upon information systems No-one To improve the efficiency of the system To decrease cost To develop core competences Various To decrease time for implementation Source: Adapted from Oraa, J. (1994) & our own elaboration Among the disadvantages perceived by the customer it is worth mentioning the following: Strategic Disadvantages a) Lose of Control a.1) Relinquishing certain internal activities may result in the lose of company know-how and a valuable source of learn- ing. a.2) Creating excessive dependance on suppliers. a.3) Transferring confidential customer firm information may enable a supplier to become a competitor in the future. b) Possible Cost Increases b.1) Costs may be higher than originally estimated. A supplier on which the firm is dependent may exact over time ever increasing compensation specially for those activities for which there are few alternate supplier or where changing supplier would be extremely costly. c) Variations in Quality Given to the Final Consumer c.1) There is a risk that the quality of goods and/or services provided by the supplier does not meet initial expectations resulting in the final consumer being adversely affected. Operational Disadvantages a) Contractual Problems a.1) It is not feasible to identify all potential contingencies and all but impossible to accurately estimate the probability of an identifiable contingency occurring. Contingencies of either type could significantly alter the projected cost estimates. a.2) Renegotiating and monitoring the contracts may be complicated and costly. b) Staff Reduction Problems 8
  9. 9. 3.2 THE PROCESS OF OUTSOURCING According to the study done by Arthur Andersen in conjunction with The Economist, there are five stages in the process of outsourcing4: THE PROCESS OF OUTSOURCING 1.-The identification of the core competences 2.-The evaluating of opportunities 3.-The choice of the suppliers 4.-The organization and management of the process 5.-The control and evaluation of performance Taking this five-stage process as tested and approved5 , we will proceed to analyze it in further depth. 3.2.1. IDENTIFICATION OF CORE COMPETENCES One of the main problems in all processes of outsourcing is that of determining which competences are key to the firm. As stated before, and following the lead of various authors, we can go on to identify the key competences, thus getting a clear and realistic view of the activities which truly have a strategic nature for any organization. Furthermore, it should be pointed out that this analysis should be as objective as possible, keeping in mind that employees at whatever level of the organization always consider their activity to be basic and essential to the firm. Therefore, the best way to formulate strategies for the future is obtain in-depth knowledge of a small number of core competences. Starting from this idea, theoretically, firms could delegate to external outsourcings all those functions in which they have decided not to develop these core competences, transferring said functions to other specialized organizations (see Figure 7.). FIGURE 7. DECISION-MAKING ON OUTSOURCING low OUTSOURCING INTERNAL EFFICIENCY INSOURCING high core non core COMPETENCES Source: Own elaboration However, it should be kept in mind that outsourcing is not the only available alternative. A study should be make of the various options and an examination done of improvements which could be implemented internal at low cost before opting to sub-contract out the activity. 4 New Directions in Finance. Strategic Outsourcing. The Economist Intelligence Unit. Written in co-operation with Arthur Andersen. 5 We think that we are dealing with a universally valid process since it is based on the stages of the scientific method. 9
  10. 10. There is not doubt that the process of outsourcing has been used most intensively in the area of information technology. For this reason according to Alarcón (1992, p.83), the firm itself should analyze its present situation with respect to the following criteria: a) What functions are presently being carried out by the IT? b) What are the minor tasks that have been integrated into the department and are not part of its basic function? c) What is its real cost? d) How is it structured and how does it operate? e) What is present staff size, how is it made up, and what are their real capabilities, especially older personnel? f) What is the volume of data processing done outside the department proper and what relationship does it have with the department? g) How efficient is the department itself? h) How effective is company control over the department? Recently, the incentive to use outsourcing has spread to other functional areas, especially the financial function. The most striking case of financial outsourcing is, without a doubt, the recent agreement between Sears and Andersen Consulting. This consultant will take over the administration of financial and accounting operations management for Sears, which is one of the largest department stores and distribution companies in London. The agreement signed by the two companies has a value of up to $500m. over the ten-life of the contract and will mean transferring 900 Sears employees to the consulting firm. Andersen Consulting is presently handling the external operations and has integrated them into the overall management of the company in such a way that the customer can keep a close eye on the operation it has transferred without being involved in them. This permits them to focus on other strategic core areas of their business. 3.2.2. EVALUATION OF OPPORTUNITIES Measuring the effects of outsourcing on organizations is not easy. All suppliers agree that there are two complementary approaches to analyzing the effects of implementing the process of outsourcing: the economic effects and the strategic effects. Looking at economic benefits, there is a general consensus for the need to use certain analytical techniques, such as, Cost-Benefit Analysis or Mapping Planning, to determine future cost savings to the organizations planning to use this type of process. This is the only way that firms are able to decide whether it is in their interest to externalize some of their non-basic activities. A few cases give a clear view of the large savings which can be obtained by using the process of outsourcing. British Petroleum Exploration, one of the major users of outsourcing, has managed to reduce its exploration costs by approximately 30% (Cross, 1995). Nevertheless, it is important to realize that the main source of advantages from outsourcing is not to be derived for the most part from future cost savings. The advantages come rather by making more time available for other types of strategic decision-making, which logically have an impact on improving the competitiveness of the firm in the future. This was the belief of 18% of the executives surveyed in the case of firms with a moderate growth rate. This percentage increases to 31% when executives from firms with high growth rates were surveyed (EIU, 1995). Along with economic advantages, all the suppliers emphasized the strategic benefits to be gained from using outsourcing, which furthermore they considered to be the most important, because the organization is freed of tasks which take time away from activities that truly generate added value within the organization. 10
  11. 11. As empirical evidence we show some cases of a variety of organizations which have already adopted the process of outsourcing. They are summarized in Table 1. which appears below. TABLE 1 FIRM PROCESS OF OUTSOURCING IMPLEMENTED GENERAL *Process of outsourcing of the information technology system MOTORS It went from having an over-sized department incurring large expenditures to using an external supplier who extended better service with and better quality at lower cost. To accomplish this, it bought Electronic Data Systems (EDS) which at that time was the market leader in computer software services in the United States. Now, after being spinned off by GM, it is the world's leading supplier of computer services. BRITISH *First used outsourcing in the area of information technology PETROLEUM (IT) and later extended its use to financial administration systems EXPLORATION B.P.X. Mr. Goodwall, Chief of Staff, Exploration Europe, summaries the B.P.X. results as follows:"In 1990, we were around 8,500 people, figuring we needed about $25 a barrel to make a living, today we are around 2,800, and we are delivering a 30% return at $14. The reason for this great success is that the company is now highly focused on its core business processes. Outsourcing is one means to aid that focus." (Arthur Andersen, EIU, 1995). MICROSOFT *Processes of outsourcing in a wide range of areas from catering and maintenance to production and distribution The sub-contractors have, in fact, become a very important part of the model? of the business. A.C. *Process of outsourcing almost all its activities INTERNATIONAL. What was in the beginning a very flexible and successful company, with time began to have A manufacturing and problems, as a result of numerous customer complaints about quality and late deliveries. The distribution company of extent of these problems forced it to reconsider its entire system of outsourcing and to carry out bicycle tubes and tires the operations internally in order to have greater control. I.B.M. *Processes of outsourcing the hardware, software and distribution It was able to drastically reduce investment and the time required to enter the market. Four years after its implementation it was the world leader, overtaking by a wide margin Apple, the pioneer in the sector?. It had gained a 41% market share and was the standard setter in the industry. However, those same factors which brought it success (the use of outsourcing) have been the cause of its later? more recent problems. As a result of yielding so many activities to suppliers, it found it difficult to maintain its competitive advantage, because there was insufficient back-up in key activities controlled by IBM. As a result IBM today has only 7.3% of the market, behind the new market leader COMPAQ, which currently has 10.5% of the market. Furthermore, the largest part of the profits earned in this market have gone to its suppliers firms, such as Intel and Microsoft, who in realty are those who have controlled its investment? (Chesbrough and Teece, 1996,p.68). 3.2.3. CHOICE OF A SUPPLIER If an evaluation of the practical value of implementing a process of outsourcing gives a positive result, we need to look at the second step of the process of outsourcing, which is that of choosing a supplier. 11
  12. 12. Because of the specific nature of the process of outsourcing (the transfer of confidential information, the delegation of responsibility, the lose of control of one's activities, the length of the contracts, etc.), the choice of a supplier will be a conditioning factor within the firm for a long period of time. Therefore, the extent of the gains to be realized will depend to a great degree on the ability of one's supplier to fulfill his commitment. It should not be forgotten that all suppliers do not deliver the same level of quality when offering their services. Many of them overly depend on a transfer of "human assets" from the customer firm in order efficiently carry out this process. However, the attributes of the supplier will vary as a function of the type of activity subject to the process of outsourcing. In the extreme, an organization can find two basic types of tasks suitable for the use of outsourcing which will determine the kind of relationship with supplier. SIMPLE COMPLEX Simple process Complex process Non-basic activity (functional) Basic activities (quasi-strategic) Weak relationship with the supplier Strong relationship with the supplier As for the simple type, any organization should be capable of outlining a basic process of outsourcing at the first preliminary stage. In the case of the complex, the organization needs the services of a supplier- consultant to help in the planning and development of the whole process. Because of the low cost of this type of service, it is recommended that organizations consult with a supplier-consultant who has more time, ability and experience to assist in this task, which otherwise may prove to be rather complicated. Furthermore, supplier-consultant rarely have high fees for this preliminary service, since they expect to earn significantly higher profits with the implementation of the process of outsourcing. 3.2.4. ORGANIZATION AND MANAGEMENT OF THE PROCESS After the process of choosing a suitable supplier, the only thing remaining to do is to start the transition to outsourcing. This is not an easy task. The great challenge facing the organization that of ensuring that all goes forward in the most efficient manner possible. This objective can be met only if the organization pays special attention not just to the technical aspects of outsourcing, but also more importantly to the human aspect. In both these areas, it is important to be able to rely on an experienced supplier. With respect to the technical aspects, as we mentioned earlier, it is essential to conduct the range of analyses to determine the future profitability of the project. On the other hand, it is obvious that impact on the personnel in the organization will be of a broad, varied and, not always, desireable nature. Many of the employees in the organization will be affected in one way or another as a result of implementing the process of outsourcing. Some of those affected will stay within the organization and even may improve the quality of their work, other will transfer to work for the supplier of outsourcing, and the least fortunate may not even be re-trainable for work with other employers. 3.2.5. MANAGEMENT AND EVALUATION OF THE GROWTH? OF THE PROCESS OF OUTSOURCING Signing the contract and implementing the process does not end, the relationship between the supplier and the customer. This is precisely when process of evaluation and control of results should commence 12
  13. 13. to ascertain how well stated objectives are being met. In spite of this, many customers of outsourcing do not know how to proceed with this phase, although it is just as important as the rest. There are two fundamental points which should be monitored after the signing of the outsourcing contract: the economic and the professional perspective. A) From an economic point of view, several aspects should be examined: 1.) On the one hand, cost saving should closely reflect the forecast estimates of the initial stages of the study produced by the supplier (except for major contingencies). If no strict controls are in place, it may permit unjustified deviations in the service provided by the supplier. 2.) Furthermore, if the customer firm foresees that there may be future contingencies regardless of their nature, the supplier should be required to include in the contract clauses clearly stating the costs which will be incurred if these contingencies should arise. B.) From a professional standpoint, the customer should make certain that the supplier is providing the same standard of service as is specified in the contract. By so doing, the customer firm will ensure a minimum level of quality of service from the supplier for the final consumer. In the following section, we will make a more in-depth analysis of the complexity which the process of outsourcing presents to an organization implementing it. 4. PROBLEMS OF OUTSOURCING The main advantages of outsourcing are based on the importance of the firm concentrating its efforts on the maintenance and development of its core competences, which today is a universal business concept. In this manner, the structure of the firm is freed from those of its activities which are carried out by external specialists, while leaving a small responsive organization to focus on those activities which maintain its nucleus of competences. In theory, this is the fundamental reason put forward in the current literature and by the firms using outsourcing and the supplier firms. This theoretical approach does not reflect, however, the importance of the problems arising from the practical application of outsourcing. Although the philosophy of the firms advocating the use of outsourcing is that of concentrating on their core competences, in practice often the main advantage obtained is from its use as a tool to get around rigidities imposed by labor laws in many countries and thus to acquire greater flexibility in the area of human resources and to gain short-term cost savings. These problems associated with the process of outsourcing can be analyzed from two angles, the external, fundamentally to be found in the relationship with the suppliers and the internal, associated with the possible repercussions on the human resources of the organization. 4.1 EXTERNAL PROBLEMS Theoretically, the best system for economic relationships is the market. In our case, it is the supplier- customer relationship resulting from the use of outsourcing. So that, this is the firm's justification for externalizing all activities except those in which the firm has a competitive advantage and as such is beneficial to keep them internalized. In practice, however, there are market utilization costs, so-called 13
  14. 14. transaction costs which make its use costly. The search, the negotiations, the drawing up of contracts, and afterwards the administration, monitoring and the control procedures of the contract are among these costs. In many cases, the existence of these costs can justify carrying out the activity within the firm, in spite of whatever economic reasons there may be for sub-contracting it. The question which this poses is not new in the business economics. What is it today that makes market costs, including transaction costs, generally lower than the co-ordination costs of an activity performed within the firm? The basic reasons from our point of view are, on the one hand, the dynamics of technological changes which require earlier investment in capital goods increasing the internal development costs to a degree which may be difficult to assume for those organizations whose main activity is in another strategic field. On the other hand, the use of the new information technologies makes co-ordination between firms easier, gradually reducing costs and associated difficulties. In many cases, it is not only a cost problem, but the fact of greater competitive pressure which forces the firm to develop alliances and co- operative relationships in order to be able to meet the changes in the marketplace. Experience gained through these relationships lets a firm establish new co-operation relationships such as outsourcing. In this case, the lasting nature of the relationship involved in outsourcing means that the transaction is not just arm’s length, and therefore, there is increased interest in co-operation in search of not, only short- term, but also long-term gains. In spite of these reasons, we believe that the costs and risks associated with the relationship between the firm and the supplier become one of the principle problems posed by outsourcing. More specifically, one must take into account a series of difficulties related to the nature of the suppliers, the consequences of the established relationship and the limitations of the contract. 4.1.1. NATURE OF THE SUPPLIER The prime supporters of the concept of outsourcing are the suppliers themselves, who in practice are basically the seven consultants. Along this line, we think that one should be aware of the contradiction that exist in the supplier-consultant extolling the virtues of a lean flexible organizations with a reduced staff, while they increase theirs by absorbing personnel of the customer through the outsourcing con- tract, creating their own structures which in the long-run will be less flexible and more costly. An impor- tant question is what happens to the transferred worker when the agreement ends. This is especially critical if the life of the contract is not very long and the customer decides not to renew the contract , to change supplier or to revert to its original structure, i.e. re-internalize the activity. On the other hand, it is understood by the very nature of outsourcing that the firm is limited in its choice of suppliers. The idea is to choose a supplier of the highest trust and professional reputation who will be a long-term partner of the organization. 4.1.2 CONSEQUENCES OF ESTABLISHED RELATIONSHIPS A long-term, close relationship, in practice, can present the same rigidities and disadvantages as carrying out the activity within the firm and lacks the flexibility of market relationships. On the other hand, if the contract is very open and short-term, it is difficult to create a relationship of mutual trust which could lead to co-operative gains. In continuation, we feel it possible to outline some specific problems: - An overly-dependent relationship may be created which firmly ties the firm to the supplier, resulting in exorbitant cost increases, reductions in quality and acceptance of out-dated technology. As we will illustrate below, these problems can be averted by anticipating them in the contract. 14
  15. 15. - On occasion, competences not considered basic may contain information of a confidential nature. This type information when transferred from customer to supplier may be leaked and so facilitate entry of new competitors including the outsourcing supplier. Guarding the confidentiality of information provided to the supplier may present additional costs in the short term which may have a negative impact on total savings, or safe-guarding it may simply not be possible. In reality, the theoretical evolution of the process of outsourcing should take the opposite direction, producing an interdependent relationship which grows over the life of the contract. Trust in the supplier can only be achieved through a stable continuous relationship during which his ethics and professional ability can be ascertained. - If a firm transfers an activity, and therefore, loses current know-how, it may be unable assess the cost and the quality of the services provided. Furthermore, the organization should be aware of the technological setback it would face if it were forced to re-internalize an activity at a future date. For activities which have been externalized, it is essential for the firm to maintain staff capable of monitoring and controlling these activities. To assist in carrying out these supplier control functions, the customer should use a process of benchmarking to compare costs and service received with those provided by "best in class" and to demand the same performance from its supplier. 4.1.3. CONTRACT LIMITATIONS Some of the above-mentioned problems, arising from the supplier-customer relationship, can be averted by drawing up a detailed contract which deals with any foreseeable contingencies (EIU, 1995). Contracts can require the supplier to meet minimum standard with respect to dynamism, competitiveness, efficiency, state-of-the-art technology and consumer orientation. Contracts of this type should include the following types of clauses: - contract extensions conditioned on an exhaustive analysis of the service provided in the first years of the relationship between the customer and the supplier. - escape clauses applicable in the first months of the contract if the supplier does not meet set goals. - a reduction in costs to the firm after the supplier has amortized its initial investment. However, what suppliers may not appreciate is that the contract, although important, cannot encompass everything. A co-operative relationship based on mutual trust and interests is difficult to maintain, but which nevertheless today is a necessity in the competitive environment in many sectors. These relationships of trust can be stimulated according to the nature of the suppliers, who are normally consultants. They are interested in maintaining their reputation in order to ensure the extension of their outsourcing contracts and to increase their goodwill in order to gain new contracts. All the risks of the relationship with suppliers are the traditional justification for internalizing activities. Therefore, we think that outsourcers must be tightly controlled to make establishing an outsourcing relationship worthwhile. As a result, the closer the activity is to the nucleus of competence, the greater the care which must be exercised in choosing and controlling a supplier. 4.2. INTERNAL PROBLEMS From an internal point of view, the main problem is the relationship with the employees, because outsourcing normally results in a reduction in staff. However, it is very possible that one of the greatest 15
  16. 16. advantages that the firm sees in outsourcing is the formation of new labor relationships in an environment highly regulated and characterized by trade union inflexibility. As a matter of fact, there is a greater propensity to use the process of outsourcing in Europe than in the United States, because of stricter European labor laws (see the survey in Figure 2.). The present trend to downsize organizations has produced major changes in labor relations of firms, especially in the area of job responsibility. The old idea that a job was a means of earning a living in exchange for eight hours of work, where the worker saw no relationship between his performance and the financial results of the firm, is currently disappearing. A growing number of workers are being hired on a short-term basis, with the renewal of their contracts dependent on their performance. Furthermore, workers with tenure contracts have seen their wage structure modified paying them on the basis of performance. Nevertheless, labor laws in many countries do not give firms the staff flexibility that they would like. From this perspective, we should ask ourselves if the present model of outsourcing does not represent a phenomenon of opportunity where current legislation is being liberalized to meet the needs of firms which require more flexible organizations and more professional and more motivated employees. Thus, we perceive that outsourcing can be used by firms as a simple tool to free themselves of permanent employees by transferring them to the outsourcing firm, which can enter into a less binding relationship with them and if necessary in the medium-term lay them off at low cost. Certain cases, as observed in the multinational IBM, seem to point to the fact that outsourcing is used to reduce staff and eliminate fixed costs. In Spain, as in other countries, depending on the labor laws and the strength of the trade unions, multinationals have used an indirect approach to obtain staff flexibility. Affected personnel have been at the intermediate or senior level of the labor pyramid, generally in the over-fifty age group. Termination of employment is negotiated, with compensation decided in the courts, breaking all ties with the firm and giving the ex-employee the right to unemployment benefits. However, at the same time, they contract some of these employees on an individual basis as free-lance employees in a service company called Skillbase, S.A., whose main activity consists of sub-contracted work from IBM, which is part owner. In this way, former senior employees, now outside the structure of IBM, continue working, but on Skillbase, S.A. projects, in the same office with the same secretaries as before, but now in the capacity of employees of the outsourcing company. Thus, IBM continues to utilize the know-how of these senior employees in on-going projects without any future commitment to them. At the same time, junior staff is being trained, but in a much smaller and more flexible personnel structure. For us, it appears clear that the implementation of outsourcing, regardless of the objective being sought, obviously causes major problems with the personnel affected, which may reach such magnitudes that the firm may have to reconsider its decision. There is even talk of insourcing, as in the case of Volkswagen, which is considering once again internalizing operations that had been externalized as a result of offers from their own workers competitive with those of external suppliers. In fact, when an activity traditionally carried out in the firm is externalized, the workers in that area lose their reason for being. As a result, there is a re-organization of the affected staff in which they may be given a new position in the firm, they may be transferred to another company, or they may even lose their jobs. Every firms solve the problem of surplus staff differently. Nevertheless, the effects on the workers of outsourcing an activity can be grouped as follows: 1.- Remain in the customer firm in the same area of activity. 2.- Remain in the customer firm in a different department, area, or function. 3.- Transfer to the supplier company. 16
  17. 17. 4.- Take part in an outplacement program. 5.- Be laid-off, normally with an incentive plan. Of these alternatives, usually the greatest percentage is represented by those workers transferred to the supplier company, especially if happens to be a large firm, as was the case with Sears. Joining a new company may be viewed by the workers as an opportunity to be part of a major company, whose main activity is related to their area of expertise. On the other hand, it may be accompanied by a feeling of insecurity and worry about their future. This brings up the question of loyalty to the original company, just as much for the transferred workers as for those who remain. The first group will probably continue providing service to their old firm through the sub-contractor. The usual and necessary practice of integrating staff and managers from the customer firm into the supplier company can be especially beneficial to the customer firm if during the transition process a sense of continuing loyalty can be instilled in the transferred employees. On the other hand, there may be motivational problems if the process if carried out against the will of these employees. Whatever the case, they will have to go through a process of adaptation to their new employer. This means becoming accustomed to a new culture, new work procedures, and different financial conditions. If the transferred employee does not adapt to the new organization, failure is almost assured. However, the new employer and the new employee need each other. Therefore, it is advisable to set up a period of dialogue in which to exchange experience and discuss work procedures. Dialogue of this type can be mutually beneficial by heightening the level of understanding of both parties. Likewise, the moral of the workers who remain behind may also be affected as they become aware of the uncertainty of keeping their jobs. Nevertheless, if the process of outsourcing causes no trauma and is well accepted by the workers, the latter, on seeing themselves freed from performing non-basic activities in the firm, may improved their quality of work, and better using their work time resulting in improved competitiveness for the firm and in greater job satisfaction for the workers. In conclusion, the ability of the organization to handle the staff affected directly or indirectly in the transition of externalizing the activity will be the determining factor in the success or failure of outsourcing. Therefore, firms involved in changes of this nature should be aware of the importance of human resources in order to minimize the risks arising from a poorly managed change. The majority, if not all of those involved one way or another in these processes, agree that there should be an involvement of human resources in the transition process, with a process of communication between workers and management. However, there is no consensus on the level, timing or duration of this communication process. Thus, while some managers feel that members of the organization should be informed from the beginning of what is occurring and where it will lead to; while, others are of the opposite opinion stating that a firm planning to externalize certain activities should put off as long as possible giving out information with regard to their future plans in this area. The advantages of communicating with all levels of the organization are derived from the benefits produced by having a better climate of consensus which will ease the transition. Thus, the feelings of anxiety which may be caused by a lack of information or by a flood of rumors, can be minimized. On the other hand, the disadvantages of an over-abundance of information are centered on later problems which might occur when affected personnel resort to sabotage by distorting and altering the process of analysis undermining the reliability of the final results. 17
  18. 18. According to Grover Wray6, it is preferable to restrict information related to the process of outsourcing to a small number of staff. His reasoning is that if the firm decides not to proceed with outsourcing the firm's image will not be damaged in the eyes of its employees. In summary, it is wise to be prudent with respect to future strategies, so as not upset the smooth functioning of the organization. CONCLUSIONS The contemporary relationship of firms to their business surroundings are conditioned by the changes in technology and the economic environment. Firms face these alterations to their surroundings by making qualitative change in the way that they perform their activities and structure their organization. In this respect, the key concept is that of flexibility, defined as the premise of rapid adaptation to any kind of change in demand so as to maintain and expand the competitive position of the firm. The new organizational models integrate this flexibility through mechanisms such as outsourcing, which give rise the existence of new organizational such as the " Irish shamrpock" model proposed by Handy. The trend towards virtual corporations based on the relationship of co-operation among several firms starts with the identification and exploitation of the concept of core competences, in such a way that new advantages are obtained from specialization and that the customer receives added value superior to the levels previously offered. Strategic outsourcing is at the center of the process of organizational change tending towards the flexibility of the business structure. In this respect, these processes may be preceded by radical changes which lay the ground work for process re-engineering. Outsourcing has a series of advantages and disadvantages, which can be divide for analytical purposes into those of a strategic and of an operational nature. The main strategic advantages are the creation of competitive advantages, the reduction of risks, an improved long-term cost structure and an increase in organizational flexibility. In summary then, from a strategic standpoint, outsourcing allows the firm to concentrate its efforts on consolidating and expanding its core competences. On the other hand, among the operational advantages, we find an increase in efficiency as a result of activities being carried out by specialized firms and reductions in permanent staff, which then become variable costs related to the level of activity. As for the disadvantages of a strategic nature, the most important are the lose of control of activity done through outsourcing, the transfer of sensitive information, the possibility of exorbitant price increases by the supplier at a future date, along with fluctuations in quality. The operational problems we have observed are difficulties related the making of the contract and arising from the effects on human resources. Nevertheless, we think that from a practical point of view, the problems associated with outsourcing can be studied from an external perspective (found basically in the relationship the customer of outsourcing has with its supplier) and an internal one (staff repercussions). The main points of interest in the external area are related to the nature of the supplier -they are mainly large consulting firms who offer outsourcing as one of their many services- consequences of the established relationships (with the contradiction between an extremely detailed relationship which could lead to rigidities similar to those which existed before outsourcing and a looser one which could under- mine the trust between the two parties), and the limitations inherent in the contract (which to a certain 6 Director of Human Resources for Contract Services for Arthur Andersen. 18
  19. 19. extent can be overcome by the desire of the supplier to maintain a level of trust in order to preserve his reputation in the marketplace). With respect to problems of an internal nature, we have seen have how certain firms have turned to outsourcing as a short-term solution to avoiding the rigidities caused by labor laws. These firms may limit themselves by viewing outsourcing merely as a simple way of freeing themselves of permanent staff. From this perspective, outsourcing could represent a phenomenon of opportunity, while labor legislation is being in accordance with the needs of firms for more flexible organizations and more professional and more motivated workers. The aspects related to the management of human resources are of crucial importance to the success of the organization. Therefore, detailed planning is imperative to the process of outsourcing, maintaining strict secrecy up until the moment that it is decided to put it into effect. From that moment on, a fluid means of communications must be set up with the staff being affected. This has a multiple objective: to guarantee the outsourcing of an activity has a smooth transition -identifying practical difficulties and proposing solutions- to set up and consolidate co-ordinating mechanisms between the customer and the supplier, to settle the problem of sharing information between organizations, and to maintain those aspects of the labor climate associated with employee moral. In summary, outsourcing facilitates the transition to the new flexible organizational models leading to the virtual corporation using a process which is not free of some uncertainties which affect its conceptu- alization and empirical analysis. REFERENCES ALARCÓN, J.L. (1992): "El outsourcing, una nueva estrategia empresarial". Dirección y Progreso, nº 126, pgs. 80-87. ARNETT, K. and JONES. M. (1994): "Firms that choose outsourcing: A profile". Information and Management, vol. 26, nº 4, April, pgs. 179-188. ARTHUR ANDERSEN; EIU (1995): New directions in finance, strategic outsourcing. Economist Intelligent Unit. BAUMAN, J.; SARATORE, S. and LIDDLE, W. (1995): "el outsourcing estratégico". Harvard Deusto Business Review, nº 67, julio-agosto, pgs. 54-69. BOYER, R. (1995): "Histoire d'A: crecimiento y progreso técnico". Investigaciones Económicas (segunda época). Vol. XVI, nº3, pp. 331-391. BUENO, E. (1996): Dirección estratégica de la empresa: metodología, técnicas y casos. Pirámide, Madrid. BUENO, E., MORCILLO, P. and RODRIGUEZ ANTON, J.M. (1995): "Management of Technology: Proposal for a diagnosis model", Journal of High Technology Management Research, (Accepted paper). CHESBROUGH, W., TEECE, D. (1996): "When is virtual virtuous? Organizing for innovation". Harvard Business Review, January-February, pgs. 65-73. CROSS, J. (1995): "IT Outsourcing: British Petrole". Harvard Business Review, May-June, pgs. 94-102. CURRIE, W. (1994): "Outsourcing: friend or foe?". COST A3 Workshop 1994, pgs. 313-340. DAVIDOW, W.H. y MALONE, M.S. (1992): The virtual corporation: structuring and revitalizing the corporation for the 21st. century. Harper Collins. New York. DE JUAN VIGARAY, D. (1995): "Outsourcing en comercialización: integrar o subcontratar los servicios de logística y distribución". ESIC MARKET. Cuarto Trimestre octubre-diciembre, pgs. 9-22. ERNST & YOUNG (1995): Managing the virtual Bank 1995. Special Report on Technology in Banking. FEENSTRA, R., HANSON, G. (1995): Foreign investment, outsourcing and relative wages. Working paper, nº 5121, National Bureau of Economic Research, Inc. 19
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