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The Hidden Risks of Outsourcing

The QD and QV Methodologies start from the fundamental premise that the key to success for practitioners is the ability to find better ways to manage buyer and seller relationships so that value can be appropriated more effectively from, or in conjunction with, their trading partners.

One of the most common difficulties faced by clients is avoiding the problem of moral hazard. Moral hazard refers to a process by which practitioners fail to create effective contractual safeguards pre-contractually, so that they find themselves highly dependent on opportunistic suppliers post-contractually.

This case is focused on the issue of IT outsourcing, because outsourcing provides the most potent contemporary evidence of the problem of moral hazard in buyer-supplier relationship management.

Over the last five years Robertson Cox has been involved in numerous outsourcing projects—ranging from Contract Manufacturing, Technical Services Management, Information Technology, 3rd Party Logistics Provision to Facilities Management, amongst others. In all of these cases the same process of moral hazard appears to be at work, although our discussion here focuses on IT outsourcing in a major manufacturing company.

The manufacturing company in question decided that since it was not an IT specialist it made sense to outsource its requirements to an IT outsourcing company. In deciding to outsource the company experienced the following phases:

• Initial Euphoria

• The Honeymoon Period

• Dawning Realisation

• After Shock

• Damage Limitation

It was only during the third phase—dawning realisation—that Robertson Cox was engaged by the manufacturing company to provide a Business Power Analysis of the problems being experienced at that time. This was because the company had initially decided that it had the competence to undertake outsourcing internally on its own. Unfortunately, since then, it has had to recognise that senior and middle managers (most without any procurement training) simply do not understand the first principles of effective outsourcing. In effect the manufacturing company has had to recognise that it did not understand moral hazard.

In general the failure of outsourcing in this (and in many other cases we have experienced) can be explained quite simply. When any company considers outsourcing its IT competence to a supplier it is normally in the buyer dominance quadrant of the Power Matrix. The reason for this is self-evident. Pre-contractually there are many potential suppliers. Of these suppliers all will be keen to win the business and willing to make any marketing commitments that they must in order to win the business.

In this circumstance the buyer will be faced with a multiplicity of highly beneficial supply offerings promising major cost reductions and quality improvements. The buyer is clearly in a strong position at this point in time. Unfortunately, once the contract has been signed—and most contracts are for 5-10 years in this supply market—the power situation shifts immediately. From a situation of buyer dominance the situation has now shifted to one of either interdependence or supplier dominance. This occurs because the buyer has rarely thought through the consequences of becoming totally dependent for its IT on a supplier whose long-term interest is normally to create a dependency in the anticipation of leveraging higher returns from the buyer.

By working with the company in question it was possible to demonstrate that, while the first two years of the contract may have appeared to beneficial, in the longer-term the supplier was well placed to take advantage of them. This was because they had simply failed to think through how their growing dependence on the supplier, in the context of a rapidly changing supply market, was allowing the supplier to take advantage of them over time. Furthermore, we demonstrated that by failing to provide for an effective exit strategy from the contract the supplier was effectively becoming dominant over them.

This realisation forced a major rethink on the part of the buying company. So much so that a major review was undertaken of the existing outsourcing contract and the supplier was forced into a re-bidding exercise in the third year of a seven year contract. The result of this re-bidding and review exercise was that some elements of the outsourced IT function (those related specifically to new product development and service level delivery to customers) were insourced back into the company. For those aspects deemed non-core two suppliers (one of whom was the former incumbent) were selected for different aspects of the formally outsourced IT activities.

The result of this transformation has been that the company has retained control over mission critical information flow, while sourcing from two suppliers, both of whom are capable of handling the outsourced requirements of the company, without the buying company becoming wholly dependent and locked into either one of them. We call this situation one of defensible interdependence.

Clearly this restructuring of the IT outsourcing strategy has not been without cost. The company has had to accept a potentially higher short-term cost by sourcing from two rather than one supplier, and retaining a higher level of in-house capability than originally was thought necessary. The benefit, of course, is that what may have been lost on short-term cost reduction has been saved by having in place an effective exit strategy from supply dependency and moral hazard.