Outsourcing and financial risk

The most common reason for labelling the decision to outsource a failure is the inability to show a positive financial return, like Sears outsourcing its IT services for 10 years to an external vendor for 344 million pounds, only to cancel the contract after seventeen months at a loss of 55 million pounds.

The risk financial failure is, beside too positive expectations by the buyer, related to the fact that the economic principles guiding an external supplier differs fundamentally from those steering an internal supplier. This financial risk has three basic appearances:

• The market of external vendors is a competitive one with the bidder offering the lowest price likely to get the contract. For the vendors the winners’ curse may now materialize: winning a contract at a price level below the cost it has to make to deliver the services. The logical result is a supplier trying to improve its yield by selling new services with a higher margin or supplying agreed services at lower quality or below specification.
• When calculating the total cost of ownership (TCO) of an outsourcing contract the ‘transaction cost’ have to be included to ensure the picture is complete. The transaction cost theory concludes that a ‘make or buy’ decision searches for a balance between production costs and transaction costs. The production costs may be lower outside of one’s own organization due to specialization, but transaction costs are lower within one’s own organization. Transaction costs include all costs associated with creating and maintaining the client-supplier relationship. Such costs may occur as a result of searching for the right vendor(s) (RfI/RfP/RfQ procedures), in negotiating and closing the contract, the transition from client to vendor and the day-to-day management of the relationship over the term of the contract.
• The vendor has no default incentive to share financial advantages due to economies of scale and technological breakthroughs. On the other hand is the drive to seek these financial benefits higher within a vendor than within the typical internal supplier. The trick is therefore, like with the two previous risks, to define and embed an adequate incentive and control strategy within the contract and relationship model.

The three risks discussed above are part of the category operational (supply) risk. The second category of operational risk is related to the demand for services (so called ‘operational demand risk’). The internal business units or business processes drive demand and here too the company outsourcing runs financial risks. A few common financial risks introduced by demand are unexpected changes in volumes for new or existing services and the financial impact of ‘hidden services’ (this last risk can among others be mitigated by a sweep clause in the contract). More on other types of outsource risk in future posts.