Reputation risk outsourcing is underestimated

The outsourcing of activities is a trend which started in the seventies with car manufacturers and has since then progressed into almost every aspect of our economy. Think of Indians analyzing x-ray pictures for European/American hospitals, South Africans administering mortgage requests and Philippine’s doing the salary administration. The main drivers behind this wave of outsourcing are technological advances and the breaking down of national trade barriers.

The same technology enabling outsourcing also allows for an increasingly intimate relation between company and customer. Books, pizza’s, insurances, movies; almost everything can be ordered these days by TV, laptop or PDA. The technology behind these advances are however so complex that most companies have to rely on external technology partners/service providers to design and manage the technology. The pressure to work with external partners is increased further by the relentless pressure to lower cost, increase quality and innovate.

If this goes all well, the advantages for the company interacting with the consumer are overwhelming. It allows the company to gather valuable information of the consumer behavior, allowing for more tailor made offerings. More precise consumer data allows furthermore for optimized production volumes and better prioritization of future innovations.

The increasing complexity of the value chain due to the ever growing number of external parties a company is relying on also poses a serious risk. So are the troubles with the Toyota Prius ‘insourced’ from an external partner as Toyota does not make the affected components themselves. Other examples are consumers investing in the Madoff scheme without them nor the bank knowing this because the bank did not exercise adequate control over its asset management value chain. In Germany financial and personal data of some 21 million went on sale on the internet after some dodgy service desk providers got hold of it. In this case the prime service provider had subcontracted the service desk activities to smaller service providers to further reduce cost.

This leads to a situation where the consumer thinks it does business with one party, but actually has to deal with a dozen. This should not be a problem for the consumer, but it turns out that the consumer often has to absorb more than a fair share of the risk when it goes wrong. The consumer is the one driving the faulty car against the tree, is the one seeing its pension evaporate due to mismanagement by the bank or sees its credit card information for sale on the internet.

This results in reputation risk resulting from outsourcing becoming increasingly important for companies. The potential damage to the brand due to external partners messing up. External partners which are often chosen for one reason alone: lowest cost. And lowest cost is directly related to what you get at the end of the day.

The resulting effect is consumers and media making a lot of noise, damaging the reputation and brand of the company (typically the external partner creating the issue in the first place stays out of the lime light). That reputation risk is becoming more of a general topic can be derived from a recent statement by Goldman Sachs, addressing it as one of their key strategic risks. On the other hand is outsourcing also a topic which gets more attention from for example regulators. The Dutch regulator DNB has appointed outsourcing as one of its key attention points for 2010.

I’m not saying that outsourcing is a bad things, on the contrary. It drives innovation and productivity gains and a more even distribution of wealth accros the world. What I am saying is that companies introduce a strategic risk when cutting up their value chain in many pieces without being able to execute adequate control over it. Governing and integrating end-to-end value chains (from consumer all the way down to the subcontractors) is thus a topic I expect to grow further in importance. And that starts with transparency. Transparency and trust. Transparency, trust, and not just going for the lowest bid.