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Strategic Outsourcing - Making it Work
In recent years, many businesses have decided to reduce the
cost of their operations by outsourcing some or all of the manufacturing
of their products and key services of their businesses. Unfortunately,
many suffer product quality and customer service problems because
of poor supplier performance. This article explains the risks
in outsourcing, how the outsourcing process can be successfully
implemented, and how to structure it to be a strategic advantage.
The Consequences of Not Managing Outsourcing
I began writing this article as I was sitting on an airplane.
I had just experienced firsthand the results of a problem in outsourcing.
My flight had just been cancelled due to a mechanical problem,
and after a great deal of trouble and miscommunication, I was
finally successfully rescheduled on a different flight. The mechanical
problem with the airplane started an entire chain of unfortunate
events for the airlines and its customers and these events are
as follows:
- First of all the air carrier lost the revenue for the entire
flight and probably lost more on subsequent flights depending
on the total downtime of the airplane.
- The airline gate personnel were forced out of their normal
routine of selling tickets and servicing new passengers and
were forced to immediately reschedule 140 passengers on flights
on other carriers.
- Many mistakes were made with the bookings because of the rush,
luggage was lost because of miscommunication, and many travelers
would miss their connecting flights thereby affecting their
business and personal schedules. Because of the domino effect
of the errors many of these travelers will probably avoid flying
on this airline in the future, myself included. This will mean
a loss of future revenue.
This scenario happens quite frequently with this airline company,
and as stated in knowledgeable circles, is brought on by their
inability to manage the outsourced maintenance of their airplanes.
Without a change in their management of this problem the end result
will be a downward spiral of continuing problems and further losses
of revenue.
Strategic Reasons to Outsource
The failure scenario described above is not uncommon for many
companies that outsource. They have misconceptions on how to use
these outside resources and the role that each party must play
in order to make the relationship successful. Listed below are
reasons for outsourcing production or services that will improve
the company's strategic position:
1. Increase Capacity. A business can add manufacturing
capacity or business capabilities without adding additional personnel,
equipment or facilities. This allows the company to leverage their
fixed costs.
2. Increase Technology. Some businesses cannot afford state-of-the-art
equipment nor have employees be fully skilled in all processes.
Outsourcing allows the use of better technology without the investment
in equipment or specialized training.
3. Add Proprietary Processes and Products. Some products
or services require the use of proprietary processes or equipment
that are exclusive to other businesses. Without the use of these
processes or components the product cannot be built to the desired
specifications.
4. Reduce Costs. Businesses with high overhead or labor
costs can use outsourcing to reduce their costs. Smaller businesses
or offshore companies may have much lower cost structures. However,
outsourcing for this reason mandates more analysis to help fully
understand the total cost of outsourcing and the real reasons
for the cost problems.
On many occasions I have seen a product or component shipped
to a lower cost producer at home or abroad and the problems were
compounded. The end result was an increase in problems in quality,
product performance, and customer service. Often these factors
combined to increase total company costs and invalidated the expected
cost savings from the outsourcing initiative. Therefore, in order
to obtain the expected benefits from an outsourcing initiative,
management is required to expend a great deal of planning and
effort in support of the outsourcing process and designated supplier.
Key Factors to Success
There are many risks associated with any decision to outsource.
However, by using the strategies listed below a business can avoid
or manage most of the risks and be successful in using outsourcing
as a strategic part of their business. Listed below are the key
factors to success:
1. Fully understand the true in-house and anticipated outsourced
costs before making a decision.
In order to make a sound decision about using an outside manufacturing
or processing supplier a business should perform an activity-based
cost study. This will include identifying and understanding the
following financial costs and subjective factors before and after
the move:
- The amortization of fixed costs.
- Technical resources such as engineering and quality assurance
and their associated costs.
- Training costs for the supplier's technical and production
staff.
- Purchasing and materials management resources.
- Ongoing support costs for the relationship from all involved
parties.
- Impact on inventory and cash requirements.
- Estimates of the impact on warranty and other service-related
costs.
- Customer service costs due to shortages or inventory stockouts.
- Understand the impact if volume goes up or down substantially.
- Understand the strategic impact to customers and the perception
of the company in the market.
- Factor in which strategic or operational opportunities are
lost or gained with this action.
2. Make good decisions about which processes or products to
keep in-house or outsource.
- Wherever possible have proprietary or process-critical operations
in-house where they can be monitored and controlled better.
I would identify these types of operations as core competency
operations that define marketing or strategic differences between
you and your competitors.
- If processes or products can have a large impact on product
quality, safety, and customer service keep them in-house.
- Choose parts or process candidates that represent worthwhile
orders for the supplier. This practice will make your business
a priority for the supplier. Try to have enough consistent volume
to be important to a supplier and it will increase their focus
on meeting your ongoing business needs.
- Ship components or products outside that are well within the
technical capabilities and capacities of the supplier. Higher
volumes of a limited variety will assure low costs and low quality
risks. Do not burden them with too many different production
variations. Keep it simple for them.
- Keep one-of-a-kind and low-volume products inside to reduce
stockouts and quality risks. Often the overhead costs to support
these types of sales, such as engineering and materials management
resources, are substantially higher than for standard products.
Repair parts for older machines are typical of these types of
items. The production of these types of components can often
be handled cost effectively in-house with flexible manufacturing
cells.
3. Don't export problems to suppliers.
- Fix all quality and engineering-related problems before outsourcing.
Do not ship problem processes or products to a supplier, especially
offshore. Adding a language barrier and ignorance of the product
and processes will only compound the problems. Instead, make
it idiot-proof for the supplier.
- Fully define and document product design and process parameters.
- Fully train the supplier's quality, design and production
staff in the required design and process parameters.
4. Establish and document Quality, technical and product performance
criteria.
- Develop testing mechanisms to check and assure product performance.
- Develop in-process Quality Assurance systems with the supplier
to assure consistency in their in-house processes.
- Establish Quality-auditing procedures to insure supplier conformance
to final design and process control specifications. This can
be performed both at the supplier and at the buyer's receiving
inspection station.
5. Establish long-term partnerships with suppliers.
- Establish key suppliers and avoid changing. Each supplier
change dramatically increases risk.
- Create an environment where both parties can mutually benefit
from a long-term relationship.
- Encourage joint value analysis programs to reduce costs and
improve product performance.
- Share cost savings generated from value analysis programs
with the supplier involved.
- Develop business processes and systems that improve the supplier's
performance on products and services.
6. Create a contingency plan.
- As needed carry additional in-house stock or have supplier
carry additional inventory or capacity to cover potential shortages.
- As practical keep necessary production capabilities in-house
until suppliers perform well and risks are minimized.
- As needed qualify secondary suppliers that can step in should
the first supplier fail to perform.
Real Life Example
I have seen firsthand the aftermath of a company moving ahead
on an outsourcing program on a critical component without factoring
in the key factors to success stated above. Several years ago
this company made a decision to outsource a major component of
its equipment. The main reason for outsourcing was to reduce total
manufacturing assets and employee headcount. When manufactured
inside the costs were competitive and the quality and performance
problems were few. In addition, the industry favorably viewed
this company's products because of their lower product failure
and downtime rates and this fact was often used as a selling point
against the competitor's products.
On paper the annual financial impact appeared worthwhile and so
the company charged ahead. Unfortunately, the method used to maintain
competitive costs was to put the product out for competitive bid
on a routine basis. Therefore, in order to meet ongoing cost reduction
objectives, it necessitated the changing of suppliers many times
and the use of some small suppliers that did not fully understand
how to build the specialized components. Unfortunately, there
was little quality and engineering support provided by the company
to insure the components provided by the suppliers would perform.
Within one year the foolishness of this action became apparent.
The company's products began experiencing failures with this component
in alarming numbers and some operators were injured in the breakdowns.
Because of the high failure rate and the anticipated operator
danger hundreds of machines were pulled out of service. At great
financial cost the dealers were forced to perform emergency repairs
and provide free rental equipment for the customers to use while
their machines were down for repair. Suppliers of the components
were slow to react and provide satisfactory products and this
problem caused additional downtime delays. Once this problem began
affecting many core products of the company the sales efforts
became more difficult and some loyal equipment users began purchasing
the competitor's products.
What started out appearing to be a sound financial decision became
a major financial and public relations debacle for the manufacturer
and its distributors. The company's perception in the market,
which had been very good up to this point, has been severely impacted.
Unfortunately, the financial implications will continue for years
because of ongoing warranty and litigation costs. The greatest
cost to the company will be in its loss of goodwill with its customers
and this will undoubtedly mean a direct loss of equipment sales
and market share. I estimate that the resulting long-term costs
to profitability and company value will be dozens of times more
than the few dollars they expected to save in the outsourcing
program.
Making It Work
What can be learned from this article? First, understand the risks
and potential costs of any outsourcing decision that you make.
Perform a proper analysis and assign estimated costs for each
risk associated with the move. Make a good decision based on a
thorough financial analysis. Second, make the commitment to do
the job correctly and provide the initial and ongoing technical
and quality support to insure a successful transition. Third,
partner with the supplier to make them a success. In order for
them to make a commitment to service you well, they must cover
their costs and also make a profit. Few suppliers have all of
the resources required to manage a satisfactory transition. They
need your help and commitment of support resources. Finally, fully
understand the subjective factors such as customer service and
market perceptions that could have a much greater impact on the
future success of the business. Consider these factors in the
final decision and insure the outsourcing action is worth the
risk.
In summary, if the key factors to success listed in the article
are properly addressed in each outsourcing decision the probability
of success is high. Outsourcing done for the right reason and
in a disciplined manner can be a sound strategic move for a company.
However, in order to make this process work, the business must
allow the supplier to be successful. This success is accomplished
by creating a win-win scenario. This includes commitments of support
resources and long-term business partnerships. One important point
to remember is that there is no free lunch in outsourcing. You
will either pay up front to do it right or you will pay more at
a later date to clean up the mess that was created.
