Short term gain versus long term loss, part 1

This post provides some of my thoughts on the effects the economic situation has on the (ir)rationality behind sourcing decisions, also known as ‘Behavioural Sourcing’. In other words, one expects that (like with Behavioural Finance) sourcing decisions are made by rational people which have complete information about alternatives, unlimited capabilities to process information, been driven by individualism and are without emotions in their decision making.

The Behavioural Finance theory teaches however that in reality people are inconsistent, subject to cognitive illusions, and often biased in their judgements (example: if the competitor outsources process XYZ, it must also work for the own company).

In my experience, and especially when under pressure like now, are people not always rational in their decisions to outsource. As the aim of this post is not to provide a lot of detail regarding the background of Behavioural Sourcing, just some key points. Behavioural Sourcing aims to:

• understand where sourcing decision anomalies come from;
• avoid in your own sourcing decision making the traps or errors that other people frequently make;
• assess better the advice, recommendations or commentary which others make.

In this post I want to focus more on the effects of (in my eyes) sometimes irrational sourcing decisions being made these days. I do this from two perspectives, client and supplier.

Client perspective
One could say (and many do) that it is the nature of these times that outsourcing deals are rushed to its closing and that any mess will have to be cleaned up later. I believe that this rational is valid only for those companies which have an acute liquidity crisis and are desperate to get some money in through an asset transfer (I guess some of the Indian captives sold last year by large financial institutions fall in this category, more on that here).

That even Chief Financial Officers (typically not the biggest risk takers in the organisation) focus on (overvaluing?) the expected return of outsourcing over the accompanying risk is demonstrated by recent research by Basware and the academic institution Loudhouse. Their ‘The Cost of Control’ research shows that CFO’s underestimate the risk they introduce in their value chain by outsourcing as cost reduction is by 64% seen as the top priority and only 39% believes that risk management should be on the top of the list. I am however not arguing that risk management should be on top of the risk, but I think that a healthy balance between risk and return is the way to go.

Many reasons exist for the failure of outsourcing arrangements from a client perspective. Some of the key risks which have a higher probability during these days of financial stress are:

• Outsourcing with the rationale that the competitor is also doing it. The decision to outsource key IT systems and business processes should be part of an integral vision on the companies value chain and how the return and risk profile of the supply chain as a whole can be optimized. Outsourcing of process ABC might work for the competitor but not necessary for you.
• Outsourcing of a broken or unmanageable function. Some companies which do not have the management capabilities to straighten out certain activities themselves outsource them with the idea that the supplier has some magic stick to improve things. Especially in these days when the agenda’s of the CxO’s are extra full it might be tempting to throw some activities over the wall, with the expectation of freeing up management attention. Those decision makers could not be more wrong and are likely to be bogged down for the next two years with participating in escalation meetings with the supplier.
• Outsourcing and looking only at reduced production cost. The basic rationale behind lowering cost through outsourcing is a supplier being able to create better economies of scale. This is however only one side of the medal. The Total Cost of Sourcing (TCS) during the term of the engagement includes however many more costs. Some costs which have a negative effect on the business case are: project and legal cost to select and contract a vendor, exit cost at the end of the term, sourcing governance/contract management cost (‘transaction cost’), VAT and currency differences (if offshoring) and benchmarking cost. Including these and other outsourcing related cost into the equation and the business case may start to look differently all together.
• Outsourcing based on insufficient service/product descriptions. The need for speed within some sourcing projects results in both client and supplier not having a clear understanding of the services and/or products which have to be delivered after the contract has been signed. This is not necessarily a problem is the contract is capacity based, but if the aim is to supply the client with a ‘service’ or ‘product’ it is necessary that both parties have a clear understanding of each others expectations. Failing to address this point triggers among others: frustrations, renegotiations, potential loss of revenue due to inadequate services/products, higher invoices due to extra work by the supplier (‘it is not in the contract, so we don’t do it unless we get paid’) and higher cost to manage the supplier.

These risks are not that difficult to manage and mitigate, but I’m afraid that these days the emotions are sometimes stronger than the ratio. The impact of overspeeding outsourcing projects will primarily rain down on the guys and gals who do the operational day-to-day work and are suddenly confronted with a delivery model which looks like a Swiss cheese.

One might think that the supplier is happy with a chaotic situation as it may result in some extra invoices, but the opposite is true. Suppliers also loose out in these situations as they will be unable to provide a good service/product and have to spend more time and money on managing the client. The only good news is for advisory firms which support clients mitigating the issues resulting from their quick and dirty outsourcing initiatives (after first getting them in trouble in the first place).

In my next post I will look at the same topic, but than from the suppliers’ perspective.