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Outsourcing to derive the benefits of
core competency
Outsourcing allows a key function like IT to be effectively removed (resources, assets and operations) while the organization still ‘enjoys’ the selected outcomes from this function (use of IT
to enable the flow of information within the organization). Non-core functions therefore can be effectively removed as regular operations are passed to the supplier of outsourcing services who, in turn, will deliver the desired outcomes to the buyer of these services. When organizations focus on core competence, advantages of economies of scale, cost reduction and more-effective operations often result. Among organizations that have outsourcing agreements, satisfaction is higher for those that outsource core activities, provided that they incur minimal risk from the relationship established.
Organizations should define the areas critical to their success, devote maximum resources to those areas, and outsource everything else that is not ‘core’. As defined earlier, the competencies of the organization provide potential access to a wide variety of markets, make a significant contribution to the perceived customer benefits of the end product, and are difficult for competitors to imitate. A definition of core competence includes activities that the organization is continuously engaged in, while peripheral activities are those that are intermittent and, therefore, can be outsourced. If this strategic perspective is adopted, the argument then holds that core activities should stay in-house, while non-core activities can be outsourced, in order to preserve core competencies. The importance of coherence in corporate capabilities that strengthen the competitive advantages of organizations needs to be emphasized. Multi-business organizations with commonalities based on shared capabilities and know-how are known to be associated with higher economic performance (Prahalad and Hamel, 1990).
To cope with increasingly aggressive environmental pressures, organizations are attempting to reposition themselves higher on the value chain so as to gain competitive advantage. In an effort to transform cost-based activities into profit centres, some organizations use separately managed profit centres or business units to induce competitive market pressures internally. These supplementary or non-core activities are then spun off into separate organizations with the intent of making them profitable.
This, however, appears to be a solution for situations where there is logical placement of these functions within the organization.
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For example, organizations that supply outsourcing services for profit motives leverage on economies of scale to provide cost-effective and resource-efficient services. The ‘economies of scale’
argument is discussed below.
2.2
The ‘economies of scale’ argument
Another common reason why organizations choose to outsource is to achieve economies of scale. Both the buyer and supplier of the ITO function would benefit from the effects of economies of scale and scope.
Outsourcing has moved markedly from attending to a single function more efficiently, to reconfiguring a whole process in order to achieve greater shareholder value across the organization. The emphasis is shifting from outsourcing parts, facilities and components, towards outsourcing the intellectually based systems, such as customer response handling, procurement and management. Herein are the benefits that can be obtained through economies of scale and scope. Equally, however, the perceived risks are greater.
When a buyer has contracted for IT services, it has assured itself a portion of any profit that would be received from selling excess capacity on its systems. If the supplier could use the additional capacity to serve other buyers, economies of scale are realized.
Large suppliers also have the scale to negotiate better acquisition terms for software and hardware. By purchasing in larger quantities to serve simultaneous users, suppliers can lower per-unit costs. Finally, software developed for a specific application can often be applied at virtually no incremental cost to other clients.
For this reason many large third-party suppliers appear in markets where a service is principally delivered through software.
The effects of economies of scale are significant. For example, a software developer would incur a one-time cost in the development of a software application. Each copy sold subsequently would earn a unit cost. Each unit sold would then contribute to a share of the original capital costs. The outsourced supplier, however, would purchase one licence to run the application at a unit cost. Subsequently this supplier would ‘host’ the application for multiple buyers. Software suppliers have since, however, changed this procedure by licensing software not by machine, but by ‘concurrent users’ or ‘seats’. This example illustrates some of the magnification effects of scale economies that exist in an outsourcing environment.
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Economies of scale have their limits in an ITO context and are only verified for the cost of machine or CPU time and not services. For example, a supplier would need a finite number of people to support a particular function. People resources are finite and cannot be broken down into partial resources. Perfect economies of scale hence do not occur in all aspects of economies of scale. People costs dominate in governance and service costs; both of which can be unpredictable as they would only be required when there is a need. The financial and resource risks that are incurred by the supplier need to be accounted for here. Likewise the same risks are passed on to the buyer if not adequately taken up by the supplier.
Economies of scale can also be observed when network externalities affect the organization’s decisions in a situation where a product or service becomes more valuable to all users, as its adoption grows. For example, the ‘Voice Over Internet Protocol’
(VoIP) system is of little use if only one person has access to the network, whereas it has an enormous value if a person from the organization can call virtually anyone for a low charge. Products, services or systems that exhibit network externalities tend to converge toward standards. Once a standard has attained critical mass, organizations may recognize that adhering to the standard is critical for survival as economies are realized.
The main advantage the supplier organizations have lies in economies of scale and scope. The benefits from economies of scale arise when costs decline as production increases. The most common form of an economy of scale is when efficient production involves a large fixed cost, such as the initial capital outlay to procure some of the buyer organization’s assets, amortized via a larger quantity of goods or services. Increasingly, outsourcing suppliers are now looking beyond running IT systems to business process management (BPM), in which they also take over functions such as billing, cheque processing and accounting.
The benefits of economies of scope, much like the economies of scale, are enjoyed by the supplier where shared fixed-cost equipment for multiple buyer organizations can be pooled and used for a common core of IT services. Generally the supplier will negotiate for activities where the total costs of delivering a common portion of the IT function lie across several buyer organizations (in a sharing scheme). These costs will be lower than the sum of the costs of producing them separately, hence the benefit from economies of scope. An example of economies of scope is when core technologies have applications across multiple industries. A detailed study of 186 systems projects 48
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between the years 1967 and 1993 in five large organizations which implemented new technologies such as fourth-generation programming languages, or which required mini-computers or multiple-computer networks, found that they were more likely to be outsourced than built in-house (Nelson et al., 1996). Rapid technological change, combined with the experience of working in different settings, often gives suppliers the advantage in providing ‘leading edge’ technology services.
2.3
Commoditization of IT
Many of the discussions around core competency no longer apply when IT becomes a commodity item. The use of IT components has become prolific and their availability abundant.
There is little restriction on access to outsourced services and products. Easy access, over time, would result in standardized (mass production, repeat transaction) outsourced services. The differentiation which used to exist with respect to lower cost, resource availability and access to expertise has become diluted.
The standardized processes which used to be outsourced now serve as building blocks or a foundation for a more complex series of interrelationships and risk elements.
2.4
The role of IT in the organization
The IT function is typically used to perform infrastructure support but it can also be utilized to differentiate an organization’s products and services.
It is a support function as it is interwoven or integrated into many essential organizational processes and is an essential tool that enables many value-creation activities to go ahead. The IT
function itself, however, can take on several roles in an organization including that of a strategic function which allows the organization to differentiate itself from its competitors, i.e. as a primary function. This ‘dual function and capability’ feature of IT adds another dimension of complication to the outsourcing decision, as this function is unsuitable for being outsourced in specific situations, i.e. when it is a strategic function that differentiates the organization from its competitors. The organization retains control of the strategic function to protect itself against possible theft – or other criminal activity (by a competitor) – of its proprietary information. The operational risk as well as risk of loss of information is higher in this situation.