Outsourcing raises a host of risks.
Here are the most important:

• Flawed direction. Considerable exit costs and damage to customer and employee relations can place a high penalty on a flawed relationship, as illustrated by the JPMorgan/IBM reversal. One option that can be overlooked is moving to an in-house, shared-service model. For companies organized into autonomous divisions or built through acquisition, the advantages of centralizing may outweigh the benefits of moving to an outsourced model.
  
  
• Loss of control. After outsourcing an activity, some companies devote little attention to it. Staff and knowledgeable managers are fired or depart for greener pastures, and no one keeps up with IT advances in the functional area. An office equipment manufacturer, for example, was forced to undertake a major new outsourcing initiative only two years after it had put most of its logistics activities out to a thirdparty provider. Initial savings were offset by lower service levels to such an extent that innovative supply chain solutions were impossible.
  
  
• Brand damage. Just as garment manufacturers like Nike have been tarred with the “bad practices” brush due to their choice of product suppliers in China and Central America, so too can banks and other service businesses (e.g., Wal-Mart) be attacked for their outsourcing partners’ reputations. With the explosion of service providers in distant countries and the political nature of outsourcing issues in developed economies, due diligence is more important than ever.
  
  
• Poor service performance. This problem can defeat the most attractive cost advantage. Capital One cancelled a contract with Spectramind, India’s largest call center provider, after instances of workers tempting credit card customers with unauthorized free gifts. Poorly integrated processes, heavily accented English, or contextual unfamiliarity also can threaten customer service. As an antidote to service risks, Amazon maintains a small team to integrate new service providers into its ongoing operations, viewing the skills for ramping up new vendors as replicable across functions.
  
  
• Weak governance. At a leading high-tech company, a major operating function had been outsourced to the same provider independently by three different divisions via eight contracts worth $100 million annually. Only when one of the divisions expressed dissatisfaction with the supplier’s responsiveness did managers connect the dots. Not surprisingly, the provider then resisted attempts to centralize control over its activities.
  
  
• Staff resistance. Outsourcing can profoundly disrupt staff and cause lower morale, lower productivity, higher turnover, and reduced service delivery. Employees should be actively involved in the project, with retention plans, role changes, reassignments, job shadowing, severance programs, and interviewing by the provider all part of the plan.
  
  
• Arrested evolution. Business requirements inevitably change, and an outsourcing solution defined from a short-term, static perspective cannot respond adequately to rapid growth or new challenges. Companies thus may face a costly reassessment and complex transition of providers. This can materialize as an inability to serve new needs, to scale up, or to innovate. Dell recently faced this problem with its Indian call center, which was unable to adapt to increased call volume resulting from expanded product lines.
  
  
• Unforeseen costs. The costs of evaluating vendors, managing major contracts, traveling to offshore sites, enhancing security, and paying severance for laid-off workers are not always foreseen in the first flush of enthusiasm. Realizing too late that packaged standardized services will not meet the real needs of the business is a classic problem. Customized solutions by the vendor will likely cost 15 percent to 30 percent more than standard, and a company can find itself captive to a multi-year agreement. Exit costs are another hidden risk, as ending an arrangement prematurely exposes both buyer and provider to litigation. Careful cost modeling and scenario planning that include good benchmark information and a solid understanding of current activity-based performance and costing are essential.
  
  
• Insurable and uninsurable liabilities. Insurable outsourcing risks are often spread across so many types of policies that it is difficult to form a comprehensive view about whether all relevant failures have been insured. In addition, certain contingent liabilities are not currently insurable (e.g., customer service level declines, revenue loss due to brand impairment). For these risks, mitigation is the best medicine, through a robust process of risk assessment and careful development of alternatives and contingency plans.
  
  
• Regulations. Restrictions on outsourcing, motivated by protectionist instincts, are appearing on state and local ballots in the U.S. and might be debated in Congress. Even without dramatic change, however, companies remain responsible for regulatory compliance. Sarbanes-Oxley, Basel II, and Health Insurance Portability and Accountability Act compliance is now, or soon will be, required of financial services and other firms. Yet not all outsourcers can assure customers that they are fully compliant, so due diligence and monitoring of regulatory change is essential.
  
  

1.

Partner selection and due diligence. This is “the most important part of the whole approach,” according to one fund manager who outsourced back-office transaction processing. Best practices include articulating the outsourcing vision, strategy, and target results, which in turn help define the selection process and criteria. It is also useful to take the time to explore the opportunity for innovative solutions. New or unconventional players may offer more desirable and competitive capabilities. In any case, managers should focus on value delivery, not on cost alone. The best outsourcing yields process and service improvements that drive customer satisfaction as well as profits.

Moreover, the critical nature of strategic services requires a deep understanding of the supplier’s internal processes, and how the services will resolve problems and add value. Value creation, not just costs, should be modeled to determine feasible targets and to compare proposed solutions with current performance.

2.

Contracting. Negotiations can be conducted based on the detailed understanding of value drivers and processes developed in the first step. The contract should be developed in partnership with the supplier, with incentives to ensure that the supplier has the right incentives to improve service and to innovate. Penalties are generally not useful here; as one financial services company told us: “If it ever came to the fine print, we knew the relationship was over.” A wellcrafted service level agreement is the heart of the contractual relationship.

3.

Transition planning. Whether activities are being shifted from an internal unit or from an existing provider, these moves require backup plans in case of customer dissatisfaction linked to service issues. To limit the risks, it pays to transfer activities in phases, starting with simpler tasks or limited geographies.

Another critical step is to hold training with the new provider at the existing location or onsite at the new location. While this step may require more time and effort than anticipated, it can be streamlined with the right approach.

One online retailer we interviewed brings new providers up to speed through a small team whose sole role is to integrate new service suppliers, whether call centers or logistics hubs, into the firm’s business processes. Only when the vendor is fully ready does the team hand off to the functional executive involved.

4.

Relationship management. Many companies don’t anticipate the complexities of managing large outsourced relationships. When services are outsourced on an ad hoc basis, responsibility for performance diffuses throughout the organization. As a result, the company lacks coherent policies and conditions and cannot leverage the benefits of significant outsourcing volume.

Instead, managers should think of strategic suppliers as true partners and develop formal partner management principles, processes, and governance. A cross-functional relationship team can be set up to manage the multiple aspects of performance and ensure close linkage with relevant parts of the organization. Formal customer/supplier meetings that involve senior management from both sides ensure prompt resolution of problems and ongoing alignment of business objectives.

It’s critical to retain strategic direction and control of the activities. This may require creating a small, high-caliber team under a senior executive to manage large outsourced relationships. Alternatively, functional vice presidents can exercise responsibility for both in-house and outsourced work. The best relationships exist where both the customer and the provider continually explore opportunities for improvement. Otherwise, the outsourced activity risks focusing solely on “getting out the wash,” effectively freezing processes in place.

Imprinting the outsourcing company’s culture on suppliers also helps as a means of instilling the company’s values and promoting efficiency, communication, and trust. This can be accomplished by training key partner staff at the company, encouraging staff exchanges between company and partner, and co-locating supplier and company staff where possible.

5.

Performance monitoring. Key performance indicators (KPIs) should be selected based on performance relevance (e.g., quality of service delivery to the customer, total lifecycle costs) and should match areas where the provider has a high degree of influence. These measures should speak to value delivered to the company, whether the metric is number of successful transactions, average customer order size, equipment availability hours, or on-time delivery percentage.

Baseline and stretch targets for provider payment should directly link to these service levels. Supplier staff bonuses at every level should align with the contract incentives to strengthen the link between a supplier’s stated goals and the behavior of its staff. Finally, the performance management process should be formally codified through the use of scorecards, monthly or quarterly reviews, and followthrough on commitments.

6.

Operating linkages.“You can never interact too much,” said a manager we interviewed at a call center provider. This is especially true when there are numerous touch points across the customer and provider organizations. Interfaces for joint operating processes must be clearly defined and fully integrated. When feasible, automated, web-based linkages can help improve responsiveness and efficiency. From the supplier side, accurate and timely demand information (including actual vs. planned demand) is essential. From the outsourcer’s side, visibility into the supplier’s activities can best be achieved through frequent, detailed review of KPIs and in-person discussion, rather than duplicative or intrusive management activities.

7.

IT systems. IT systems play a central role in many outsourced operations. So it pays to draw a clear technology roadmap that communicates the company’s system architecture plan to the provider. Systems functionality and interfaces must be defined and tested, and the customer company must ensure that it has permanent access to critical data.

One key decision will be whether applications will reside with the customer or the provider. Many activities are outsourced in part to gain access to a provider’s superior systems capability. The challenge here is to avoid the “hook” and ensure portability of key systems and data to another provider at some future point. One financial services provider we interviewed noted the importance of clients having “an exit strategy”; thus, the provider uses an industry-standard data warehouse to facilitate its clients’ business operations in case a client should ever decide to shift the business.

8.

Risk management. Outsourcing of strategic services carries risks, particularly if the provider is located offshore. As one bank executive put it, “Moving IT across the street was a disaster. How could we ever contemplate offshoring?” Effectively dealing with risks, some less obvious than others, is a critical part of deal design, transition, and ongoing management. Anxiety that the risks will outweigh the benefits slows many outsourcing initiatives. The most effective response is to conduct a thorough assessment of risks, address them through detailed business planning and risk transfer vehicles, and implement processes and metrics that allow for ongoing monitoring of each major risk.