How to Avoid Outsourcing Pitfalls
- The success or failure of outsourcing depends on multiple factors, requiring a strategic assessment framework.
- Academic research points to four types of risk factors: to do with the client, the provider, their relationship, and the outsourcing contract.
- To mitigate failure risk, we recommend a structured checklist of key risk categories, specific risks, and potential mitigation strategies for companies looking to outsource.
The global outsourcing industry has experienced significant growth and transformation over the years. Outsourcing, which involves delegating specific tasks or services to external vendors or service providers, has become a strategic business practice for organisations worldwide, and continues to thrive as an industry. As we noted in our previous Insights article, companies commonly outsource a range of business functions that includes finance and accounting, human resources (HR), payroll administration, data entry, customer support, IT support, software development, and supply chain management.
While there is little doubt about the future growth potential of the industry, companies looking to outsource for the first time, or those wishing to evaluate its overall potential, can benefit from a critical assessment of how successful the average outsourcing engagement tends to be. Some research suggests that up to 25% of outsourcing relationships can fail within two years. So if outsourcing as an industry is continuing to grow, how can it go wrong for individual firms?
In this article, we have tried to answer this question by digging into the research available on this topic. Although academic research is limited by the fact that most unsuccessful outsourcing relationships are not publicly documented, some studies have been carried out in previous years. Insights from this literature have been extracted, and based on them, a strategic framework to mitigate outsourcing risks is suggested.
Most academic research that does exist on the determinants of outsourcing success or failure is based specifically on IT outsourcing, since this has been one of the major sub-sectors within the broader outsourcing industry. Nevertheless, it yields learnings that can be applied more generally. To do that, we have first summarised the findings from three studies on the topic.
A research study published in 2014 in the Journal of Systems and Software assessed the factors impacting the success or failure of small-scale software projects, conducted through an online marketplace. The analysis was based on a data set of 785,325 projects and tasks completed through the marketplace, and tested multiple possible factors for a possible causal link with the outcome of projects. It found four factors to have a statistically significant effect.
- Prior history of collaboration: The risk of failure was reduced if the client and outsourcing provider had previously worked together on a project. This makes intuitive sense, as prior collaboration probably helps the two entities develop a mutually agreed way of project execution.
- Provider credentials: It was more likely for projects to be successfully completed by a providers that already had a low failure rate in the past. This result is also unsurprising, as past performance is generally a decent, although by no means a perfect, indicator of future successful delivery.
- Pricing: The study showed that an increased client emphasis on a lower price was associated with a higher risk of the project failing. This is an interesting finding, which indicates that contrary to conventional wisdom on the topic, it may not serve companies too well if they prioritise cost saving as the primary objective of outsourcing.
- Project size: A higher risk of failure was associated with an increased project size, according to the research. This likely occurs due to the increased complexity of larger projects, making it more challenging to manage and execute on the deliverables.
Further insights can be gleaned from a similar research study conducted in 2016 and published in the journal, Science of Computer Programming. It focused on the Dutch IT outsourcing market, and analysed 30 such deals with an average deal size of about 3 million Euro. Compared to the study cited above, this one focused on larger, direct outsourcing partnerships, and thus offers an additional perspective. Furthermore, it investigated factors that tend to be in the control of the client during the initial stages of the outsourcing project. The study found that the following factors tended to be relevant to the chances of success.
- Managing the provider: Improving the management of the outsourcing provider, which included contract management, financial agreements management, and performance management, was found to reduce the chance of failure. This suggests that contrary to the general expectation, outsourcing arrangements are unlikely to work well if they are constructed as relatively hands-off from the client’s perspective.
- Communication internal to the provider: Somewhat surprisingly, effective communication within the organisation providing outsourcing services was found to be correlated with a lower failure risk. This could indicate that different stakeholders within the provider entity all need to properly understand the project and client requirements for successful delivery.
- Following a transition plan: Adherence to a defined plan of transitioning knowledge, assets, or systems to the provider for outsourcing purposes was associated with a lower chance of failure. This result makes sense, since any laxity on this front would be disruptive to the actual outsourcing work planned to be done.
Finally, a case study of a well known and large scale outsourcing project that did not succeed offers some additional pointers about risk factors to watch out for. Specifically, it looked at a past attempt of the Australian Federal Government’s attempt at outsourcing its IT infrastructure, abandoned in 2001. Three major learnings can be gleaned from this case.
- The business case: Managers can often spend too little time properly defining the business case for outsourcing. This can lead to a difference between the expected benefits from outsourcing, and those actually realised. Specifically, this can occur due to inaccurate assumptions about costs, savings, and ongoing managerial effort. In particular, the study found that coordination and transaction costs tended to be overlooked in the outsourcing business case.
- Contract term: The study suggests that shorter outsourcing contracts tended to be associated with a higher failure chance, partly because transaction and coordination costs tended to be higher in that case. This may occur because pricing tends to be more competitive in longer term relationships, and both parties likely develop a better working synergy.
Provider alternatives: From a client’s perspective, the success of an outsourcing project is defined by its completion, irrespective of who the provider is. Therefore, it is unsurprising that the lack of, or few, alternatives to an existing provider limits the client’s flexibility, raising the risk of failure.
Outsourcing risk framework
This analysis allows us to draw some generalised but practical conclusions about the nature of risks that typically confront companies. As a starting point to better understand this, we have categorised the above factors by four main types in the table below, as the research highlights the following common elements.
Table 1 : Outsourcing Risk Categories
Mitigating outsourcing risk
This risk framework suggests that while not all factors are under the client’s control, most of them are. So as a first step, firms considering outsourcing need to do some detailed advanced planning from a strategic perspective, so they can anticipate likely risks and devise mitigation strategies.
In view of the research presented in this article, we have a drafted a general checklist of major risks at each stage of the outsourcing process, and key actions that clients can take to manage them proactively throughout the project lifecycle.
Table 2: Outsourcing Risk Mitigation Framework
This checklist can serve as a basic framework that companies can use as a starting point to devise a more thorough strategy to conduct all their outsourcing operations. Of course, the specifics will vary for each firm, depending on which function or functions are being outsourced, which outsourcing model is being used, and other such variables. Nevertheless, in the light of academic research and the critical risk factors identified from it, a structured approach towards de-risking outsourcing efforts is critical for their long term success.