Wednesday, 10 August 2011

Strategic Make or Buy Decisions (1)

Outsourcing or ‘contracting out’ traditional known as ‘make or buy’ decisions refers to the process of procuring a good or service from a third party, rather than generating such offering internally, in accordance with terms which are legally enforceable, or contractual. Outsourcing is a decision to move internal functions to an external supplier. Traditional make or buy decisions were confined to manufacturing operation. Toady such decisions are extended to the service industries. This articles reviews outsourcing as a strategic exercise, potential benefits and problems, and considers a new management skill, supply chain management. In another article I will be looking at how the finance function can be contracted out, a case study of outsourcing the finance department and review of internal outsourcing.
Strategic Decision
Outsourcing has been part of revolution of strategic thinking; the aim is develop a competitive organisation, where investment and management attention is to focus on narrower set of activities, mainly core capabilities to obtain competitive advantages. An organisation using a cost leadership strategy will adopt cost reduction decisions including a consideration to outsource. Others follow a differentiation or focus strategy will be aiming to improving core competencies to create value for their customers.

Cost Reduction
In a fiercely competitive business environment, organisations strive to deliver greater value at reduced cost. Pressure to reduce indirect or overhead costs necessitates contracting out some functions. The cost of the finance function is one such cost. Outsourcing aspects of the finance function may, therefore secure cost savings.

Focus on Core Competencies to Add Value
In assigning responsibility for activities to third parties, organisations are afforded the opportunity to focus on core competencies integral to the creation or addition to value. Where a core activity has high profit margin, the internal provision of financial services to support this operation erodes this profit unnecessarily if a similar service can be purchased for fewer resources from an external source.

Potential Benefits and Problems
An organisation’s core capabilities form a chain of activities that managers integrate to create a distinct type of value for its customers, thereby achieving competitive advantage. The organisation has to question performance for each activity in the value creation system. What level of performance is good or better than any organisation in the commercial world?  Could improvement be achieved through outsourcing or some other form of external supply?

Outsourcing improvements are strategic in nature: in terms of cost, quality, flexibility, reduced overheads, costs becoming variable, access to economies of scale and to advanced technologies; increased leverage of core knowledge and skill; improved focus on development of core abilities and a more compact organisation.

However outsourcing failures are not uncommon. Failure to achieve anticipated cost savings often occurs. A large proportion of outsourcing clients only break even, or sometimes find costs increase. These may arise due to low vendor estimates, misunderstanding of the contract, and the costs of establishing and monitoring supply. Similarly, outsourcing can results in reduced quality, especially, where service levels are poorly specified and monitored. More seriously, outsourcing has been accused of helping create the ‘hollow corporation’. This is the cumulative effect of outsourcing decisions which were not made to provide leverage for a firm’s skills and knowledge, but to incrementally undermine those core capabilities on which the organisation relies for its competitive ability.
Outsourcing requires skills to identify, evaluate, and compare the relevant costs of using an external or internal source of supply. As outsourcing decisions has become of increasing strategic importance, so the skills required of managers had to develop to ensure they are fully able to contribute to the development and implementation of an organisation’s outsourcing strategy. These include assessing strategic decisions in preparation for evaluating available strategic choices, followed by implementation, change management and supply chain management.

The outsourcing decision has, in many instances, become more strategic requiring recognition of other strategic factors and their longer-term development, in particular supply market conditions and effective management of the supply chain. In addition, managers need to constantly bear in mind that outsourcing decisions must be consistent with achieving increased strategic effectiveness, particularly by helping to develop the organisation’s particular form of competitive advantage.
Supply Chain Management
The development of a new management skill is the results of external supply. Managers need to develop skills in identifying potential suppliers and evaluating their reliability. Contracts will need to be specified and negotiated to deliver standards of performance which the buying organisation may not have explicitly recognised before. Change management is required to address changes in employment required by outsourcing, and to deal with the possible loss of motivation experienced by in-house staff. In addition managers have to learn how to work with supply organisations and its different culture, and to effectively monitor supplier performance.

Making Outsourcing Decisions
Each industry and business is, in some respect, unique. Consequently, the factors that should be considered when making an outsourcing decision will differ between each organisation and its specific context. Standard analytical tools are useful when considering the context of outsourcing decisions, while the value model helps maintain an overview of the sourcing decisions being made by an organisation. Organisations often develop a comprehensive analysis of variable and overhead cost including all of the activities associated with the operation of the activity, its supporting assets and its development. Others include opportunity costs associated with those resources that would be made available through outsourcing, such as an alternative revenue stream that could be established by in-house staff, or alternative use of office space.

In principle, cost analysis should also be extended to include the cost of potential supplier. To avoid the familiar disappointing cost performance of outsourced activities, any claim for lower cost of supply must be confirmed by identifying such cost drivers as economies of scale, superior learning leading to cost reduction, and labour agreements that provide a lower cost base.

Conclusions
Many industries face conditions that include increasing competitive pressure, the need to achieve developments more rapidly, and variable demand and the consequent threat of periodic excess or insufficient in-house capacity.
A closer examination of the outsourcing option is called for each of these factors. The manager, through developing cost comparisons, has always had a key role to play when making outsourcing decisions. The outsourcing decision has, in many instances, become more strategic requiring recognition of other strategic factors and their longer-term development, in particular supply market conditions and the effective management of the supply chain. In addition, the manager needs to constantly bear in mind that outsourcing decisions must be consistent with achieving increased strategic effectiveness, in particular by helping to develop the organisation’s particular form of competitive advantage.

Making outsourcing decisions and managing supply relationships requires wide-ranging expertise. This requires a team approach in which all members – including the manager – seek to develop a full understanding of what can often be a complex strategic decision.

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