Understanding Risks and Benefits of Outsourcing in Small and Mid-size Businesses

In today's business world, no company (regardless of its size) has the resources and skills to do everything required to stay in business. Survival depends on outsourcing or contracting some business functions to companies with the expertise and resources to do the work efficiently and cost-effectively. The following list represents the top reasons why one company outsources or contracts with an external company for its services:

• To access resources (both human and technology) not available in house
• To reduce or control operating costs
• To free internal resources (both human and technology) for more strategic purposes
• To improve quality of services to its clients and/or productivity in manufacturing products
• To reduce cycle time, or speed up time to market
• To gain flexibility/agility in the company's capability to take advantage of new opportunities (turning internal fixed costs to variable costs paid to an outsourcer is one strategy)
• To free up cash flow tied to labor-intensive, time-consuming support functions (such as accounting or employee benefits administration), so the capital can be invested in growing the business
• To avoid a capital expenditure
• To reduce risk (the outsourcer takes on the risk of accomplishing the agreed-upon business outcomes)
• To introduce change that transforms the way a company does business, or even the business and market it's in

What Exactly is Outsourcing?

Although the two terms are often confused, there is a difference in whether the strategy to solve these business challenges will take the route of outsourcing or contracting. In a contracting situation, the buyer controls when, where and how the provider performs a particular task. In an outsourcing situation, the buyer turns over control—ownership—of an entire business function or process (a process incorporates several related functions) to the external company.

The difference between the two solutions impacts the price and control of the services, as well as the extent of outcomes and benefits that are possible. As an example, let's consider printing services for 100 reports on a monthly basis. If a buyer tells the provider what kind of paper to use, how to bind the report (glue, brads, spiral, staple), how many people should work on the project, and when and where the work is to be performed, this is a contracting situation. If the buyer outsources the work, it tells the provider what results it wants to buy (higher quality, faster work, lower cost than can be performed in house, for example). The provider will be responsible for making all decisions about how to achieve those goals.

Between the two solutions, outsourcing produces more value for a buyer, more return on the investment. This is possible because of the nature of the relationship. Outsourcing is a long-term alliance that helps both companies grow their businesses. Its goals require long-term contractual arrangements, often for three, five or ten years. Although both companies have their separate interests and goals, they act together for each other's benefit where and when their interests match; that is, in the outcomes they agree to achieve, the buyer benefits by eliminating its business challenges, and the provider benefits by achieving a profit for its services.

Risks for Small and Mid-Size Businesses

However, numerous studies reveal that 50 percent of outsourcing deals fail to achieve the buyer's desired outcome. Simply put, this happens because the parties enter into an agreement that has not taken into account all of the basic, foundational principles that make outsourcing successful (and there are many).

Outsourcing seldom encounters difficulties from a provider's poor performance (they are, after all, experts at the services they offer). The buyer's unclear expectation up front as to its objectives (the level of service, scope of work, desired outcome) is usually the culprit. Also to blame are deals lacking clearly stated accountability of both parties and poor (or no) governance agreements for the ongoing relationship.

Another major problem is either party's unwillingness to be flexible during the term of the relationship. Since outsourcing's optimal value is achieved only over a lengthy term of several years, the relationship will definitely encounter changed business needs, changed technology, and changed markets and economies. Indeed, outsourcing is often compared to a marriage in that both companies must enter into the agreement intending to stay together for the long haul and both must be willing to do what it takes to make that happen. The price of splitting up is too costly.

Because of the high odds for failure—as well as the high odds for achieving stunning success and value if done correctly from the start—buyers should never enter into an outsourcing arrangement without an outsourcing expert to guide them through the contractual negotiations. Otherwise, a buyer is likely to not understand how to protect its interests and achieve the desired return on the investment. This is crucial, as outsourcing arrangements are extremely costly when terminated early; penalty fees for early termination are built into the arrangement to protect the outsourcing provider's up front investments into resources on the buyer's behalf.

The Cost

There is a difference between cost and price. Outsourcing providers are in the business to make a profit (and rightfully so) on the services they provide. Their model of one-to-many delivery of services, as well as best practices, enables them to perform the work at a cost lower than the buyer could achieve in house. But that does not always translate to a lower price for the buyer. Profit margin is built in, and customization of the one-to-many services to better fit a particular buyer's special requirements adds to the price.

Operational cost-cutting is often a top priority for outsourcing in large businesses; but for small and mid-sized businesses, access to resources and avoidance of capital investments are the top priorities.

With expert help in setting up the contractual and ongoing governance arrangements, outsourcing enables a small or mid-size company to have cost-effective access to world-class resources and best practices; thus, it can compete on a much larger scale and grow its business more quickly. In fact, outsourcing enables many small businesses to be “virtual”—that is, they may do business over the Internet and need to have only one or two people in the company because various outsourcing providers perform all the functions except the strategic decisions on how to grow the business. With outsourcing, it's not a small world, after all.

By Kathleen Goolsby