In recent years, many businesses have decided to reduce the cost of their operations by outsourcing some or all of the manufacturing of their products and key services of their businesses.  Unfortunately, many suffer product quality and customer service problems because of poor supplier performance. This article explains the risks in outsourcing, how the outsourcing process can be successfully implemented, and how to structure it to be a strategic advantage.

The Consequences of Not Managing Outsourcing

I began writing this article as I was sitting on an airplane. I had just experienced firsthand the results of a problem in outsourcing. My flight had just been cancelled due to a mechanical problem, and after a great deal of trouble and miscommunication, I was finally successfully rescheduled on a different flight. The mechanical problem with the airplane started an entire chain of unfortunate events for the airlines and its customers and these events are as follows:

• First of all the air carrier lost the revenue for the entire flight and probably lost more on subsequent flights depending on the total downtime of the airplane.
• The airline gate personnel were forced out of their normal routine of selling tickets and servicing new passengers and were forced to immediately reschedule 140 passengers on flights on other carriers.
• Many mistakes were made with the bookings because of the rush, luggage was lost because of miscommunication, and many travelers would miss their connecting flights thereby affecting their business and personal schedules. Because of the domino effect of the errors many of these travelers will probably avoid flying on this airline in the future, myself included. This will mean a loss of future revenue.

This scenario happens quite frequently with this airline company, and as stated in knowledgeable circles, is brought on by their inability to manage the outsourced maintenance of their airplanes.  Without a change in their management of this problem the end result will be a downward spiral of continuing problems and further losses of revenue.

Strategic Reasons to Outsource

The failure scenario described above is not uncommon for many companies that outsource.  They have misconceptions on how to use these outside resources and the role that each party must play in order to make the relationship successful. Listed below are reasons for outsourcing production or services that will improve the company’s strategic position:

Increase Capacity. A business can add manufacturing capacity or business capabilities without adding additional personnel, equipment or facilities. This allows the company to leverage their fixed costs.

1. Increase Technology. Some businesses cannot afford state-of-the-art equipment nor have employees be fully skilled in all processes. Outsourcing allows the use of better technology without the investment in equipment or specialized training.
2. Add Proprietary Processes and Products. Some products or services require the use of proprietary processes or equipment that are exclusive to other businesses. Without the use of these processes or components the product cannot be built to the desired specifications.
3. Reduce Costs. Businesses with high overhead or labor costs can use outsourcing to reduce their costs. Smaller businesses or offshore companies may have much lower cost structures.  However, outsourcing for this reason mandates more analysis to help fully understand the total cost of outsourcing and the real reasons for the cost problems.

On many occasions I have seen a product or component shipped to a lower cost producer at home or abroad and the problems were compounded. The end result was an increase in problems in quality, product performance, and customer service.  Often these factors combined to increase total company costs and invalidated the expected cost savings from the outsourcing initiative. Therefore, in order to obtain the expected benefits from an outsourcing initiative, management is required to expend a great deal of planning and effort in support of the outsourcing process and designated supplier.

Key Factors-to-Success

There are many risks associated with any decision to outsource. However, by using the strategies listed below a business can avoid or manage most of the risks and be successful in using outsourcing as a strategic part of their business. Listed below are the key factors to success:

Fully understand the true in-house and anticipated outsourced costs before making a decision.

In order to make a sound decision about using an outside manufacturing or processing supplier a business should perform an activity-based cost study. This will include identifying and understanding the following financial costs and subjective factors before and after the move:

• How to amortize of fixed costs of the current business.
• Technical resources such as engineering and quality assurance and their associated costs.
• Training costs for the supplier’s technical and production staff.
• Purchasing and materials management resources.
• Ongoing support costs for the relationship from all involved parties.
• Impact on inventory and cash requirements.
• Estimates of the impact on warranty and other service-related costs.
• Customer service costs due to shortages or inventory stockouts.
• Understand the impact if volume goes up or down substantially.
• Understand the strategic impact to customers and the perception of the company in the market.
• Factor in which strategic or operational opportunities are lost or gained with this action.

Make good decisions about which processes or products to keep in-house or outsource.

• Wherever possible, have proprietary or process-critical operations remain in-house where they can be monitored and controlled better. I would identify these types of operations as core competency operations that define marketing or strategic differences between you and your competitors.
• If processes or products can have a large impact on product quality, safety, and customer service keep them in-house.
• Choose parts or process candidates that represent meaningful orders for the supplier. This practice will make your business a priority for the supplier. Try to have enough consistent volume to be important to a supplier and it will increase their focus on meeting your ongoing business needs.
• Ship components or products outside that are well within the technical capabilities and capacities of the supplier. Higher volumes of a limited variety will assure low costs and low quality risks. Do not burden them with too many different production variations. Keep it simple for them.
• Keep one-of-a-kind and low-volume products inside to reduce stockouts and quality risks. Often the overhead costs to support these types of sales, such as engineering and materials management resources, are substantially higher than for standard products. Repair parts for older machines are typical of these types of items. The production of these types of components can often be handled cost effectively in-house with flexible manufacturing cells.

Don’t export problems to suppliers.

• Fix all quality and engineering-related problems before outsourcing. Do not ship problem processes or products to a supplier, especially offshore.  Adding a language barrier and ignorance of the product and processes will only compound the problems. Instead, make the product or process idiot-proof for the supplier.
• Fully define and document product design, performance and process parameters.
• Fully train the supplier’s quality, design and production staff in the required design and process parameters.

Establish and document Quality, technical and product performance criteria.

• Develop testing mechanisms to check and assure product performance.
• Develop in-process Quality Assurance systems with the supplier to assure consistency in their in-house processes.
• Establish Quality-auditing procedures to insure supplier conformance to final design and process control specifications. This can be performed both at the supplier and at the buyer’s receiving inspection station.

Establish long-term partnerships with suppliers.

• Establish key suppliers and avoid changing. Each supplier change dramatically increases risk.
• Create an environment where both parties can mutually benefit from a long-term relationship.
• Encourage joint value analysis programs to reduce costs and improve product performance.
• Share cost savings generated from value analysis programs with the supplier involved.
• Develop business processes and systems that improve the supplier’s performance on products and services.

Create a contingency plan.

• As needed carry additional in-house stock or have the supplier carry additional inventory or capacity to cover potential shortages.
• As practical keep necessary production capabilities in-house until suppliers perform well and risks are minimized.
• As needed qualify secondary suppliers that can step in should the first supplier fail to perform.

Real Life Example of a Failed Program

I have seen firsthand the aftermath of a company moving ahead on an outsourcing program on a critical component without managing the key factors-to-success stated above. Several years ago this company made a decision to outsource a major component of its equipment. The main reason for outsourcing was to reduce total manufacturing assets and employee headcount. When manufactured inside, the costs were competitive and the quality and performance problems were few. In addition, the industry favorably viewed this company’s products because of their lower product failure and downtime rates and this fact was often used as a selling point against the competitor’s products.

On paper, the company’s analysis of the cost savings appeared worthwhile and so the company charged ahead. Unfortunately, the method used to maintain competitive costs was to put the product out for competitive bid on a routine basis. Therefore, in order to meet ongoing cost reduction objectives, it necessitated the changing of suppliers many times and the use of some small suppliers that did not fully understand how to build the specialized components.  Unfortunately, there was little quality and engineering support provided by the company to insure the components provided by the suppliers would perform.

Within one year the foolishness of this action became apparent. The company’s products began experiencing failures with this component in alarming numbers and some operators were injured in the breakdowns. Because of the high failure rate and the anticipated operator danger, hundreds of machines were pulled out of service. At great financial cost the dealers were forced to perform emergency repairs and provide free rental equipment for the customers to use while their machines were down for repair.  Suppliers of the components were slow to react and provide satisfactory products and this problem caused additional downtime delays. Once this problem began affecting many core products of the company, the sales efforts became more difficult and many loyal equipment users began purchasing the competitor’s products.

What started out appearing to be a sound financial decision became a major financial and public relations debacle for the manufacturer and its distributors. The company’s perception in the market, which had been very good up to this point, has been severely impacted. Unfortunately, the financial implications will continue for years because of ongoing warranty and litigation costs. The greatest cost to the company will be in its loss of goodwill with its customers and this will undoubtedly mean a direct loss of equipment sales and market share. I estimate that the resulting long-term costs to profitability and company value will be hundreds of times more than the few dollars they expected to save in the outsourcing program.

Wrapping it Up

What can be learned from this article? Listed below are the take-home points to be successful at outsourcing:

1. Understand the risks and potential costs of any outsourcing decision that you make. Perform a proper analysis and assign estimated costs for each risk associated with the move. Make a good decision based on a thorough financial analysis.
2. Make the commitment to do the job correctly and provide the initial and ongoing technical and quality support to insure a successful transition as well as ongoing high levels of delivery and quality performance.
3. Partner with the supplier to make them a success. In order for them to make a commitment to service you well, they must cover their costs and also make a profit. Few suppliers have all of the resources required to manage a satisfactory transition. They need your help and commitment of support resources.
4. Fully understand the subjective factors such as customer service and market perceptions that could have a much greater impact on the future success of the business. Consider these factors in the final decision and insure the outsourcing action is worth the risk.

Summary

If the key factors-to-success listed in the article are properly addressed in each outsourcing decision, the probability of success is high. Outsourcing done for the right reason and in a disciplined manner can be a sound strategic move for a company. However, in order to make this process work, the business must allow the supplier to be successful. This success is accomplished by creating a win-win scenario. This includes commitments of support resources and long-term business partnerships. One important point to remember is that there is no free lunch in outsourcing.  You will either pay up front to do it right or you will pay more at a later date to clean up the mess that was created. 

(Article was originally created and published on 7/16/01 on OMC website and has been updated for republishing on 7/15/09.)