What do we mean by outsourcing?

What do we mean by outsourcing

Outsourcing refers to a company that contracts with another company to provide services that might otherwise be performed by in-house employees. There are many reasons that companies outsource various jobs, but the most prominent advantage seems to be the fact that it often saves money. Many of the companies that provide outsourcing services are able to do the work for considerably less money, as they don't have to provide benefits to their workers and have fewer overhead expenses to worry about.

Outsourcing also allows companies to focus on other business issues while having the details taken care of by outside experts. This means that a large amount of resources and attention, which might fall on the shoulders of management professionals, can be used for more important, broader issues within the company. The specialized company that handles the outsourced work is often streamlined, and often has world-class capabilities and access to new technology that a company couldn't afford to buy on their own. Plus, if a company is looking to expand, outsourcing is a cost-effective way to start building foundations in other countries.

There are some disadvantages to outsourcing as well. One of these is that outsourcing often eliminates direct communication between a company and its clients. This prevents a company from building solid relationships with their customers, and often leads to dissatisfaction on one or both sides. There is also the danger of not being able to control some aspects of the company, as outsourcing may lead to delayed communications and project implementation. Any sensitive information is more vulnerable, and a company may become very dependent upon it's outsource providers, which could lead to problems should the outsource provider back out on their contract suddenly.

Although outsourcing has been around as long as work specialization has existed, in recent history, companies began employing the outsourcing model to carry out narrow functions, such as payroll, billing and data entry. Those processes could be done more efficiently and therefore more cost-effectively, by other companies with specialized tools and facilities and specially trained personnel.

Currently, outsourcing takes many forms. Organizations still hire service providers to handle distinct business processes, such as benefits management. But some organizations outsource whole operations. The most common forms are information technology outsourcing (ITO) and business process outsourcing (BPO).

Business process outsourcing is defined as "it encompasses call centre outsourcing, human resources outsourcing (HRO), finance and accounting outsourcing, and claims processing outsourcing" (www.sourcingmag.com). These outsourcing deals involve multi-year contracts that can run into hundreds of millions of dollars. Frequently, the people performing the work internally for the client firm are transferred and become employees for the service provider. The 'sourcing mag' website states that the "Dominant outsourcing service providers in the information technology outsourcing and business process outsourcing fields include IBM and Accenture". (www.sourcingmag.com)

The process of outsourcing generally encompasses four stages. Stage 1 is strategic thinking, to develop the organization's philosophy about the role of outsourcing in its activities. Stage 2 consists of evaluation and selection, to decide on the appropriate outsourcing projects and potential locations for the work to be done and service providers to do it. Stage 3 follows and concerns contract development, to work out the legal, pricing and service level agreement (SLA) terms. To finish off, stage 4, which handles outsourcing management or governance, to refine the ongoing working relationship between the client and outsourcing service providers.

In all cases, outsourcing success depends on three factors: executive-level support in the client organization for the outsourcing mission; ample communication to affected employees; and the client's ability to manage its service providers. The outsourcing professionals in charge of the work on both the client and provider sides need a combination of skills in such areas as negotiation, communication, project management, the ability to understand the terms and conditions of the contracts and service level agreements (SLAs), and, above all, the willingness to be flexible as business needs change.

It is made clear that "The legal basis of any outsourcing agreement is the contract. This determines the legal parameters of the service and the responsibilities of each party." (www.theoutsourcezone.com). A well-defined outsourcing contract helps in a number of areas. The first of these is clearly articulating the success criteria to the stakeholders in both the client and the outsourcer teams. The contract should also define some of the high level metrics used to measure the outsourcer's performance as well as defining the project requirements in terms of people, process, security, technology and business continuity. New Tech Ltd would also be able to benefit from defining the incentives and penalties, based on the outsourcer's performance. It may also prove vital when handling the unpredictable scenarios without causing undue frustration on either side.

During the creation of the contract, New Tech Ltd and the chosen outsourcer should make sure that the contract serves the purpose of their short-term and long-term goals. This will ensure that there are sufficient incentives for both parties to guarantee the success of the outsourcing relationship.

It's important to clearly define the requirements for the projects in terms of people, infrastructure, security, business continuity and processes. People-related requirements include the skill set of resources, size of the team, duration of ramp up, etc. Infrastructure requirements include hardware, software and network details. Process-related requirements include resource induction process, status reporting, delivery knowledge transfer, quality process etc. Security requirements include physical, personnel and network security. Business continuity requirements include planning for physical theft, data theft, virus attacks and natural and man-made disasters. The service levels for the outsourcing relationship and the corresponding incentives and bonus clauses should be clearly defined. This will help the vendor to internally measure and manage the outsourcing projects as well. The governance of the contract in terms of termination clauses, contract breach and governing clauses should be clearly defined.

Once these areas are covered, the IT team at New Tech should discuss commercial terms. New Tech Ltd should also expect to be flexible in the reduction or increase of scope for the clauses defined above based on the flexibility shown by the vendor during the pricing negotiations. The contract, terms and the quality of the contract will largely influence the outsourcing relations, governance and overall the success of the outsourcing venture.

Once the work to be done has been determined New Tech and the vendor must decide how and when it is to be done. This includes the level of service needed. Pricing and service levels are closely linked. The challenge is to achieve the goals of the outsourcing venture without sacrificing service level. The important step in establishing expected service levels is to determine what level of service New Tech has been receiving internally. This can serve as a baseline for the contract, giving New Tech the upper hand when outlining the contents if the contract.

It is important for New Tech to note that contracts for outsourcing usually fall in to one of three categories, labour based, transaction based and goal based contracts.

In the case of Labour based contracts there is an hourly or monthly labour rate assigned to different skill levels. Here the contract anticipates a general volume of work, has quality of service goals, and places constraints on the total labour anticipated for accomplishing the work within that framework. In this type of contract there is little to no incentive for the vendor to improve efficiency, since the result is fewer billable hours and less revenue.

However Transaction based contracts means the vendor is paid for completed transactions. Usually there are service quality goals, as well as expected transaction volume. This type of contract could encourage the service provider to find ways to be more efficient to process more transactions with the same resources. This type of contract is typical for BPO services.

And finally Goal based contracts, where New Tech Ltd and the vendor establish efficiency and effectiveness goals together in a way that it encourages improvements. This is accomplished as a result of transparency and accountability. New Tech Ltd and the vendor can jointly investigate efficiency and effectiveness initiatives, quantify the potential impact, and share the benefits of achieving the goal of the initiative.

Due to the difficulties experienced previously by the IS/IT manager it is imperative that the correct contract is drawn up before any outsourcing operation takes place. Therefore New Tech Ltd has an obligation to analyse the options available and make a decision that mostly benefits their company. In this case it may be safer for New Tech Ltd to opt for a goal based contract as that it encourages improvements and they can work closely with the vendor to incorporate effectiveness initiatives and work out the best way to achieve these objectives. As outsourcing is a new function for this company, the other options available may not benefit them in the same way as a goal based contract. However this decision is at the discretion of the IS/IT manager.

he contract should address the vendor's responsibility for security and confidentiality of New Tech's resources for example information and hardware. The agreement should prohibit the service provider and its agents from using or disclosing New Tech's information, except as necessary and to protect against unauthorized use. This would ensure that the vendor would not disclose information that New Tech holds to its competitors. If the vendor receives non-public personal information regarding customers, New Tech should verify that the vendor complies with all applicable requirements of the privacy regulations. The IS/IT manager should require the vendor to fully disclose breaches in security resulting in unauthorized intrusions into the vendor that may affect the business or its customers. The vendor should report to the IS/IT manager when intrusions occur, the effect on the institution, and corrective action to respond to the intrusion, based on agreements between both parties.

The contract should also address the vendor's responsibility for backup and record protection, including equipment, program and data files, and maintenance of disaster recovery and contingency plans. The contract should outline the vendor's responsibility to test the plans regularly and provide the results to IS/IT manager. New Tech should consider interdependencies among vendors when determining business resumption testing requirements. The vendor should provide New Tech with a copy of the contingency plan that outlines the required operating procedures in the event of business disruption. Contracts should include specific provisions for business recovery timeframes that meet the institution's business requirements. New Tech should ensure that the contract does not contain any provisions that would excuse the vendor from implementing its contingency plans. This would further ensure that the IS/IT manager does not face any of the problems that she was faced with at her previous company.

After the contract has been planned and created it is the responsibility of both the vendor and New Tech Ltd to address the issues that have been planned in the contract. However failure to do so can create problems which may be similar to that already experienced by the IS/IT manager. After signing the initial contract, both New Tech and the vendor have multiple team members who are trying to manage the initial implementation activities and ongoing operations. New Tech will have staff that are just learning the details of the agreement and have a personal view of what the vendor should and should not perform. The vendor has team members who are also new to the transaction, and sometimes bring a view of "this is what we did in my last deal" without fully understanding nuances of the specific agreement that has been negotiated. The significant number of new people combined with a high speed of implementation impairs an absorption period, leading to uninformed views on both sides of "what's in the contract." Therefore the process-related requirements including resource induction processes, status reporting, delivery knowledge transfer and quality processing need to be addressed in order to minimise the effect of this problem. As New Tech will be aware, process related requirements form a part of the contractual issues that were outlined above.

In light of the issues raised it is imperative that the outsourcing contract should clearly describe the rights and responsibilities of the parties to the contract. Considerations should include:

  • Descriptions of required activities, timeframes for their implementation, and assignment of responsibilities. Implementation provisions should take into consideration other existing systems or interrelated systems to be developed by different service providers (e.g., an Internet banking system being integrated with existing core applications or systems customization)
  • Obligations and services to be performed by the vendor including software support and maintenance, training of employees and customer service
  • New Tech Ltd's and the vendor's rights in modifying existing services performed under the contract
  • Guidelines for adding new or different services.

The outsourcing vendor not suitable to handle volume of activities and unable to produce contractual results is another problem, be it a serious one, that New Tech also has to overcome and ensure does not become an issue. This is another area that further emphasises the need for a contract before outsourcing operations begin to ensure that the vendor carries out all tasks expected and so does not leave New Tech with uncompleted work. In the contact the service levels for the outsourcing relationship and the corresponding incentives and bonus clauses should be clearly defined. This will help the vendor to internally measure and manage the outsourcing projects as well. Also the governance of the contract in terms of termination clauses, contract breach and governing clauses should be clearly defined. Therefore if New Tech addresses these issues the problem of the vendor not being able to handle the tasks expected should not become apparent. However, if New Tech did not raise these issues during the drawing up of the contract they may be faced with a big problem if the vendor cannot deliver. New Tech will have no comeback if the vendor does not deliver and the service levels have not been outlined in the contract. This further emphasises the point made by a business associate of the IS/IT manager, 'should it ever come to a dispute, only three things matter: the contract, the contract and the contract!'

It is important to remember that the contract should properly and accurately define New Tech Ltd's own specific requirements. This is actually the bottom line, and those who shortcut this often expose themselves to significant risk. New Tech should leverage the process and framework to negotiate and structure a win-win contract with the chosen vendor. It often helps to get third-party consultants to help in defining and negotiating the contract terms. This will minimize the risks involved in structuring the outsourcing relationship and set it up for success. It also enables the stakeholders to focus on planning the outsourcing project requirements, goals, transition and management


* Class Notes

* Class Discussions

* Service Level Agreement SLA in Outsourcing


Business Process Outsourcing


* Outsourcing Contracts




* Outsourcing Framework for evaluation and management PDF Article

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