Challenges of outsourcing
Strategic decision challenges
Vendor selection challenges
Vendor management challenges
Technology and technological challenges
Cost reduction as a benefit of outsourcing
Strategic advantage of outsourcing
Dual advantages of Portfolio outsourcing
Benefits of Outsourcing
In the past few years, most of the firms used outsourcing strategies as a way of managing their operations. Outsourcing is the use of outside organizations to provide services for a firm. Offshore outsourcing is a type of outsourcing and it is defined as the use of an outside service provider in the operations of a firm from another country other than the one where the firm is based (Evaristo et al., 2005 p. 3). Outsourcing as a way of improving a firm’s performance has grown quickly in the past decades. According surveys that have been conducted recently, 82% of big and medium companies in Asia, Europe and North America depend on outsourcing to do most of their activities (Gottfredson, Puryear, and Philips, 2005 p. 132). Reports from many business presses express that firms are outsourcing service providers for work that was initially performed internally. With this growing trend, it is impossible for firms not to outsource in this globalized economy (Burkholder 2006 p. 45).
According to McFarlan and Nolan (1995 p. 9), there are a number of benefits that a firm gain from outsourcing which include: reduction in costs of production, provision of quality services, increased flexibility and link to new technology sources. Outsourcing also enables the employees in a firm to work harder towards attaining service value and increased output. The need to gain competitive advantage like lower expenses and technical knowledge is also a reason that forces firms to outsource their operations. Apt & Mason (1995 p. 1250) expresses that, US based firm’s take advantage of outsourcing to explore the IT progression opportunities and workforce in the global market. IT sourcing globally creates strategic benefits for firms which include low cost and skilled labor access and access to a wider potential market (Cohen et al., 2002 p.).
Auburt et al., (1999); Earl, (1996), argue that although outsourcing is associated with a number of advantages, there are also several risk factors that firms face. According to Grover et al., (1996 p. 89), the employment of resources in a firm’s processes does not always lead to a competitive advantage in the firm. Despite the market growth at a faster pace during the early 2000s (Karamouzis and Terdiman 2003 ; Ross and Orlov 2003), in the recent times it has decreased due to many economic pressures that firms face (Chapman 2009 p. 45).
Chapman (2009 p. 45) argues that firms have to look for ways they can employ to cut costs like reducing staff number and increase in standardization. For firms being global players in the offshore outsourcing market, there is a need for them develop additional resources and capabilities (Barney 1991 p. 99). Several researchers have discussed various risks that arise from outsourcing such as unexpected high costs, disputes and litigations, lock-ins and loss of competency of the organization (Auburt et al., 1999 p. 51; Bahli & Rivard, 2003a p. 211). Therefore, there is evidence to support that the disadvantages of outsourcing outweigh the benefits.
Challenges of Outsourcing
Strategic Decision Challenges
There are various perspectives of researchers to understand sourcing decisions employed by firms. The main ones are: production and transaction costs economics (Ang & Straub, 1998 p. 535), resource-based views (RBV) and resource-dependence views (Teng et al., 1995 p. 75). According to the Resource-Based View (RBV), the resources in a firm and how they are used is the main determinant of its competitive advantage. Resources that are valuable and hard to be found can lead to competitive advantage in a firm. (Wade & Hulland, 2004 p. 107). Competitive advantage can exist for a long period of time in that a firm is able to shield against resource limitation, transfer, or substitution. According to the knowledge-based theory, knowledge is the most valuable resource of the firm. Proponents argue that knowledge being a resource that is difficult to imitate and a complex one, heterogeneous knowledge bases and know-how abilities are the main determinants of competitive advantage and better corporate performance (Wee & Peng, 2010 p. 613)
Some researchers however have raised concerns about the internal expertise and intellectual property that is lost when a firm outsources its information systems (Willcocks et al., 2004 p. 67; Chen et al., 2002 p. 100; Evaristo et al., 2005 p. 3). Whenever there is outsourcing, the risk of foregoing the knowledge of the firm arises. According to Hoecht & Trott (2006 p. 672), a firm’s innovativeness which cannot just be bought and sold is determined by the cumulative knowledge generated over the years of operations. Earl (1996 p. 26) argues that resources, organizational process that are both organic and fluid, entrepreneurial and experimental competencies: all these cannot come from external sourcing.
There is some level of paradox when firms outsource using resource-based view or knowledge-based view. Those firms that use outsourcing have always used resource-based view to make their outsourcing decisions. Firms can use the sharing arrangement to acquire beyond its boundaries those resources that it lacks (Teng et al., 1995 p. 75). Outsourcing has been taken as one of the ways that firms gather knowledge from suppliers (Shi et al., 2005 p. 901). Hence an information system (IS) outsourcing can be taken as a mechanism that firms can use to integrate IS knowledge of IS vendors.
According to Aron (2005 p. 3), these risks are described as long-term and their nature affects the internal part of an organization. Those firms that practice outsourcing often find it hard to avoid these risks. A company that outsources an activity for a long time later loses the core group of expertise that is familiar with it. For these employees whose skills are being outsourced, they are forced to retire, change employment to look for a place where their skills are more needed or they become out of date due loss of technical competencies. According to Earl (1996 30), outsourcing for prolonged periods of time leads to loss of expertise to the outside providers and also lack of prolonged leadership edge expertise as these outsiders providers may not be there in the future. The firm also faces the risk of spreading its expertise among the many clients that exist due to competition. Hoecht & Trott (2006 p. 675) warn managers of the disadvantages that they may face as far as their ability to survive is concerned if their core competencies are slowly losing through outsourcing.
Vendor Selection Challenges
Kern et al., (2002 p. 3) came up with the various challenges that arise in the selection and the bidding process of outsourcing. In Information Technology outsourcing for example, there may arise various suppliers that have bid to provide the service but the problem here may be the lack of mediators to help in the selection of the vendors (Agrawal et al., 2005 p. 861). There is often the danger of the suppliers delivering something different from what they put in their advertisements. It is also hard to determine the very value and the requirements of the services needed. For most suppliers, their bids are based on incomplete information as the environment that they operate in is often too highly integrated to find out the exact service expenses and the technical requirements.
The problem that arises in such bidding circumstances is to select those suppliers that present the best and desirable deal against their counterparts. The standard that is used to measure their capabilities is the cost efficiencies that they can deliver (Kern et al., 2002 p. 50). There is also the likely danger of the suppliers out-bidding themselves hence being unable to proceed with the deal as structured and priced. Such like experiences insert much pressure to the outsourcing firm making it to re-negotiate or even terminate the deal at an early stage. Due to this pressure, the parties involved often face significant costs that lead to doubts over the financial viability of such like deals. For firms to avoid such like scenarios they have to have the expertise of determining when such can arise. Hence, the challenge that is posed to the manger is to select viable vendors who are experienced in assessment of the project’s scope and also the ability to foresee such like problems arising (Weerakkody 2010 p.624).
According to Aron et al., (2005 p. 5), the outsourcing ventures are also exposed to many risks arising from operation stoppage at the vendors’ locations. These risks are however not caused by the actions of the vendors but are caused by the operations complexity of a byproduct and the geographical separation of the client and the vendor. The risks are also caused by the cultural gap in the environment that the vendor and the client operate, and/or the communication and transmission system limitations that exist between the two parties (Weerakkody 2010 p.624). Offshore outsourcing poses many other risks that need to be considered before the selection of a vendor is done. According to Apte & Mason, (1995 p. 1250); Cohen et al ., (2002 p.); Evaristo et al., (2005 p. 4); Kliem, (2004 p. 22), some of these risks include: cost savings risks, internal employee issues, management complexity, geographical risks, risk of Intellectual Property (IP) loss, internal data sharing, global cultural environment, financial risks and difficulties in communication and coordination. These risks make selection of a viable vendor in the appropriate country challenging (Tambe 2010 p. 67)
Vendor Management Challenges
Earl (1996 p. 30) proposes that various vendor management challenges arise out of operations in the IT industry and its development is uncertain. The end-users are also not always sure of their requirements, there is risk associated with new technology, changes in business requirements and implementation is not an easy task. While clear and specifications of the problem and expectations are necessary, he argues that a clear project management period that requires no changes to specifications and rigid timing and budget controls can lead to applications. These applications do not often find their potential or create user-specialist conflicts.
Companies are expected to avoid outsourcing contracts that are rigid. Due to this, the contracts have different clauses advice build from the various outsourcing literature, develop agreements on the annual evaluation and the short-term contracts are the ones that are signed. A one year review tends to be expensive as they involve annual contracts that are costly. Short term contracts are more likely to lead to cost premiums, and the variations in the clauses of the contacts may not be able to foresee all the uncertainties. To be able to pay for a flexible contract can be better than having to specify the tight contracts arising out of performance, followed by litigation. Due to many suggestions regarding what is beneficial, managers face the challenge of the contract’s appropriate length and the knowledge of how to find the best balance between cost implications and flexibility.
The vendor can demand for full payment for work that less than required, less than contracted for or less than what is being paid for. According to Aron et al., (2005 p. 5), this deliberate underperformance is termed as shirking. This occurs because of the variations of the vendor’s incentives for hard work and due to the inability to detect underperformance arising from the limited information available. Hoecht &Trott (2006 p. 672) expresses that can use the information the legitimate contracts for uses it was not intended. According to Aron et al., (2005 p. 5), this phenomenon is described as poaching which means reversing business processes, misdirecting them through theft and reselling them or reusing them as a direct competitor against a client (Pouder, Cantrell &Daly, 2007 p.10).
Information being a valuable asset for organizations, stealing of intellectual property has become more significant to organizations. Lock-in condition for client result from his or her lacking any alternative source of support, goods or support. Into such like conditions, the client is forced to pay the current supplier any amount of money that is asked. The loss of bargaining power and the attached price increases has happened so fast and consistently that it has gained a name; vendor holdup according to the outsourcing literature (Kliem 2004 p. 2)
Balhi & Rivard (2003a p. 211, 2003b p. 6) and Aubert et al., (1996 p. 51, 1998 p. 6) discuss various risks that come up from outsourcing transactions. These are locked-ins that arises out of asset specificity, fewer suppliers, and degree of client’s expertise in the outsourcing contracts, contractual amendments that are costly due to uncertainty, unexpected transaction and management costs, and disputes and litigations that arise out of measurement challenges and supplier’s expertise in IT operations.
Technology and Technical Challenges
According to Earl (1996 p. 28) outsourcing leads to various technical and technology challenges due to the problem of legacy in IT skills. Vendors that are sometimes chosen to supply the services are technologically ahead of their clients. There is also the problem of lack of technological synchronization between the two because of the distance arising out of them working across sites. Claim (2004 p. 22) and Jennex & Adelakun (2003 p. 12) outline other technical challenges that arise out of outsourcing which include: antiquated network of the communication infrastructure, complexity and configuration control due to absence of versioning of modules or objects, expensive data conversions, noncompliance to the methodologies, conflicts from development standards, poorly articulated requirements and incompatible development tools (Gilly 2000 p. 786).
Benefits of Outsourcing
Most firms use outsourcing as an attempt to reduce production costs and improve on their positioning strategically (Bolumole, 2001 p. 87; Cooke, Shen, & McBride, 2005 p. 432; Farag & Krishnan 2003 p. 1623; Hayes, Hunton and Reck, 2001 p. 109). Although outsourcing that arise out of cost reduction is normally short lived, this does not discourage firms to outsource. On the other hand outsourcing that is motivated by strategic positioning is long term and presents numerous opportunities that leads to many results like repositioning in the market, adapt to the altering business environment, products of better quality and speed improvement in the market (Craumer, 2002 p. 4-6).
Cost Reduction as a Benefit of Outsourcing
Firms have been able to improve their short term performance due to cost reduction that arises out of outsourcing (Tadelis, 2007 p.265). As a standard of advantages assessment, firms equate the cost of acquiring more resources to be employed internally to the cost of outsourcing (Kavan, Saunders and Nelson, 1999 p. 104). Multiple gains or profits of a vendor’s ability which eventually decreases the client’s costs of operation leads to a provision of services at a reduced cost. The relative cost advantages of the vendors may arise from extending economies capacity and services outsourced from many clients and undertaking many projects that share capabilities (Loh& Venkatra-man, 2001 p. 7; Mc Carthy & Anagnostou, 2004 p. 61).
According to Juma’h & Wood, (2003 p. 161); Smith, Mitra & Narasimha, (1998 p. 61), outsourcing generates the required cash from selling assets or proceedings received from transferring employees to vendors. Cost merits may be generated from the reduction of elimination of new investments or renewals of the same (Gilley & Rasheed, 2000 p. 763; Kaakbadse & Kakabadse, 2005 p. 183). This result from vendor services through more efficient technologies than the skills of the clients that tend to be costly to be developed internally (Abraham and Taylor, 1996 p. 394; Quinn and Hilmer, 1994 p. 43). The internal costs of administration, politics, and bureaucratic procedures can also be reduced through outsourcing (Gilley and Rasheed, 2000 p. 763; Holcomb and Hitt, 2007 p. 464 ; Smith et al., 1998 p. 61).
Strategic Advantages of Outsourcing
The strategic advantages as a motive of outsourcing enables firms to perform their operations on a long term basis. The benefits show an open window to create value that is enhanced by the relationship between firm and vendors. For instance a firm can match a vendor’s skill and expertise in its value chain and be able to venture into good growth opportunities. A firm often achieves this when it transfers logistics to a vendor who has the capabilities in supply chain and worldwide markets (Pellicelli 2011 p.280)
Quicker, higher quality and versatile services result from good performance competition in the global market (Daugherty and Pittman, 1995 p. 54; Razzaque and Sheng, 1988 p. 89). The same way is also used by firms to outsource information to get the innovative systems and applications from a vendor. A firm is eventually able to venture into new business opportunities or respond to demand changes from consumers (DiRomualdo & Gurbaxani, 1998 p. 67). Firms are motivated to be strategic in their outsourcing so as to be able to attain the core competencies. Its expected impact is to enable affirm to improve on its performance (Gilley 2000 p. 765).
Empirical studies that reveal that firms that are strategic in their outsourcing have shown consistent improvement in their performance. Farag & Kirshnan (2003 p. 1623) found positive cumulative abnormal returns for those firms that used strategic motivated outsourcing for information technology and the chance for new operational processes. Although Oh and co-authors (2006 p. 271), failed to find crucial results from outsourcing advertisements with attempts to enhance strategic effectiveness, we cannot deny the fact that firms have attained much through strategically outsourcing their processes.
Dual Advantages of Portfolio Contracts Outsourcing
With the wide growth of outsourcing, many firms nowadays are going for portfolio contracts of outsourcing (Tadelis, 2007 p.265). There is a trend in a current research being undertaken to evaluate the benefits that accrue to firms when they outsource with both motives: to cut costs and to maintain the strategic competitiveness. As Oh et al., (2006 p. 271) noted, “Information Technology outsourcing can help to reduce firms’ information technology spending or provide opportunities to better compete and expand in the marketplace”. According to Mclver, (2009 p. 45); Quelin and Duhamel, (2003 p. 647), firms enjoy the double benefits when they go for portfolio contracts with cutting costs and strategic advantages.
According to Lubatkin and Shrieves, (1986 p. 497), investors examine available information about the decisions managers are to make on short term results and the projected earnings. A dual contract received in the market means a firm is working towards increasing its financial performance and improving its long-term strategic advantage(Tadelis, 2007 p.265). Moreover, investors use short-term information to make conclusions on long-term customers (Laverty, 1996 p. 825). By advertising the double motives of outsourcing, investors are given information about long-term and short-term cost cutting benefits by the managers. This helps to remove the uncertainty of opportunities for increased performance profits.
There is evidence to support the argument that the disadvantages of outsourcing outweigh the benefits. This argument is supported by the various limitations of outsourcing that are more than its benefits as cited in the discussion above. There are fewer benefits that a firm gain from outsourcing than being the limitations. The benefits include: reduction in costs of production, creation of value through the strategic motive of outsourcing, and the dual benefits that arise from portfolio contracts of outsourcing. Outsourcing also enables the employees in a firm to work harder towards attaining service value and increased output. The need to gain competitive advantage like lower expenses and technical knowledge is also a reason that forces firms to outsource their operations
Although outsourcing is associated with some advantages, there many disadvantages outweighing these benefits that firms face. These limitations or challenges include: strategic decision challenges, vendor selection challenges, vendor management challenges and technology and technological challenges. The employment of resources in a firm’s processes does not always lead to a competitive advantage in the firm. It has also been noted that market growth at a faster pace during the early 2000s in the recent times has decreased due to many economic pressures that firms face in the global market.
Today firms are using much of administrative time to look for ways they can employ to cut costs like reduction of staff number and increase in standardization. For firms being global players in the offshore outsourcing market, there is a need for them develop additional resources and capabilities. Several researchers have discussed other various risks that arise out of outsourcing such as unexpected high costs, disputes and litigations, lock-ins and loss of competency of the organization.