How Outsourcing Works

What is outsourcing?

Outsourcing is the process of transferring what would otherwise be performed by an internal company function to an external one. For example, accounting, IT, or marketing can be delegated to a third-party provider.

The outsourcing provider delivers specific services to its customers at an agreed-upon price. As a client, there can be many reasons to outsource an internal function. To consider whether an outsourcing solution may be right for your business, we will cover how it works, use cases and benefits.

How it works

The business models behind outsourcing are relatively simple. Before we look at an example of how it works, let’s first clarify the difference between ‘capability’ and ‘capacity’ as these are what the outsourcing provider delivers to you at a high level.

Understanding Capability v Capacity

Capability refers to the breadth of skill sets. For example, you have a chemical engineer, a civil engineer, and a mechanical engineer. The three roles make up a relatively broad set of skills, but not much capacity (one person in each field). Conversely, if you have three chemical engineers, your capabilities are narrow, but you have more capacity.

Imagine your company needs a certain amount of IT capability, perhaps ‘100’ (an arbitrary, relative value). Let’s say 10 IT staff are needed to achieve this capability.

The challenge, however is that there is only enough workload for about 5 IT staff (we’re talking about capacity now). If you hire 10 people, you achieve ‘100’ capability, but you also have too much capacity. The result is low utilisation and productivity for your team. This approach is relatively expensive from an ROI perspective. Alternatively, if you hire 5 people, you have the correct capacity but achieve only ‘50’ for capability.

Reduced costs via shared resources

The alternative to hiring internally is to outsource the IT function to a third party who has a team of at least 10 IT staff available. Because the third party has 10+ IT staff available, we reach the ‘100’ level of capability, but for significantly less cost.

How does that work? Well, the IT company spreads those 10 resources across multiple clients, increasing their utilisation and making it economically viable. In other words, the capacity of these employees is spread across multiple clients.

Hypothetically, let’s say the cost of hiring those 10 resources is $1,000,000 dollars per annum and the IT company spreads these 10 resources across 5 different clients. The IT company would only need to charge each client $200,000 each to cover the cost of these employees. Of course, the IT company would be looking to make a profit and cover overhead costs, so assume a margin would be added to each client, totalling $300,000 for their services.

Their income from all 5 clients would be 5 x $300,000 giving a total of $1,500,000 – providing the IT company a margin of $500,000 per annum. The clients on the other hand are only paying $300,000 per annum for a capability that would have otherwise cost them $1,000,000 if they were to hire internally, saving them $700,000 per annum.

Of course this is highly simplified, but it gives you a conceptual overview of how outsourcing can work for your business. Two key benefits become obvious under an outsourcing model — one is reduced costs for your business and the other is increased capability.

Benefits of outsourcing

If you deprive yourself of outsourcing and your competitors do not, you’re putting yourself out of business.

Lee Kuan Yew, former Prime Minister of Singapore

It’s a cliché, but it’s also true that the most important asset of a company is its people. We also know that finding good people is always a challenge, especially in the small business space. That’s why once you find the right person, you want to ensure they are focused on delivering maximum value and not wasting time on tasks that are outside of their core competency.

Improved company focus

This brings us to the first major benefit of outsourcing — improved company focus. With this benefit, your employees are freed from responsibilities that don’t align with their core roles. For example, as a small business, your ‘tech-savvy’ manager might also be your ‘IT guy’. Outsourcing IT responsibilities to a third party who specialise in that area allows your business and its employees to focus on their core services or products.

Increased capability and capacity

The next benefit is one we have already discussed — increasing our capability and/or capacity. As we have already seen, because specialised outsourcing companies focus on one function, they typically have a greater breadth of capability and capacity in that one area. This makes outsourcing a more cost-effective choice over hiring internally for the same role. Outsourcing allows your business to grow without the costly overhead of inflating staff numbers internally.

Cost savings – Manufacturing

The last major benefit of outsourcing is cost-savings. How cost savings are achieved is very dependent on what you are outsourcing and how. Let’s take a look at some examples.

Today, a lot of manufacturing is outsourced to China for two major reasons — one, they have lower costs of labour. Two, they have massive economies of scale with broad supply chains available locally. These advantages mean China can produce products locally cheaper than competitors in other countries.

The first major cost saving is that you don’t need to purchase or build out a manufacturing facility — a huge upfront expenditure. The second cost saving is in the ongoing unit production of goods. Each unit produced is cheaper because the outsourced manufacturer has much larger economies of scale (think Foxconn and Apple), but also cheaper cost of labour.

Cost savings – Marketing

Within the services industry, marketing agencies are a great use case. Let’s say you need an advertising campaign developed. You hire a marketing agency who develops this campaign for you with 10 of their staff over a period of 2 months. The alternative is to hire 10 people internally for the job. But now you have 10 extra employees on payroll. For this type of cyclical work, the agency is obviously going to be more cost effective.

There are many other benefits to outsourcing, but they all generally fall into one of these broad categories.

Challenges of outsourcing

“show me the incentives, I’ll show you the outcome”

Charlie Munger, Berkshire Hathaway

Why outsourcing fails

Probably the most common complaint with outsourcing is that the quality of work performed does not meet expectations. Often this is the result of poor execution and capability from the outsourcing provider or misaligned incentives.

Importantly, who you choose to do business with matters. Taking the time upfront to carefully research a trusted outsourcing provider with demonstrated experience will yield the best results for your outsourcing solution down the track.

Aligned incentives

Even when partnering with the best service provider, not putting in place the correct incentives at the contracting phase (typically an afterthought), can have detrimental consequences. Consideration should be given to whether the provider is incentivised to produce high quality work, or are they incentivised to cut corners and minimise cost? What incentives are baked into the agreement? Also, should penalties be included in the agreement? A combination of carrot and stick can be used effectively in contract agreements to ensure that vendor incentives are aligned with client goals.

Cost blow-out

The other major concern with outsourcing providers is paradoxically, cost. This is usually an issue with larger enterprise organisations. In an effort to drive cost down, these enterprises often struggle to find outsourcing providers that have a large enough scale. This has led to many outsourcing, insourcing cycles in the past. In the end, these organisations may find that they can achieve the same outcomes internally at a lower cost.

What to outsource?

“…don’t you do guard services at your plant. Get someone who specialises in guard services to do them for you.”

Peter Drucker, author and renowned management consultant

Core and shared functions

Within every business, there are a variety of departments or functions. These functions can be categorised broadly into two different groups — ‘core’ and ‘shared services’ functions.

Core functions are what make up a company’s main services or products. For example, if a company builds and sells widgets, it may have two core functions such as ‘design’ and ‘production’.

The ‘shared services’ functions could be ‘HR’, ‘IT services’, and ‘accounting.’ These functions are not directly involved in the service or product the company sells, but are required for the running of the company. You can also differentiate between core and shared services by thinking about which functions provide a competitive advantage and which do not. Typically, it’s these shared services functions that are well suited for outsourcing.

Industry examples

An example of outsourcing that’s common is the use of recruitment agencies. The process of recruitment is typically a HR function. However, recruitment agencies now take on early-stage hiring, which is the initial rounding up of candidates. Even the largest of companies outsource this particular function to recruitment agencies because they get more capability and capacity from a specialised agency. Recruitment agencies have a far wider reach to candidates and better resources for the task.

Marketing is another good example. Many companies run marketing campaigns in cycles. Once the campaign is developed, advertisements or promotions are run over a period of time. You then build another campaign and the cycle continues. As this kind of work is very cyclical, it doesn’t make sense for many companies to have an entire marketing team in-house all the time (you have the capability and capacity problem discussed earlier).

A cost-effective solution is to use a smaller team. Although it won’t have the resources or capabilities to deliver what a larger team can. Conversely, if you have a relatively larger team, its utilisation will be poor. The team would be highly utilised only during the creation of marketing campaigns.

The clear solution is to outsource marketing. Marketing agencies have dedicated teams built just for this purpose. Outsourcing provides scale and a high level of capability when needed. They’re hired only when there is work to be done.

And of course, we have whole industries of accounting and IT firms that offer their services as a form of outsourcing.

Managed IT Services

What is managed IT services? It refers to IT services provided to your business by a third-party company. Also referred to as ‘managed service providers’ or MSP’s. These companies are essentially your outsourced ‘IT department’.

MSP’s typically operate in the small to medium business space. When we look at enterprise companies, due to their size, they typically have an internal IT department. Large enterprises usually leverage niche IT outsourcing services rather than broad outsourcing.

Small businesses of up to around 100 staff get the most financial benefit from outsourcing to MSP’s. At this size, if you want to hire IT staff internally, you’re looking at either hiring at minimum a single senior person who can ‘do everything,’ or a junior person alongside a more senior ‘manager.’ This can equate to $120K – 200K in annual salary. Then there is the overhead cost that comes with managing additional employees.

With an IT managed service provider, you get a team of IT professionals with broad capabilities, services that are delivered within well-defined service level agreements, all at a cost well below that of an internal hire.

If you’re ready to set your business up for success and growth, contact us to find out how we can help with your technology needs.

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