Monday, October 29, 2012

Outsourcing -- How it Works in Theory

Parsley Sage Rosemary & Ginsburg llp
“always a reasonable result for a reasonable fee, always”

All Partners and Senior Admin Staff
Mike Marget
October 28, 2012
Outsourcing – How it Works in Theory

Outsourcing is a $500 billion-a-year business.  Big business embraces outsourcing in a big way to reduce cost, foster greater efficiency and free management time to focus on core competencies. 

Outsourcing initiatives tend to target back office tasks – HR, payroll, call centers, help desk and accounting/billing activities.  Xerox – who in recent years has become a big outsourcing service provider (“OSP”) – runs a number of TV commercials[i] touting how they perform accounting tasks for Michelin and Marriott and call center management for Virgin Airline. 

The purpose of this memo is to discuss how outsourcing works from the perspective of the OSP and the benefits to the OSP’s business customer.

How Outsourcing Works for the OSP
The OSP’s goal is simple.  Deliver quality services better, cheaper and faster than the business customer can accomplish with internal resources, and do so profitably over the course of an enduring relationship.  In order to grow its business, an OSP works hard to provide excellent service to each business customer in order to secure quality references essential to attracting additional customers.

The outsourcing business model is significantly more complex than simply moving jobs from high cost metropolitan areas to places where salaries are lower.  While wage differentials may be part of the equation, an OSP’s success is primarily dependent upon two other factors: 
       1.       Economies of scale; and
       2.      Technology, talent and process improvement.

Economies of Scale/Leverage
Volume matters.  An OSP with multiple business customers enjoys a higher volume of work.  Higher volume results in more consistent capacity utilization with fewer peaks and valleys in the workflow.  Fewer peaks and valleys permit the OSP to leverage its workforce for higher productivity – and consequently lower operating costs – as compared to a single organization with lower volume. 

In Microeconomics 101, we learned that higher volume generally results in greater productivity.  The higher volume/greater productivity thesis is confirmed in the context of a law firm’s back office with data from a national survey of law firm economies focusing on firms with 20 or fewer lawyers.  According to the survey, firms with 11-to-15 lawyers average 0.12 FTE accounting personnel per lawyer versus a 0.11 FTE per-lawyer ratio among firms with 16-to-20 lawyers. [ii]  So, what does this mean?  Take for example a firm with 13.33 FTE lawyers and 1.6 FTE accounting personnel; then assume the firm increases 50% in size to 20 FTE lawyers.  Will this now-bigger law firm require a corresponding 50% increase in support staff to 2.4 FTE to handle the increased number of accounting and billing transactions?  Not according to the survey.  The now-bigger law firm should require just a 37.5% staff increase (not 50%) – to 2.2 FTE – since the typical 20-lawyer firm is able to manage its accounting and billing operations with 2.2 FTE, rather than 2.4.  The 0.2 FTE difference illustrates the workforce economies of scale available in a higher volume environment.  A high volume OSP is able to further maximize the economies of scale when leveraging the work effort supporting dozens or even hundreds of lawyers.

Investment in Technology, Talent and Supervision
Whether you work in a law firm or a Fortune 500 company, it is infinitely easier to justify capital spending on front office activities – the things which attract clients, generate higher revenue or reduce direct costs – than on measures aimed at improving back office functions or reducing indirect costs.  Granted, if a particular back office system is broken or on its last legs, you have a shot; short of that, back office capital spending is a tough sell.  An OSP views capital investment on matters related to the business customers’ back office activities through a different lens.

With outsourcing, the business customer’s back office is the OSP’s front office.  As such, OSPs invest heavily in technology, talent and process improvement in order to bring down the OSP’s operating costs.  The OSP requires lower operating costs in order to (a) pass a portion of those savings on to the business customer, (b) recoup marketing and capital investments and (c) make a reasonable profit.  It is standard practice for OSPs to upgrade the business customer’s (former) back office technology and implement “best practices” in order to streamline and standardize operations. 

From a staffing perspective, OSPs generally engage better talent than the business customer is able to attract and retain in a on its own.  Recruiting and retention is easier for a larger, focused OSP who can provide a career path and greater responsibilities and opportunities than can the business customer on its own.  This is particularly true when the OSP’s business customer operates in an environment where mobility from the back office to the front office is limited, if not impossible, due to training, experience or licensure, as it is with law firms.

Finally, a high volume OSP has greater flexibility and management depth to utilize part-time workers and provide 24/7 services than a single organization trying to operate hard-to-supervise second and graveyard shifts. 

How Outsourcing Works for the Customer Firm
From the business customer’s perspective, the primary motivation to outsource is to save money.  Outsourcing permits businesses to reduce their indirect costs and either realize higher profit or pass the savings on to their customers in the form of lower prices.  However, cost is only one of three motivating factors when businesses evaluate outsourcing.

Cost Savings
Obviously, each situation is different, but proponents of outsourcing trumpet 30%-to-40% cost savings when businesses outsource.

In addition, outsourcing generally relieves business customers from ever again having to make capital expenditures to support the outsourced tasks.  From the business customer’s perspective this conserves capital for expanding front office activities and converts back office fixed costs into variable costs.

Improved Internal Services
As a result of its ongoing investments in technology, talent and supervision, OSPs support business customers as change agents.  They tend to document and clarify back office procedures leading to continuous process improvement and error reduction associated with back office activities.  Time-saving technologies are introduced and the OSP staff brings new ideas and perspective to back office tasks. 

The back office procedural improvements collaterally enhance front office operations as well.  For example, reducing the back office time needed to process invoices can lead to saving time and resources in the front office.  Similarly, the new technology implemented to reduce the billing process may provide more meaningful financial data to improve management supervision over sales, billing and collection efforts.

Reduced Management Distraction on Non-Core Activities
Perhaps the most important collateral benefit derived from outsourcing involves liberating management time to focus on core competencies.  Outsourcing avoids management headaches such as finding, recruiting and evaluating back office staff, supervisory oversight and problem-solving.  It permits management personnel to focus on their “highest and best use” – those things directly associated with revenue generation – customers, delivery of goods and services, attracting new customers and increasing profit margins by reducing direct costs.

A $500 billion-a-year industry isn’t going away anytime soon.  I believe it is here to stay because a big part of management involves managing the costs of running the business.  Goods and services are generally purchased from the supplier who offers the requisite quality for the lowest reasonable price.  If an OSP can provide back office services of comparable (if not better) quality for a lower price, shouldn’t such offers be entertained?  If not, isn’t management letting down the business’ shareholder owners?  Moreover, what happens when the business’ direct competitors make the move to outsourcing and thereby obtain a competitive advantage? 

Today most OSPs focus on big business – where there are bigger contracts and bigger profits to be made.  Eventually, outsourcing will expand further among middle market companies and make inroads into small business as well.  It’s inevitable.  It just makes business sense.

[i] Xerox has a really coolwebsite devoted to their outsourcing prowess.  The TV commercials tend to run during Notre Dame football games on NBC.  GO IRISH!
[ii] Small Law Firm Economic Survey, 2011 Edition, p. 179.  This survey is published annually by ALM and The National Law Journal.