Chapter nine of 'Purchasing and Supply Chain Management' focuses on strategic outsourcing, outlining its definition, benefits, and hidden costs. The chapter emphasizes the importance of a thorough strategic assessment, relationship management, and continuous contract evaluation to maximize outsourcing effectiveness. Key components covered include core competencies, risk management, and the need for long-term partnerships to mitigate traditional outsourcing concerns.

1. Purchasing and Supply Chain Management
by W.C. Benton
Chapter Nine
Strategic Outsourcing

2. Learning Objectives
1. To learn the precise definition of outsourcing.
2. To learn why organizations outsource manufacturing
and services business processes.
3. To learn the outsourcing process is not considered
contracting or joint venturing.
4. To learn about the benefits and pitfalls of
outsourcing.
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3. Learning Objectives
5. To about the hidden cost of outsourcing.
6. To learn about core and non-core competencies.
7. To learn about the elements of strategic outsourcing
8. To learn about the role of the outsourcing
relationship manager.
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4. Outsourcing
• Defined as the complete transfer of a business process that
has been traditionally operated and managed internally to an
independently-owned external service provider.
– A complete transfer of all associated internal business process
activities
– Once outsourced, the people, facilities, equipment, technology and
other assets are no longer maintained internally
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5. Outsourcing
• Not the same as subcontracting, joint venturing or contract
manufacturing
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6. Outsourced activities
Source: Handley, S.M., The Evaluation Analysis and Management of
the Business Outsourcing process, Unpublished Dissertation, The
Ohio State University, 2008 9-6

7. The concept of Outsourcing
• A process rather than simply an event
Source: Handley, S.M., The Evaluation Analysis and Management of the Business
Outsourcing process, Unpublished Dissertation, The Ohio State University, 2008
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8. Reasons for
Outsourcing Business Processes
The generic strategic benefits of outsourcing are:
1. Cost Minimization
2. Refocus Organization to Core
3. Improvement in Operating
4. Increased Market Share and Revenue
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9. Outsourcing Business Processes
• The usual primary driver for outsourcing :
• A reduction in direct operating costs which must be
significantly lower than the current direct operating
costs
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10. Specific Purposes & Benefits of
Outsourcing
1. To reduce and control operating costs
2. To improve quality
3. To change company focus
4. To acquire external capabilities
5. To refocus scarce resources for alternative uses
6. To reduce cycle time
7. To obtain cash infusion
8. To reduce risks
9. To gain flexibility
10. To turn fixed costs into variable costs
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11. The Following are Important for Realizing
Expected Outsourcing Benefits
•An extensive strategic assessment
•A true commitment to a cooperative relationship with
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12. The Hidden Cost of Outsourcing
1. Quality Costs
– Preventative
– Appraisal
– Internal failure
– External failure
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13. Detecting Quality Failures
The buying firm will need a proper mechanisms that are
capable of detecting quality failures by an external source.
This may be more difficult than with internal sourcing
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14. The Hidden Cost of Outsourcing
2. Supplier or Vendor Relationship Management
The most effective external sourcing relationships involve
considerable management time and coordination
External Sourcing which involve:
– Commodity products or services may not require extensive
relationship building and coordination.
– Strategic products and services require extensive relationship
building and coordination activities.
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15. The Hidden Cost of Outsourcing
• Relationship Management Costs
– Labor expense of purchasing personnel
– Travel
– IT infrastructure and management
– Supplier development programs (e.g. training and
performance evaluation systems)
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16. The Hidden Cost of Outsourcing
3. Internal Coordination
• Contrasted against the internal coordination and overhead
costs associated with internally sourcing (Vertically
integrate or Make)
• The costs of bureaucracy
– Payroll, benefits management
– Utility expenses, IT expenses, etc.
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17. Understanding Overhead Costs
Firms need to have a thorough understanding of these
marginal overhead expenses and how they would be
incrementally impacted by outsourcing
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18. The Hidden Cost of Outsourcing
4. Implementation of External Sourcing Model
• Costs associated with the transition resulting from switching
sources
– supplier search, evaluation and contracting
– the transfer of physical assets
– domestic and international travel during start-up
– training of the new source
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19. Additional Hidden Costs Associated
with the Internal Workforce
• relationship manager training for internal
employees
• retention bonuses, severance packages,
employee turnover
• management time required to thwart labor
disputes
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20. The Hidden Cost of Outsourcing
5. Coordination of Product / Service Design and
Development
– There appears to be a significant interplay between the architecture
of the product or service and the cost of coordination.
– Cost of coordination: the number of engineering hours
required to bring a new product to market
– Tightly coupled or integrated product designs require
higher levels of coordination
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21. A Need to Coordinate Sourcing
Alternatives
• Firms need to develop a deep understanding of the
coordination cost implications of various sourcing
alternatives
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22. The Hidden Cost of Outsourcing
6. Governmental and Political Related Expenses
• Costs involved with ensuring compliance with governmental
laws, regulations, and even local business customs
– legal expenses incurred to learn about a foreign location’s laws and
regulations, travel
– taxation, local content obligations, lobbying efforts
– tariffs, quota systems, etc.
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23. The Hidden Cost of Outsourcing
7. Supply Chain Risk Management
• Risk can be defined as a measure of the probability and
severity of adverse effects.
• Four iterative phases
1. Risk assessment
2. Risk mitigation
3. Risk monitoring
4. Contingency planning.
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24. Supply Chain Risk Management
• A comprehensive risk management approach will introduce
costs that are different for various sourcing alternatives.
• Different options will carry with them different types and
sizes of risks.
• Some specific costs includes
– insurance, dedicated risk management personnel,
financial hedging, and operations hedging.
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25. The Hidden Cost of Outsourcing
8. Miscellaneous Financial Considerations
Sources of financial benefit from outsourcing
 Vendor’s better economies of scale
 External suppliers’ capability to aggregate the demands
of their multiple customers
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26. Miscellaneous Financial
Considerations
• The size of the buying firm’s portion of cost
improvement is determined by competitive
conditions in the supply market, power structures,
and the overall threat of opportunistic behavior by
the external supplier.
• If a firm’ internal efforts can generate nearly equal
financial improvement as outsourcing, the
outsourcing decision is called into question.
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27. Core Competencies
• Core Competencies are:
• The collective learning in an organization
• Unique combinations of thought, focus and
implementation methodologies
• Achieved over the long term
• Outsourcing can provide short-term competitive
benefits, but does not significantly improve Core
Competencies
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28. Keys to Outsourcing Success in Today's
Economy
1. Understanding and avoiding the pitfalls of cost-focused
outsourcing and apply a total business-outcome-focus
2. Continuously re-evaluate contracts to improve efficiency and
costs. The drivers of efficiency and costs are:
• Provider selection and retention,
• Services delivery policies, contract pricing and etc.
3. Ensure a certain level of flexibility in contract terms in order
to be response to corporate changes
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29. Elements of Strategic Outsourcing
• The steps are highly
interrelated.
• Modification to the
steps are required to
fit each specific
organization and
outsourcing
objectives.
• Concurrent
relationships between
steps reduce the
implementation cycle
time.
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30. Elements of Strategic Outsourcing
1. STRATEGIC EVALUATION
• Outsourcing is the act of reversing a previous decision to
“make” or perform a particular function internally.
• The first step is to understand the strategic importance
(value) of the activity or system.
• Standardized processes, commoditized products, etc.: extremely
low strategic value.
• Buying firms must make decisions as part of a
comprehensive sourcing strategy.
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31. Elements of Strategic Outsourcing
2. FINANCIAL EVALUATION
• Outsourcing decisions are required to make short and
long-term financial sense.
• However outsourcing benefits are not mutually exclusive
and independent constructs, but rather significantly
interrelated.
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32. Elements of Strategic Outsourcing
3. SUPPLIER SELECTION AND CONTRACT DEVELOPMENT
• Supplier Selection
– Supplier profiles
• Key management contacts, a company overview
• SWOT analysis, Porter’s five key financial figures
• Information on current contracts, “owners” of the
relationship within the firm, and an organizational
chart.
• Functional evaluation of the content
– Establish expectations, scope of work, pricing
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33. Supplier Selection and
Contract Development
• Contract Development
– a minimum for an enforceable contract include:
1. A clearly defined scope of work and elements of the
processes to be supplied
2. An agreed upon approximate price for each aspect of
what is being supplied.
3. An understanding of an acceptable level of operating
flexibility as circumstances and requirements change.
4. Consider a short term contract with provisions for
extensions and renegotiations
5. Ground rules that encourage relationship and alliance
maintenance
6. Determination of a means for measuring performance
for each aspect of the agreement. 9-33

34. Element of Outsourcing
4. TRANSITION TO EXTERNAL SOURCING MODEL
Begins with the contract execution to the transfer of the
agreed upon activities and resources
• The buying and selling organizations must both follow the
specific roles outlined in the contract
• The buying organization must also appoint a relationship
manager
• The relationship manager and the supplier must merge their
independent plans into one consensus plan
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35. Elements of Outsourcing
TRANSITION TO EXTERNAL SOURCING MODEL (continued)
• Consensus transition plan must include at a minimum
– Communication Criteria
– Personnel Criteria
– Transition Criteria
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36. Elements of Outsourcing
TRANSITION TO EXTERNAL SOURCING MODEL (continued)
• Communication Criteria
– About the process of communicating external initiatives to
the affected and unaffected employees
– The following actions should included in the process
• Announce that the contract has been signed and awarded
to the supplying firm
• Discuss how severance packages will be offered to
affected employees
• Conduct extensive question and answer session
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37. Elements of Outsourcing
TRANSITION TO EXTERNAL SOURCING MODEL (continued)
• Personnel Criteria
– About the overall message itself that will be
communicated to the affected and non-affected
employees
– Create the perception of procedural and interpersonal
justice
1. Communicate early and clearly why the decision was made
2. All stakeholders need to feel as though their interests were
represented
3. Retained employees need to be trained to enhance their
“lateral” skills such as relationship management, negotiation
and consensus building.
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38. Elements of Outsourcing
TRANSITION TO EXTERNAL SOURCING MODEL (continued)
Transition Criteria
1. The schedule involving the transfer of activities and
resources to the supplying organization
2. The list of activities to implement outlined in the project
management schedule should include:
– An organization meeting for employees being transferred to
the supplier’s organization.
– A meeting with the buying firm’s manager whose activities are
being outsourced conducted on-site at the new location.
• A creation of a plan to address the issues involved in
transferring significant physical assets
– a specific third-party agreement in the contract
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39. Relationship Management
• In order to effectively cultivate the relationship, the
buying firm must actively monitor and evaluate
performance. The buying firm must also solve
outsourcing related problems.
• The original contract establishes
• the performance measures
• deliverables, due dates
• the expected supplier requirements
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40. Relationship Management
1. Performance measurement is the cornerstone of the buyer-
supplier relationship.
• It establishes control which provides the ability to manage
the relationship
1. The buyer and supplier relationship managers should
develop and execute the reporting system established in the
contract.
• A performance report is also needed. See the
following slide.
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41. Performance report
Performance Performance 2009 2009 2008 2008 2007 2007
Measures Standard Actual Variance Actual Variance Actual Variance
Number of
outputs
Number of
errors
Number of
on-time
deliveries
Number of
day-cycle
time
Number of
outputs per
employee
 The performance report should be designed to compare
the actual performance to the contractual standards.
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42. Risk
• Outsourcing risks include:
– Breaches in intellectual property
– Provider shirking
– Opportunistic renegotiation
• The combination of contractual incompleteness,
asset specificity, and uncertainty gives rise to these
risks when firms pursue external sourcing
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43. Performance Report
• Risk is the difference between risk and uncertainty
• Risk as defined By Knight:
– Risk is measurable, but uncertainty cannot be
measured
– Buyers outsourcing risks (BOR) = PA x NC
– PA = the probability that an adverse event will
occur
– NC = negative consequences if the adverse event
occurs, assuming that each of the adverse events
is independent
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44. Forms of Governance
• Traditional theory
– Hierarchy (i.e. internal sourcing) v. Market (i.e. external
sources)
– Market: arm’s-length relationship between the customer and
supplier organization
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45. Forms of Governance
• Hybrid governance theory
– From the observation of Japanese- style supply chain
relationships
– Neither purely hierarchical nor a purely arms- length
market mechanism.
– Seeks to realize the control, goal alignment, and improved
coordination associated with retaining an activity
internally, while also benefiting from the potentially
superior skills and cost position of specialized, external
organizations.
– The relationship is more of a long-term, collaborative
partnership
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46. Long Term Relationships
• Benefits
– A reduction in transaction costs
– Improve learning and control opportunism
– Greater social capital
• Improved dissemination of information and reduced
motivation for opportunistic behavior
• Social capital: the sum of the actual and potential
resources embedded within, available through, and
derived from the network of relationships possessed by
an individual or social unit.
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47. Long-term relationships with service providers can
mitigate many of the traditional concerns with
external sourcing
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48. Requirements for
Long Term Relationships
• Strong commitment from both parties
1. The sharing of timely, rich, and often proprietary
information including:
– demand forecasts, detailed cost information
– new product plans, strategic change
1. For building trust between the organizations
2. For more effective planning and execution
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49. Requirements for
Long Term Relationships
• Joint effort by the organizations.
• Equitable distribution of pain and gain (tying their destinies
together)
• A contract that defines performance incentives by means of
penalty and reward structures
• A constructive and flexible change management and dispute
resolution process
• A formalized procedure for communicating the buyer’s
expectations and evaluating the supplier’s performance
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