Outsourcing

Outsourcing is the transfer of an activity or business process that could be performed internally to an independent specialist provider. The label became common in the 1990s, but the underlying make-or-buy decision is much older. A sound decision considers capability, quality, resilience and control as well as price.

When to use it

• Consider outsourcing when an external provider may lower unit costs, raise service standards, supply scarce expertise, accelerate access to technology or release internal attention for strategically distinctive work. Use expanded throughout the 2000s and 2010s, including in government, but prevalence is not evidence that it suits a particular activity.

Origins

The practice has no single inventor. It developed from manufacturers’ long-standing make-or-buy choices and from contracting for professional services. In the 1980s, information-technology services became an important early market: rapid changes in hardware and software made specialist providers attractive to organisations that struggled to maintain the required investment and expertise. During the 1990s, the outsourcing label broadened to cover complete business processes.

What it is

The central question is: can another organisation perform this activity better, more reliably or at an acceptable total cost without weakening capabilities that matter to the strategy?

Peter Drucker argued that organisations should concentrate on customer-facing or strategically central “front room” work and obtain “back room” activities from providers for whom that work is core. This logic extends the manufacturing decision to make a component internally or buy it from a focused supplier. Applied broadly, it can produce vertical de-integration and “virtual firms” that coordinate, combine and market products or services supplied by others.

The traditional arguments for buying a component also apply to processes:

Lower costs — a specialist may spread fixed investment across customers and gain economies of scale.

Focus on the core business — capital, research and management attention can be concentrated on distinctive capabilities.

Higher quality — a provider whose position depends on the activity may invest more deeply in people, processes and technology.

Faster speed to market — the buyer and provider can develop complementary elements in parallel.

These are hypotheses, not guaranteed outcomes. Transaction costs, contract management, transition work, duplicated controls, supplier margins and exit costs can erase a headline saving. Quality can also decline when work is fragmented or incentives are poorly aligned.

IT services led early business-process contracting in the 1980s. Outsourcing later expanded into technical support, customer service, payroll, training, debt collection, claims management and many other functions.

It is useful to distinguish three provider choices:

Specialist providers offer expertise, scale or scope in a defined activity.

Low-cost providers operate from a lower-cost location and may or may not be specialists.

Overseas low-cost providers combine external provision with relocation across borders—offshoring—often to Eastern Europe, South Asia, South-East Asia, China or South America for US clients.

Outsourcing and offshoring are therefore different decisions: work can be outsourced domestically or retained internally overseas. If quality or expertise is the main objective, a domestic specialist may be preferable to the lowest-cost location.

How to use it

Start with the strategic need rather than a competitor’s choice. Typical triggers include persistent margin pressure, a major capital request, poor customer feedback, obsolete technology, variable demand or a capability gap. Define the required outcome, service levels, risk tolerance and the full baseline cost of the current process.

Next, identify what must remain under direct control. Map dependencies on customer knowledge, proprietary data, intellectual property, regulatory accountability and core competence. An organisation can delegate delivery but not its ultimate responsibility for customers, workers, safety, privacy, security or legal compliance.

Compare specialist, lower-cost and offshore options using total lifecycle economics. Include transition, retained management, integration, monitoring, currency and tax exposure, business continuity, switching and termination—not just the provider’s unit price. Obtain comparable proposals and draft contracts, then test assumptions through due diligence, reference checks, pilots or staged migration.

Assess the workforce consequences before committing. Determine whether employees will transfer, be redeployed or face redundancy; comply with applicable consultation and employment obligations; and account for knowledge loss, morale and the effect on the remaining workforce. Establish a realistic knowledge-transfer plan rather than assuming the provider can reconstruct tacit expertise.

Before:

An outsourcer

After:

Govern the relationship with measurable service and outcome standards, audit and access rights, data rules, incident escalation, change control, pricing mechanisms, continuity requirements and an executable exit plan. Keep enough internal expertise to act as an informed customer and to recover or re-source the work if circumstances change.

For a multi-business firm, place the decision in its wider corporate strategy. The market-positioning school locates most competition at business level and uses corporate strategy largely for portfolio choices. The resource-based school emphasises capabilities and competences that span the corporation. Outsourcing should be tested through both lenses: it may improve a business’s competitive position while inadvertently weakening a resource shared across the group.

Six essential corporate-strategy tools illustrate that wider analysis. The market-positioning school contributes optimising the corporate portfolio, creating value from M&A and McKinsey’s Corporate Restructuring Hexagon. The resource-based school contributes Hamel and Prahalad’s core competences. Collis and Montgomery’s Strategically Valuable Resources blends the two schools, while Goold, Campbell and Alexander’s Creating Parenting Value examines how the corporate centre creates value through portfolio and resource management.

Related articles in this collection: OVERVIEW 231. Other relevant perspectives include Barney and Kay on the resource-based view, Christensen on disruptive technologies, Mintzberg on deliberate and emergent strategy, and Gratton on innovation hot spots.

Top practical tip

Compare specialist, lower-cost and offshore providers against a defined outcome and the full lifecycle cost. Retain enough internal capability to govern performance, protect critical knowledge and execute an exit.

Top pitfall

As with business process redesign in Business process redesign (Hammer and Champy), outsourcing can remove a core competence. A low quoted price is especially dangerous when transition, control, dependency and exit costs are ignored.

Further reading

Lacity, M.C. and Willcocks, L.P. Global Information Technology Outsourcing: In Search of Business Advantage.