The Strategic Contribution of
Business Process Outsourcing to Corporate Planning

by

Goetz Erhardt

2003

MBA Management Project Report

Management Project submitted to NIMBAS Graduate School of Management
in accordance with the rules of Bradford University School of Management
in partial fulfilment of the requirements for the degree of
Master in Business Administration

ABSTRACT

Focus strategies that seek to leverage company skills, capabilities and resources have become a dominant paradigm in business strategy planning and implementation. As a consequence, firms increasingly seek to reduce investments in non-core business processes and functions while freeing up resources and management attention for core competency development to achieve competitive advantage and provide unique value for customers. Activities for which companies do not have critical strategic needs or special capabilities are considered for external sourcing. Combining the two approaches can yield significant benefits. Outsourcing business processes can give access to provider economies of scale and learning thereby reducing operating costs and enhancing the quality of the activities outputs. The expected value of an outsourcing initiative is constituted by the aggregate projected benefits - both efficiency and effectiveness gains within the externalised process and strategic rewards – that flow from the exercise of the option. Strategic fit of the sourcing strategy with the current competency profile of the firm plays a key role in securing the success of vertical dis-integration policies and to obtain the highest value contribution from outsourcing initiatives. Corporate planners who are involved in firm boundary and competitive business policy decisions have to understand the market and service characteristics of outsourcing service provision, the relevant strategic linkages between non-core and core processes as well as the various types of interaction and governance models that are available to fulfil the needs of the organisation. Empirical evidence suggests that corporate planning procedures and externalisation strategies could be integrated more comprehensively.

KEYWORDS
Outsourcing, value contribution, corporate planning, core competencies, make-or-buy decision, interaction costs, business process re-engineering, interconnected value system, information technology, activity costs, standardisation, relative cost differentials, strategic sourcing, total cost of ownership

ACKNOWLEDGEMENTS

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TABLE OF CONTENTS

1. INTRODUCTION ... 9
1.1 THEORETICAL CONSIDERATIONS AND PROJECT METHODOLOGY  ... 10
1.2.1 Literature review  ... 10
1.2.2 Project methodology  ... 14
1.3 A BRIEF HISTORY OF OUTSOURCING  ... 15
1.4 THE FOUNDATION: THE CORE COMPETENCY PARADIGM  ... 17
1.5 OUTSOURCING: INDUSTRY STRUCTURE  ... 18
1.5.1 Service provision and cost structures  ... 20
1.5.2 Outsourcing industry growth and trends  ... 23

2. DISAGGREGATING THE VALUE CHAIN – BUSINESS PROCESS OUTSOURCING  ... 25
2.1 OUTSOURCING OF BUSINESS FUNCTIONS  ... 26
2.2 THE ROLE OF INFORMATION TECHNOLOGY  ... 29
2.3 BUSINESS PROCESS OUTSOURCING AND CORPORATE TRANSFORMATION  ... 30
2.4 MODES OF COLLABORATION AND CONTROL BETWEEN SERVICE PROVIDERS AND CORPORATIONS ...  33
2.5 LINKS BETWEEN COMPANY PERFORMANCE AND OUTSOURCING  ... 35

3. OUTSOURCING STRATEGY: COSTS AND BENEFITS OF OUTSOURCING  ... 38
3.1 GETTING STARTED: RESOURCES AND CAPABILITIES  ... 39
3.2 EXPERIENCE CURVES IN MAKE-OR-BUY DECISIONS  ... 41
3.3 DECISION CRITERIA  ... 44
3.3.1 Financial considerations  ... 45
3.3.2 Process and quality improvements  ... 47
3.3.3 Business risks and risk management  ... 50
3.4 STRATEGIC ISSUES  ... 53
3.4.1 Monitoring strategic alignment  ... 54
3.4.2 Maintaining strategic flexibility  ... 56
3.4.3 Termination and continuation decisions  ... 58
3.5 KEY SUCCESS FACTORS  ... 60
3.5.1 Strategic alignment – option identification, selection and choice  ... 60
3.5.2 Relationship management – value creation and learning  ... 61
3.5.3 Performance management – operational excellence  ... 62

4. OUTSOURCING STRATEGY IMPLEMENTATION  ... 64
4.1 GOVERNANCE: STRUCTURE, SYSTEMS AND CONTROL  ... 64
4.2 PRELIMINARY PHASE  ... 65
4.2.1 Vendor selection  ... 66
4.2.2 Contract design  ... 67
4.3 OPERATIONAL PHASE ...  68
4.3.1 Service level management: measuring performance and managing scope  ... 69
4.4 VALUE EXPECTATIONS AND LEVELS OF SATISFACTION  ... 71

5. CONCLUSIONS AND RECOMMENDATIONS  ... 74
5.1 CONCLUSIONS  ... 74
5.2 RECOMMENDATIONS  ... 76

BIBLIOGRAPHY  ... 79

APPENDICES  ... 85

LIST OF ABBREVIATIONS

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LIST OF TABLES AND FIGURES
Figure 1: A generic perspective on strategic sourcing models
Figure 2: Networked economy inter-firm relationships
Figure 3: Re-drawing firm boundaries – the functional perspective
Figure 4: Outsourcing services industry life-cycle
Figure 5: Relationship between business process management and backbone technologies
Figure 6: Major domains and sub-domains of BPO
Figure 7: Alternative approaches to corporate transformation
Figure 8: Types of outsourcing provider and buyer interaction
Figure 9: Outsourcing option space – competitive advantage versus strategic vulnerability
Figure 10: Outsourcing strategy – context, capabilities, performance and choice
Figure 11: Outsourcing outcome orientation and service delivery
Figure 12: Sources of outsourcing option value
Figure 13: Process performance and core competencies
Figure 14: Impact of economies of skill and scale on outsourcing risks and returns
Figure 15: The sourcing portfolio and implications for governance
Figure 16: Contractual relationships and the trade-off between flexibility and control
Figure 17: Make-or-buy revisited – a strategic decision model
Figure 18: Key success factors for business process outsourcing initiatives
Figure 19: Measuring performance in Business Process Outsourcing
Figure 20: The outsourcing management and learning cycle

Table 1: Financial comparison of make versus buy options
Table 2: Performance measurements and strategic implications for target setting

PREFACE

The current economic decline has accelerated the need to focus on cost performance and on the relative value contribution of individual business activities. Intense pressures on margins and from competitors lead to rigorous analysis and tough decisions regarding business value chain components. Despite shrinking budgets companies have to invest in their core competencies and processes to remain competitive.

Traditionally, the dilemma between operational excellence and cost conscious strategic management would have provoked a standard answer: re-structuring and process improvements. The necessary know how can be purchased in the open market by hiring consultants. But the traditional answer actually has proven to be a double-edged sword since consultants rarely implement and assume responsibility for their proposals. Therefore, root causes of substandard performance and costs often tend to persist. 

Given these historic experiences companies are turning to an alternative method. Outsourcing information technology intensive parts of the business has become increasingly fashionable. Since the early 1990’s major corporations in the Anglo-Saxon world have started to outsource large parts of their IT infrastructure and operations, as well as significant parts of their value chains such as procurement, manufacturing, and component design.

In Germany the market for captive¹ and non-captive information technology related outsourcing services has reached a market volume of Euro 13 billion in 2002 and is forecasted to expand to Euro 21 billion in 2006². The comparably premature business process outsourcing market is projected to reach US$27.5 billion in Western Europe in 2003, growing close to 10 percent compounded annually³. The worldwide market for third-party outsourcing services had doubled from 1997 to 2000, when it had reached US$1 trillion⁴.

In parallel, a new breed of service providers has emerged. These service providers handle large parts of selected business processes of blue chip companies on a long-term contractual basis. This trend has extended beyond activities that were traditionally perceived as non-core – i.e. inventory and facility management – since companies have begun to outsource training and development, human resource management, finance and other core related business functions. This has led to a new role for the buyer companies’ corporate centres, which increasingly have become specialised functions that integrate and coordinate activities throughout the entire intra- and inter-firm value system.

Multi-billion outsourcing mega deals and breakthrough arrangements have a flipside. A recent survey of 200 German top managers reveals that 30 percent of the respondents judge their outsourcing initiatives as being “not successful”⁵. It should always be remembered that insourcing as a result of failed outsourcing initiatives is not uncommon.

Therefore, the key question is: How can managers reliably assess outsourcing options and structure decisions accordingly? Given the spectacular growth of the outsourcing services provider market and the importance of focused and cost conscious strategies for sustainable competitive advantage, the capability to make informed sourcing decisions can be regarded as a crucial management task of the future. The impact of effective outsourcing strategies on costs, service quality and competitive performance cannot be underestimated.

1. INTRODUCTION

This project analyses the role business process outsourcing initiatives play within and for the corporate planning function. Outsourcing, although sometimes regarded as a shortcut to dispose of routine and noncore operations, is by its very nature strategic, since it involves the re-definition of the firms’ boundaries. Outsourcing decisions have to be grounded in a clear understanding of strategic principles and tools and the relative merits of sourcing alternatives. This project seeks to develop an analytical framework for an assessment of the value contribution of outsourcing options, including the impact of relevant external and internal factors, respective decision criteria and analytical tools to evaluate optimal sourcing strategies. 

Chapter 1 provides the background to this project from a theoretical and empirical perspective. It explores outsourcing market characteristics and strategic linkages between the core competency paradigm in business policy formulation and external sourcing. Chapter 2 gives a general overview of the nature of business process outsourcing relationships and the underlying factors that shape these long-term interactions. Chapter 3 analyses the specific issues and criteria that surround the selection, choice and implementation of an outsourcing strategy. The questions of operational implementation are addressed in chapter 4. Conclusions and recommendations of the project are laid out in chapter 5.

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1 “Captive outsourcing” denotes a preferred supplier – mostly a former internal department – that provides services to the parent firm. In most cases, the supplier and the parent are linked by equity stakeholdings. Captive arrangements tend to be budget rather than balance sheet-based and therefore have only limited potential for sustainable business improvements.

2 PAC (2003).

3 Gartner (2003b).

4 Dun & Bradstreet, quoted in: Auguste, Hao, Singer and Wiegand (2002). For a methodological discussion of the market value assessments and projections see section 1.5.2.

5 IMCS (2002); cf. Doig, Ritter, Speckhals and Woolson (2001) who refer to international and US-based surveys with similar results and Gartner research quoted in: Computerwoche, March 26, 2003.