Functional Outsourcing: Your back-end is other companies’ front-end
Welcome to the latest instalment of our "Close The Gap" blog series. In this chapter, we delve again into the compelling world of "Outsourcing" and spotlight Functional Outsourcing. Today, we invite you to explore a strategic approach that could reshape how you operate your business.
Consider this: What if your highly skilled workforce could devote their energy solely to their unique capabilities, driving customer satisfaction and enhancing your bottom line? Imagine a scenario where innovative processes, products, and service solutions take centre stage while specialized entities seamlessly handle routine, tactical tasks. Is now finally the opportune moment for companies to shed back-end activities?
At its core, Functional Outsourcing challenges the traditional notion of monolithic corporate structures. Instead, it encourages a shift towards network concepts. Think of it as a string of pearls, where each entity contributes its specialized expertise, rather than a complex web of semi-professional processes outside your core domain.
Enjoy!
Examining the Current State of Affairs
Corporate leaders are increasingly frustrated with the lacklustre returns derived from their commercial functions. Simultaneously, employees within these functions grow equally annoyed by the mounting tactical work that hampers their ability to contribute value as intended. Despite these challenges, many leaders hesitate to outsource specific tasks or entire functions because they believe their staff and intricate functional structures are too distinctive to be entrusted to external providers.
However, upon closer examination, the question arises: How genuinely unique are the activities performed by legal, tax, procurement, HR, customer service centres, market intelligence, IT, or accounting?
These activities do not appear to possess overwhelming uniqueness on a broader industry scale. Consider the following examples of services being offered by a whole industry:
Market, competitor, or product analysis conducted by highly educated PhDs and MBAs in boutique firms across Europe, India, and the USA, employing up to 3,000 professionals.
Comprehensive scanning of products, spare parts, and supplier components to generate 3D drawings, opening doors to contract manufacturing opportunities, particularly for products with outdated visual documentation.
Complete or back-office management of HR processes.
Execution of tactical and strategic sourcing.
Hosting and administration of IT infrastructure.
End-to-end control of the record-to-report process within finance operations.
Operation of customer service centres, employing algorithms enhanced by machine learning to analyze phone conversations and yield new sales leads or detect early signs of quality issues.
Let's embark on an "out of company experience": By adopting an outside-in perspective, it becomes pertinent to question whether a company renowned for producing exceptional widgets can be equally adept at executing invoices, managing IT servers, drafting standard contracts, or efficiently operating their vehicle fleet. Is it not preferable for companies to dedicate as little of their valuable attention as possible to becoming experts in these back-end operations? Are these operations truly as unique as functional leaders assert? Might there exist external entities, as highlighted earlier, that excel at performing these tasks precisely because it is their core business?
Here is a quick excursion on what other people across the board think about outsourcing:
"Do what you do best and outsource the rest." - Tom Peters
"Outsourcing is not just a trend; it is an integral part of how smart businesses operate in today's global economy." - Timothy Ferriss
"Outsourcing allows you to focus on your core competencies while leveraging the expertise of others in specialised areas." - Richard Branson
"Outsourcing is no longer just about cost savings; it's about gaining a competitive advantage by accessing the top talent and resources around the world." - Peter Drucker
"Successful outsourcing is not just about finding the right vendor; it's about building strong partnerships based on trust, collaboration, and shared goals." - Andrew Carnegie
Since in this blog, we look at both sides of the coin, here are some other not-so-positive thoughts on outsourcing:
"Outsourcing is just a fancy term for shipping jobs overseas and betraying the American workforce." - Bernie Sanders
"Outsourcing can create dependency on external vendors and erode internal capabilities, leading to a loss of strategic advantage." - Vivek Wadhwa.
"Outsourcing can have a negative impact on local communities, as jobs are shifted elsewhere, causing economic distress and social unrest." - Naomi Klein.
"Outsourcing can lead to a loss of control over critical business processes and sensitive data, increasing security risks and vulnerabilities." - Bruce Schneier.
"Outsourcing can be a slippery slope, where companies start by outsourcing non-core functions but end up losing core competencies and competitive advantage." - Henry Mintzberg.
Both stances hold validity, and when contemplating outsourcing functions, companies must ensure that their board of directors maintains clarity regarding their objectives and the impact such a process will have on their triple bottom line—namely, the performance in terms of profit, people, and the planet.
Having witnessed the unintended repercussions of the untamed ‘global trade’ doctrine in Europe and the USA over the past three decades, we have acquired valuable insights into fostering resilient operations and upholding decent working conditions. This includes providing a living wage for all individuals within our extended value chain. Moreover, we have recognised the significance of designing net-zero supply chains that do not necessitate traversing half the globe.
The future state of functional outsourcing in the 21st century looks promising.
Companies seek lower costs, increased speed, and better services, benefiting from the cross-industry expertise of the service provider. However, thinking about outsourcing just for labour cost arbitrage in low-cost locations is an outdated approach.
Today, modern outsourcing providers often sit on the same continent, understand the cultural context, and have a functional grasp on what their clients need. They optimise various back-end functional processes, using RPA and software bots to remove manual intervention. The best providers enhance these bots with machine learning and AI to adapt to the inconsistencies of corporate processes.
This is the next exponential level of arbitrage, increasing (‘no more’)-labour arbitrage to over 90% (!) and eliminating the need for human intervention. Whether current mega-outsourcing suppliers or innovative start-ups will lead this field remains to be seen.
The prospect of loss of labour exceeding 90% may seem daunting: it evokes a similar sentiment to what farmers, cobblers, smiths, and bakers experienced two centuries ago during the industrial revolution. These professions nearly vanished with the advent of increasingly advanced technology and automation processes.
However, when we examine this in the broader scope of humanity, these transformative shifts have yielded positive outcomes: According to the United Nations macro-economic data, the percentage of people living in extreme poverty has decreased from 85% in 1800 to 50% in the 1960s and is now below 9%. Similar progress is visible in child mortality rates, nutrition levels, and education statistics.
Thus, we should maintain trust in our human capacity to construct the next level of society and welfare based on these newest technologies and bring new gainful employment and purpose to those people. There are no insurmountable obstacles except for our limitations.
Let's evaluate your company's readiness for embracing functional outsourcing by considering the following statement.
Take note of how many of the following questions you can confidently answer with a resounding "yes" based on factual evidence:
In the last 3-5 years, have your board of directors members visited a functional outsourcing provider for benchmarking processes or learning about the latest digitalization trends?
Does your corporate culture promote transparent engagement with employee representation, such as workers' councils, regarding outsourcing discussions?
Do you possess excellent internal knowledge of the outsourcing process, or are you open to seeking external expertise if necessary?
Do you agree that function outsourcing is a science that requires transparency, well-defined statements of work, market testing, and clear contract development?
Do you believe that your remaining functional leadership should have a vested interest in the success of outsourcing and be incentivized accordingly to establish a stronger and more productive outsourced functional setup?
Are you willing to ensure the entire company embraces the need for change and adapts to new processes?
Are you and your employees satisfied with the performance of typical targets for functional outsourcing, such as HR, IT, legal, tax, procurement, internal service centres, accounting, and financial reporting?
Have you established benchmark levels for personnel in your commercial or engineering functions using reputable sources like The Hackett Group?
Do your functional leaders perceive outsourcing not as a threat to themselves but as an opportunity to engage in more strategic work for the company?
Suppose you have answered "yes" to most of these questions. Congratulations! You clearly understand the factors necessary to evaluate the relevance of functional outsourcing for your company. Well done! There is no need to continue reading; it is best to focus on other topics.
Size of the prize
If, however, you find that you either don't know the answers or have responded negatively to several questions, you have an excellent opportunity to enhance your gross margin, improve cash flow, and streamline your commercial processes. To determine the "size of the prize," follow these steps to establish the gap and set a target.
In the past, the calculation would have been based on low-cost labour arbitrage, typically allocating 40% cost reduction to countries like India, China, Vietnam, or Bulgaria and 25% to other Eastern European countries (e.g., Poland) or Mexico. A sliding scale would be implemented to achieve these benefits, with a gradual increase over three years (e.g., 10% in the first year, 80% in the second year, and 100% in the third year).
However, in today's context, we approach the "size of the prize" differently:
Identify the annual personnel costs of functions with high repetitive or manual workloads, such as Finance, HR, back-end sales (e.g., order processing), service centres, tactical procurement, and IT.
Conduct an internal assessment, potentially with the help of process mining software, to evaluate the level of automation within these functions. Ensuring that the function does not solely conduct the assessment is crucial, as objectivity is essential.
Grant potential outsourcing partners access to your current state and allow them to evaluate their ability to reduce costs through bots, AI, and standardization. Request an implementation timeline outlining the anticipated benefits (be cautious of estimates exceeding 1,000 days).
Depending on the supplier partner and deal structure, anticipate restructuring costs ranging from 50% to 90% of the outsourced personnel in the first year. These costs should be considered non-EBIT relevant but will impact your cash performance during the transitional period.
Calculate the cumulative gross margin improvement over the three years, considering the benefits achieved each year. Beyond year four, this improvement will continue perpetually.
Factor in an annual productivity increase of 5% to 10%, reflecting the level of standardization you aim to achieve.
Additionally, expect a minimum 5% improvement in cash flow due to the accelerated turnover of your cash conversion cycle (separate from the impact of lower personnel costs).
Alternatively, if you consider back-office functional competence core to your company or cannot find the right outsourcing partner, consider investing in process mining, lean methodologies, machine learning, and data scientists to entirely digitize your processes using software bots and machine learning. The transformative impact of such changes on your company is best left to your imagination. While you will not achieve the same benefits as if you had outsourced, it might be the right solution for your specific company or industry culture.
As always, in this blog, we aim to provide a practical and actionable pathway for improvement.
Setting up a functional outsourcing project
Here are the key points to consider for a functional outsourcing project:
Time plan: Allocate 30 months (2.5 years) to ensure adequate planning and execution.
Board Sponsor: The CEO should act as the board sponsor, providing the necessary support and oversight.
Project Lead: Appoint the heads of the affected functions as project leads, accompanied by a small team of experts from their respective organizations. Alternatively, consider assigning a respected leader from outside the function(s) as the Outsourcing Project Head, reporting directly to the CEO or CFO. It is crucial to incentivize the project leaders throughout and after the change process.
Project set-up:
Conduct a full market test involving a maximum of four potential outsourcing providers. Evaluating more providers can make assessing the tender document volumes challenging.
Perform due diligence with potential outsourcing partners.
Develop a request for quotation (RFQ) based on clear key performance indicators (KPIs).
Establish a joint project team that conducts daily action-based catch-ups during the first year. Afterwards, shift to a weekly task force with clearly defined objectives. The project lead should provide monthly reporting at the board level, highlighting progress against the project plan and output KPIs (e.g., project plan progress, identified and realized opportunities, digitalization of work through bots).
Sustain success: Conduct quarterly business reviews with the outsourcing partner and the head of the function to monitor and ensure ongoing success and alignment.
Digitalization/Automation opportunity: As previously discussed, leveraging digitalization and automation presents significant opportunities for improvement and cost savings.
Risk: Acknowledge that the risk associated with functional outsourcing is high. Therefore, it is crucial to plan and execute every aspect of the outsourcing process diligently.
Cost: Consider setting up an internal task force full-time or hiring a small external team to support project management. Most of the costs incurred can be integrated into the restructuring costs during the transformation period and should not directly impact EBIT.
Watch out for:
Be cautious of lowballing the opportunity by comparing different cost levels. Ensure a fair assessment of the potential benefits.
Maintain high levels of confidentiality until a recommendation can be made.
Team dynamics: Run the team offsite for the first six months to foster a dedicated and focused environment. Ensure all team members sign non-disclosure agreements, and if feasible, provide a success bonus and/or offer a job within the new functional set-up as additional incentives.
By adhering to these considerations and guidelines, you can set up a robust framework for functional outsourcing, mitigating risks and maximizing the potential benefits for your organization.
Conclusion
Outsourcing of functional operations presents businesses with many advantages, including speed, excellence, cost savings, access to specialized skills, scalability, focus, risk mitigation, and global market expansion. By outsourcing non-core functions, companies can concentrate on their core competencies, reduce operational and financial risks, and extend their reach into global markets.
When engaging with outsourcing partners, you can expect the same level of excellence and commitment that you uphold for your core business.
Stay safe and be bold in your quest to design the corporate network set-up of the 21st century.
Daniel
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