Top 10 Hidden Costs of Outsourcing

Once again, to avoid unnecessary pitfalls and unpleasant surprises that wreck havoc with a project's budget, one of the most important items that will need to be well thought out, and well-drafted--the contract!  Does anybody see any important issues that might not have been covered in this article?  Please comment and fill us in on any missing pieces.    Marlene

By David Brown <http://www.cioinsight.com/cp/bio/David-Brown/>

2008-09-09

Businesses often make avoidable mistakes in crafting and executing their outsourcing plans. Here’s a list of typical pitfalls and how your company can avoid them.

 

When it comes to outsourcing, there’s more to your business case than the service provider’s price. Some outsourcing costs are less visible or downright  hidden. EquaTerra …, an outsourcing consultancy, reviews the top 10 hidden costs and how to avoid them.

 

Hidden Cost No. 1: Currency

Problem: Because of currency fluctuations, last year’s invoice of $1

million a month could be $1.4 million today.

 

Solution: Hedge the currency risk by including caps and collars in the

contract. For example, you and your service provider might agree to

share responsibility for currency adjustments up to a certain dollar

amount, beyond which you’ll go back to the table and renegotiate. By

hedging the risk in this way, many domestic companies protected

themselves against the devaluation of the U.S. dollar.

Hidden Cost No. 2: Hardware/software refresh

Problem: Your contract may include a two-year refresh of hardware like

desktops/laptops and software like Microsoft Office. But if your

outsourcing deal is five to seven years, you’re going to need another

refresh and it’s usually not in the contract. Fail to account for it,

and the cost can be $500 to $2,000 per employee. One pharmaceutical

company, for example, mistakenly assumed its service provider would pay

for an unscheduled refresh, and the company had to come up with $20 million.

 

Solution: Anticipate updates beyond the typical one-year refresh, and

put them in the contract. That means carefully evaluating the

outsourcing solution, asking service providers the important questions

about hardware, and developing contract terms that are clear and

precise. To ensure the price includes refreshes throughout the equipment

lifecycle, ask your service provider to include a refresh schedule for

every piece of hardware.

 

Hidden Cost No. 3: Retained organization

Problem: You transferred 50 percent of some employees jobs to the

service provider, but you’re still paying them for the full function.

This eats into your savings. One retailer, for example, had the work of

1,100 employees in scope, but the company held onto 50 percent of the

work for 200 of those employees. As a result, the company overstated its

business case by $24 million.

 

Solution: After the transition, redesign the organization, redefine

job functions, and redeploy or sever. Indeed, if the same retailer had

realigned its retained organization, it could have regained $12 million

of its lost savings.

 

Hidden Cost No. 4: Lack of governance

Problem: Companies typically underestimate the people, process and

technology required to manage the outputs of an outsourcing contract. In

fact, provider invoice errors alone can erode your monthly savings by

two to 10 percent. For example, when one global consumer goods company

assessed the performance of its governance organization, it discovered

overcharges on 5 percent of the provider’s invoices, to the tune of

$40,000 month.

 

Solution: Remember, just because you’ve outsourced a process doesn’t

mean you’ve outsourced the need to manage the contract. Invest in

governance teams and tools to mitigate risk and achieve the deals

intended value.

 

Hidden Cost No. 5: Internal transition

Problem: Companies typically overlook the effort required to do things

in a new way. In one outsourcing deal for finance and accounting, which

included a new e-system for accounts payable, the buyer failed to budget

for the interface development required on the client side, an oversight

that cost $2.5 million in the original business case.

 

Solution: Anticipate these costs, including time, external resources,

and applications for interfacing with the service provider and include

them in your estimates.

 

Hidden Cost No. 6: Retirement costs

Problem: Many companies continue to pay into retirement plans and

pensions even after employees have been terminated and they never

realize the error. This overpayment can cost hundreds of thousands of

dollars a year in foregone savings. One company, for example, eventually

discovered that it was paying thousands annually into a pension fund for

each of about 1,000 displaced employees.

 

Solution: After the outsourcing transaction, review the list of

employees that will be displaced, and work with the HR department to

update the database. May seem pretty simple, but this is a common

oversight that can add big cost.

 

Hidden Cost No. 7: Planned headcount reduction

Problem: Most companies plan to reduce headcount through outsourcing,

but they usually end up keeping some employees to help in the transition

and that’s a cost they didn’t account for. To minimize its risk, for

example, one pharmaceutical company kept about 20 percent of its staff

for six months after the go-live date, which added $1.5 million in cost.

Overambitious headcount estimates can cut projected savings by 10 to 20

percent.

 

Solution: Don’t overstate the savings. Many companies, for example,

will anticipate a ‘ramping down’ of employees after the provider takes

over the services. This helps ensure a smoother transition and a more

realistic business case.

 

Hidden Cost No. 8: Poor change communications

Problem: Change communication in outsourcing is extremely complex and

burdensome. If you do it poorly, some employees may leave before the

transition. Or, if you fail to give enough notice, some employees or

union workers may stay too long. In this case, you won’t be able to

reduce your headcount in time, which means you’ll end up paying your

employees and your service provider for the same work.

 

Solution: Develop a thorough communication strategy with external

counsel if necessary and start communicating well in advance of the

transition. One company, for example, was outsourcing development and

maintenance for a very strategic application, but it wanted to retain

about 45 critical staff for their knowledge. Thanks to a ‘high-touch’

communication plan including frequent communications, an engaging mix of

tactics, and strategic messaging the company kept all of them, including

at least 10 at-risk resources. Loss of those resources would have cost

the company about $1 million for backfill and knowledge transfer.

 

Hidden Cost No. 9: Shadow organizations

Problem: Shadow organizations, those employees in the retained

organization who continue doing things the old way, almost always exist

in an outsourcing relationship. For example, even though a global

retailer’s service provider was doing operations testing and reporting,

a shadow organization continued doing it as well, which eroded savings by

$3 million in the first two years of the relationship. Left unchecked,

redundancies created by shadow organizations can reduce outsourcing

value by 10 to 15 percent.

 

Solution: As part of change management, educate the organization on

why it’s important to use the new services. If some departments or

executives don’t trust the service provider, then the governance team

should find out why and fix it.

 

Hidden Cost No. 10: Staff augmentation

Problem: If your transition is six- to 12-months long, but employees

leave before the transition is complete, then you have to backfill those

positions, which adds unanticipated hiring and training costs. One

transportation company, for example, failed to keep about 20 employees

long enough to do the testing and process-mapping required for the

transition. So it paid its service provider an extra $500,000 to do the

work. That’s a premium of about 20 percent over the salary of each lost

employee.

 

Solution: Most employees are more willing to stay if there’s a

monetary payout at the end of the road. Hold on to employees by tying

their severance to the end date, or give them a retention bonus.

 David Brown, a client executive with EquaTerra, leads the firm’s financial architecture competency.

 

Comments

[Philippine outsourcing]

The outsourcing trend of a lot of industry today really helps business entrepreneurs

[Alex Yakima]

Very useful article, David. Actually it is helpful for both clients and outsourcing companies. For those service providers that care about not surprising their clients with a big bang of something (e.g. contractor is not proactive and active enough to react on changes or they need a lot of governance involved and do not demonstrate solid approach to solve client's problems but just do what are they said instead etc.).

Very cool article!

[Glenn Rogers]

A cost note mentioned and often overlooked is the cost of people leaving the project. When important personnel at an outsourced vendor leave a project the cost of training and bringing that person up to full speed is a cost consideration. It isn't huge but certainly is significant. Especially on smaller teams of less than twenty. Such costs should be considered when estimating the overall budget.

- Glenn Rogers

[Ishani Mitra]

Excellent compilation there of the risk areas companies should avoid while outsourcing as that can only make the latter a worthwhile process. This article at http://outsorcerer.com/blog/?p=53 may also be an interesting read on the 3 major conceptual errors made while outsourcing.