An overview of the outsourcing methodology

The principal proposition of the outsourcing methodology is that

implementing a successful outsourcing strategy must involve an analysis of
a number of dimensions including relative capability in the process,
contribution of the process to competitive advantage and the potential for
opportunism from outsourcing the process. Analysing each of these
dimensions yields a number of sourcing strategies.

Contribution of the process to competitive advantage

Resource-based theorists argue that organisations will attain competitive

advantage by building superior performance positions in processes that are
valued by customers. Therefore, organisations should perform internally,
and build capabilities in areas that deliver competitive advantage. For
purposes of outsourcing, processes are either critical to competitive
advantage or not critical to competitive advantage. Processes that are
critical to competitive advantage have a major impact upon the ability of a
company to achieve competitive advantage, either through the ability to
achieve a lower cost position and/or create higher levels of differentiation
than competitors. Adhering to the logic of the RBV, building a superior
performance pos ition in such a process that is difficult to replicate will lead
to sustainable competitive advantage.
Alternatively, processes that are not critical to competitive advantage have
a limited impact upon the ability of a company to achieve competitive
advantage. Although these processes have to be performed well, and are
necessary for serving the needs of customers, any performance
improvements achieved in such processes are unlikely to be a source of
competitive advantage as they are not key differentiators in the eyes of
customers. The logic of the RBV is that such processes are of limited value,
readily accessible in the supply market, easy for competitors or vendors to
imitate, and provide no basis for competitive differentiation if performed
internally.
Processes that are not critical to competitive advantage include those that
have either a marginal or insignificant impact upon competitive advantage.
Resource-based theorists argue that organisations should focus scarce
resource on processes that are valuable, rare and difficult to imitate.
Although processes that have a marginal or insignificant impact upon
competitive advantage are necessary for serving the needs of customers,
they are not a means through which competitive advantage is created, and
therefore are potential candidates for outsourcing. In addition, there are
risks with focusing scarce resource on such processes, as this will divert
resource from areas which are critical to competitive advantage, and where
a company can build superior performance positions that are difficult to
replicate. Processes that are critical to competitive advantage are limited in
number and require considerable resource and management attention to
maintain and develop strong performance positions. Table 3.1 outlines the
key questions that should be considered when assessing the contribution of
a process to competitive advantage.

Contribution to competitive advantage factors

Does achieving superior performance levels in the process enable an

organisation to achieve a competitive advantage?
Will improving performance in the process allow an organisation to win more
business or improve the chances of gaining more business?
Will investing additional resource in the process allow an organisation to
achieve a competitive advantage?
Can important knowledge associated with the process be exploited in other
parts of the organisation to enhance future performance?
Is it likely that senior management will commit additional internal resource
to achieving superior performance levels in the process?

Relative capability position in the process

A key issue in competitive strategy involves understanding why one firm

differs in performance from another. Some firms gain advantage over others
because they conduct certain processes in a superior manner rel ative to
their competitors. Superior performance in the process is considered
sustainable where it is difficult for competitors to replicate. Determining
organisational performance in processes relative to competitors is a key
concern for organisations in the outsourcing decision. Determining the
relative capability position in a process involves identifying the performance
disparity between the client and competitors and vendors. For outsourcing
purposes, the client can possess either a distinctive capability position or a
non-distinctive capability position in the process. The logic of the RBV
is that organisations must perform internally processes that are valuable,
rare and difficult to imitate, to gain sustainable competitive advantage. This
logic is integrated into the relative capability position dimension.
Processes in which an organisation has a distinctive capability position
should be performed internally, whilst processes with a non-distinctive
capability position are potential candidates for outsourcing. Non-distinctive
capability position processes include those in which an organisation has a
lower or par performance position. Clearly, an organisation should outsource
processes in which it has a weaker performance position. However, par
performance processes are also potential outsourcing candidates, as they do
not create competitive advantage and competitors or vendors can achieve
similar levels of performance. If all an organisation can do is perform
processes in the same way as competitors or vendors, the best performance
it can achieve is competitive parity.5 However, RB theorists argue that an
organisation should perform internally processes in which it has a superior
performance position that is difficult to replicate.
Determining relative capability position involves understanding both the
type and source of advantage in the process.

Type of advantage. This can be based on attributes such as lower costs,

superior quality, service levels, time-to-market and reliability. Superior
performance in a process can also include a combination of these attributes.
There are a number of aspects to this analysis including cost analysis and
benchmarking. Cost analysis involves comparing the costs of performing the
process internally with the costs of sourcing the process from a vendor. An
assessment of the relative cost position of the client in relation to both
vendors and competitors in the process under scrutiny should be
undertaken. The major drivers of cost associated with the process
should be identified. For example, for capital-intensive pro cesses, the major
cost drivers are likely to be the cost of equipment and production volume.
Alternatively, in highly labour-intensive manufacturing processes, the major
driver of costs is labour rates. Benchmarking is another useful tool for
assessing the organisations capabilities in the process relative to potential
vendors and competitors. Benchmarking also involves consideration of the
cost position relative to competitors and vendors.
Source of advantage. This is concerned with understanding how superior
performance in the process is achieved. Examples of sources of advantage
include scale economies, process experience, location and cross-functional
linkages that create superior performance. Determining the type of
advantage will have revealed valuable insights into the reasons for any
disparity in performance identified. The analysis may have revealed that
external vendors can provide the process at a much lower
cost than internally within the client organisation. However, it is important
to understand how this relative cost position is achieved. The superior cost
performance of vendors may have been as a result of scale economies and
greater experience in the process under scrutiny. These types of insight will
inform the analysis of the sustainability of a sup erior performance position.
This type of analysis can also assist in understanding how performance can
be improved internally without having to outsource the process. Many
organisations mistakenly rush into outsourcing without attempting to
understand the underlying causes of poor performance.

Relative capability position factors

Is it difficult to understand how an organisation or its vendors/competitors
achieve superior performance levels in the process?
Is it difficult for an organisation or a competitor to replicate the superior
capability of any organisation in the process?
Is it difficult for vendors or competitors to replicate or advance upon
superior levels of performance in the process?
Do resource constraints within an organisation impact upon the sourcing
decision, for example, reductions in capital expenditure impede internal
improvement or developing a capability in the process internally?

Potential for opportunism

This stage involves assessing the potential for opportunism from

outsourcing the process. Opportunism is at the heart of transaction costs,
and refers to the ability or willingness of organisations to pursue their own
interests at the expense of other parties to the relationship by shirking on
responsibilities or withholding information. There are a number of indicators
of opportunism potential in outsourcing situations.
Asset specificity. This refers to the level of customisation associated with the
outsourcing arrangement. Highly asset-specific investments represent costs
that have little or no value outside the outsourcing arrangement. The
presence of investments in assets specific to a particular relationship will
create switching costs for the client. These costs can be in the form of
physical asset specificity (level of product or service customisation), human
asset specificity (level of specialised knowledge involved in the transaction)
or site specificity (location). Asset specificity can be non-specific (highly
standardised), idiosyncratic (highly customised to the organisation) or mixed
(incorporating standardised and customised elements in the transaction).
TCE asserts that the potential for opportunistic behaviour is greatest in an
outsourcing situation when one or both parties have to make significant
transaction-specific investments. For example, the vendor may use its
specific investments in an outsourcing arrangement as bargaining power
over the client when the contract is being renewed, as other vendors would
have to commit the same investment to win the contract.
Uncertainty. This can occur both in the business environment and in the
requirements of the client. The presence of uncertainty means that it is not
possible to write complete contracts, and renegotiation and frequent
amendments are required as circumstances change. Rapid advances in
technology associated with the outsourced process can create high
uncertainty and lead to frequent changes during the contract and at
renegotiation.
Performance measurement. Difficulties with measuring the contribution and
performance of the vendor can also create opportunism potential in an
outsourcing arrangement, as the vendor might renege on its requirements.
The presence of performance measurement difficulties means the client
must expend additional resource on monitoring performance. For example,
the contract can include clauses to allow thirdparty performance monitoring
and benchmarks to assess performance. Differences in relation to the
interpretation of performance can create difficulties in the relationship.
Where effective performance measures have not been developed for the
outsourced process, it will be difficult to determine whether the vendor has
executed the process better than when it was performed in-house.
Process interdependencies. This refers to the interconnections between
processes, business units and tasks. Complex interdependencies between
business processes can also increase the potential for opportunism. The
presence of interdependence means that the performance on one process is
dependent upon the execution of other pro cesses, which can have a
negative impact upon performance. High levels of interdependencies
between processes either internally or with other outsourced processes
increase the need for co-ordination, joint problem-solving and mutual
adjustment. Interfaces between processes performed by vendors and those
performed internally can be complex to manage, and often require close co-
operation to maintain the integrity of the interfaces. Small number of
vendors. This refers to the number of capable vendors the client has to
meet its requirements. The presence of a limited number of vendors means
that the client is in a weak position when negotiating
the contract and will incur additional costs when switching to another
vendor. Such conditions make the client vulnerable to opportunism during
the contract, and at the time of contract renewal possible to draft a
sufficiently complete contract to deal with the potential for opportunism.
However, in many circumstances it is possible to deal with the potential for
opportunism by adopting an appropriate outsourcing relationship. In an
outsourcing situation where there is a low level of investment in specific
assets and relative certainty in requirements, a short-term outsourcing
relationship can be adopted with the vendor. Alternatively,
where the requirements of the client are highly specific and there is
uncertainty surrounding the transaction, a relational outsourcing
relationship is more appropriate. Relational contracting involves more than a
formal contract and includes social mechanisms that promote flexibility,
information exchange and joint problem-solving. Finally, a potential sourcing
strategy involves reducing the complexity of the process by redesigning it
into a number of more non-specific pro cesses that can be provided by more
than one vendor. This in turn will reduce the level of uncertainty in the
transaction. Moreover, it is possible that these more standard outsourced
processes share some of the characteristics of a short-term market contract.
A further strategy for reducing opportunism involves transferring the
process
to a vendor with which the client already has a relational contracting
arrangement. In fact, the outsourcing of such a process may be part of a
wider strategy of the client, further strengthening a relational contracting
arrangement with one of its key vendors.
Opportunism potential factors

Is the approach to performing the process highly customised to the needs of

the organisation?
In order to undertake the process, would the chosen vendor have to acquire
highly specific knowledge of the operating procedures of the process and
the organisation?
If the contract were to be terminated with the vendor, would there be
considerable costs incurred in switching to another vendor or bringing the
process back in-house?
Can the potential vendor undertake standardised routines in relation to
delivery of the process?
Is it possible to establish clear written rules and procedures to enable the
vendor to perform the process?
Is it difficult to predict current and future demand levels associated with the
process?
Is it possible to establish clear performance levels for the process, for
example, in terms of quantity, quality and timeliness of output?
Is it possible to negotiate a contract that clearly specifies the standards of
performance required and the means of evaluation?
How critical are the results of the outsourced process to the execution of
one or more internal processes?
How critical are the results of the outsourced process to the execution of
one or more outsourced processes?
How many capable external vendors are available to provide the process?