Seven Myths About Outsourcing

By PHANISH PURANAM AND KANNAN SRIKANTH
June 16, 2007

4. Contracts Don't Matter
On the other hand, sometimes companies try to rush into an outsourcing deal without a contract. They draft a memorandum of understanding or letter of intent -- informal documents that set out grand visions of the client-vendor relationship rather than focus on nitty-gritty details, as a contract does.

These documents are useful in setting the joint vision of the relationship, but they are not substitutes for contracts. Since they are usually vague on critical operational details, they may be hard to enforce in court, lead to different interpretations by different managers and ultimately undermine trust in the client-vendor relationship.

Moreover, negotiating these agreements sometimes isn't as easy as it looks. In some lawyers' experience, managers negotiate and agonize over a memorandum of understanding for such a long time that they could have negotiated a contract instead. For instance, a large U.K.-based insurance company negotiated an outsourcing memorandum for over 40 days. It was in place for less than a month before the contract negotiations kicked in and changed the terms of the deal.

Another version of this myth holds that companies don't need a contract because the deal with the service provider is much more than a simple procurement relationship. The client would rather regard the vendor as a partner, or another division of the company.

This is a good goal for the relationship -- but not something that can be assumed on day one, since the client and the service provider will not always have identical interests and aspirations. For example, the vendor might want to bid for a contract with the client's competitor, but the client might object to the deal, fearing its trade secrets might be disclosed.

A contract can help head off those tensions. The process of negotiating a contract will enable the client and vendor to understand the risks, rewards and interests for both sides. That, in turn, will make it clear what should be on and off the table in the relationship.

5. Vendors Are Insurance Companies
The sharing of risk between clients and vendors is one of the most contentious issues in outsourcing, leading to acrimonious negotiations and poor relationships. There is a very common -- and reasonable -- perception that vendors should bear greater liability for failure than regular, in-house employees who do a job. However, client executives shouldn't take an exaggerated view of risk or believe that they can outsource risk entirely.

The client can specify standards that the vendor must meet, and penalties for falling short. However, it is unrealistic for the client to ask the vendor to take on unlimited liabilities or unlimited indemnities for failure.

Let's say an auto maker outsources the manufacture of its seat-belt system. It remains the auto maker's responsibility to ensure that the seat belts meet quality standards before selling the final product -- an automobile -- to customers. Outsourcing doesn't make the auto maker less responsible for the ultimate quality of its product.

For instance, Ford Motor Co. faced numerous lawsuits arising from the defects found in Firestone tires used in Ford vehicles. Similarly, when pharmaceutical companies outsource clinical research, the responsibility for the integrity of the research still rests with the pharmaceutical companies.
Rather than spending inordinate time negotiating unrealistic contractual clauses in case of failure, clients and vendors should concentrate on understanding the process as it operates. They should identify acceptable rates of error based on real data, and -- jointly -- invest in understanding and eliminating the problems.

6. It's Not Our Headache Anymore
Similarly, sometimes companies think once they outsource a process they can wash their hands of it. "The biggest obstacle to a satisfactory partnership is that one party sees itself as relieved of all responsibility and abdicates control to the other," in the words of one senior executive from a client firm. Outsourcing does not mean that the process is not your headache anymore -- though it is (one would hope) less of a headache!

Sean Egan, former head of offshoring for Aviva PLC, the U.K.'s largest insurance firm, holds that the key to Aviva's success in its offshoring efforts in India has been the high level of engagement of his senior management team. The team visits offshore locations two or three times a year, and when there they make a habit of giving informal talks to employees, in order to build a greater sense of identification with Aviva. The senior managers also work with offshore managers on process-improvement plans. And the senior managers ensure that the offshore managers are treated as part of their extended team, and conduct joint management-development and training activities.

Such efforts are "what makes this a partnership, and a very successful one at that," says P.V. Kannan, the CEO of 24/7 Customer Inc., one of Aviva's offshore partners.

Besides building a partnership, there are other strategic reasons why clients can't afford to "fire and forget." When outsourcing an operation, the client firm should retain the knowledge underlying the process and how it fits with the overall organization. If the client firm simply abandons the process to the vendor, it can compromise its ability to produce future innovations.

For example, auto makers still carry out R&D in parts they stopped making 10 years ago, and often collaborate with parts suppliers in these efforts. This allows the auto makers to keep up with changing market trends and technology; it also allows them to figure out how to integrate those new technologies into their existing processes.

Another problem with losing all knowledge related to a process is that the vendor holds all the cards and could easily take advantage of the client. It also puts the client in a difficult position if it wants to end the relationship. The client may no longer have the competence to evaluate other vendors, negotiate suitable contracts or even lay out how the job should be done.

7. Our First Failure Should Be Our Last Attempt
Very few companies report great success with their very first outsourcing project. But that doesn't mean they should give up. There is evidence of significant learning on the part of both the client and the vendor in such relationships.

With time, partners learn to communicate better, leading to more efficient coordination and fewer mistakes. Clients and vendors learn about each other's needs and are able to negotiate better contracts focusing on value creation. Our survey indicates that companies with greater experience have greater success implementing more-complicated models and face fewer problems in their outsourced and offshored activities.

--Dr. Puranam is an assistant professor of strategic and international management at the London Business School and a scholar at the Advanced Institute of Management in London. Mr. Srikanth is a Ph.D. candidate at the London Business School. They can be reached at reports@wsj.com.

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