Talent Management Column

Should You Outsource?

Sourcing decisions are human resource judgments that too often are made based solely on economic issues. HR leaders need to better analyze -- and decide the best ways to deal with -- the business risks of outsourcing work.

Monday, December 5, 2011
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In my view, the single most important human resource decision made in organizations today is also the one that is newest -- and that is how to "source" work. Should we do it with our own employees? Should we engage contractors to do it onsite? Should we outsource it to a vendor who operates elsewhere -- here or offshore? These are huge decisions, and they are fundamentally about human resources.

The problem is that they rarely seem to be made by human resources. Instead, they seem to be made by financial operatives -- and they are doing it wrong.

Yes, that's right. The reason they are doing it wrong is that they almost always focus on direct costs as the only criteria: How much per call will it cost us if we outsource versus doing it in-house, etc.

What's wrong about this approach is that it leaves out an assessment of risk. We're talking about business risk here -- bad outcomes that put the business as a whole at risk.

The biggest risk in these sourcing decisions is reliability: What are the odds that the vendor won't be able to deliver, or at least do so in a consistent manner? The most important factor in reliability is, not surprisingly, human resources: Is the turnover rate in the Philippine call center we are thinking about using so high that it suggests they would not be able to provide consistent service?

We are inclined to think that reliability is highest when we do things in-house with our own employees, but sometimes that is not the case. If we have a small information technology group, for example, the loss of one key employee can shut down our operation, whereas if we outsource it to one of the major vendors, they have such deep back-up capacity that the risk of reliability problems is actually much less.

The other risk, which does not get nearly enough attention, concerns responsiveness.

In most organizations, but especially businesses, demands change frequently and unpredictably. We have to respond to those demands somehow.

What do we do if demand for one of our products falls sharply, and we don't need the call-center capacity dedicated to it? Or if a new product using a different sales channel takes off?

In situations like these, the decision to outsource generates considerable risk because such arrangements are governed by contracts, in which adjustments are costly and slow. It is possible to build some flexibility into contracts, but vendors usually extract big fees for that because it causes them headaches as well.

When we look at sourcing decisions -- or when others in the organization look at them -- they need to factor in these two risks and the potential costs associated with each. If we decide to engage in a joint venture to produce something for our supply chain, for example, someone needs to assess whether that venture will have the reliability needed to keep the overall business safe and whether it has the capability to respond when our needs inevitably change.

A cheaper operating price is no bargain if the risks of reliability and responsiveness are low.

How are those judgments made? Poorly is probably the right answer -- but the way they should be made is by concentrating on the human resource practices and capabilities of the joint venture: Do they have policies and practices that will stabilize turnover? Do they have the resources to staff up quickly if demands change? Is their human capital good enough to handle a new approach and what would these changes cost us?

Our own human resource departments are the most capable of making those assessments of vendors, joint ventures or other external partners. Even if what we come up with is as simple as "big risk, medium risk, small risk," that's a lot better than what we have now.

Beyond assessing the risks is the more complicated process of managing those reliability and responsiveness risks.

In the world of supply chains, they talk about two types of strategies for managing risks like these. The first is a mitigation strategy that is built in up-front and represents a fixed cost.

In the HR realm, a mitigation strategy would be maintaining a bench of talent ready to step in if key executives leave. We pay people on the bench if or until they step in.

The second is a contingency strategy that only goes into effect once a problem arises. Calling a search firm to find a replacement for that key executive is a contingency strategy. An equivalent distinction in medicine would be the difference between preventative treatments and emergency-room visits.

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It may seem like mitigation strategies are uniformly better, but that's not true. They are a very expensive solution for an event that may not be very likely to ever occur and that is not catastrophic if it does occur.

Consider, for example, trying to manage the risk that a given manager will leave. We estimate that it will cost us $500,000 if she does -- both the costs to replace her and the lost value of her contribution until a replacement gets up and running.

So we are thinking about "locking" that manager into the company with $200,000 of stock that vests, say, five years in the future.

Is it cheaper to pursue a mitigation strategy that involves upfront costs? Or, is it better to just deal with the problem if it occurs and accept those replacement costs -- the contingency approach?

In this case, that depends what we think the odds are of losing that manager in the next five years. (The odds determine the likelihood that we will ever need the contingency approach, while the mitigation strategy has to go into place no matter what.)

If the odds are less than one in three, go with the contingency approach. If they are much higher than that, put the mitigation approach in up-front and lock the employee in.

Assessing risks and managing them are topics now at the top of every CEO's desk. If we want our CEOs to take our issues seriously, analyzing them in this format is one way to do that.

For more details on these ideas, see my 2011 article on "HR Sourcing Decisions and Risk Management" in Organizational Dynamics (40(3): 310-316).

Peter Cappelli is the George W. Taylor Professor of Management and director of the Center for Human Resources at The Wharton School. His latest book, with Bill Novelli, is Managing the Older Worker: How to Prepare for the New Organizational Order.

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