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A risk-based approach to a risk-based approach to identifying the total cost of outsourcing: as the use of outsourcing continues to grow, managers may not be aware of all the associated costs. A framework is presented to help managers identify and classify all the potential risks and hidden costs a company might face in an outsourcing agreement.

Article Excerpt
At its core, outsourcing involves transferring ownership of an organization's business activities to an outside provider. The traditional outsourcing arrangement involved purchasing component parts from an outside manufacturer, but outsourcing has moved beyond that tactical arrangement to become more of a strategic tool. Strategic outsourcing is intended to do more than simply create cost savings--it seeks overall business improvement so that a company can achieve its long-term strategic goals by focusing on the activities central to its success. To this end, outsourcing has taken on three distinct characterizations: manufacturing outsourcing, information technology (IT) outsourcing, and business process outsourcing. As its application has spread, managers may not see all the costs associated with the arrangements, and they may need a framework to help decide if entering into an outsourcing agreement is the right move. This article provides a strategic outsourcing framework to help managers identify the risks that represent the hidden costs of an outsourcing arrangement.

Although outsourcing currently receives a great deal of media attention, it is not a new phenomenon. It emerged in the early 1980s as a response to prevailing economic pressures, taking many forms across many industries. In a 1997-1998 survey, two-thirds of executives indicated that they had outsourced a business process and that outsourcing market penetration was expected to grow from 6% in 1995 to 10% in 2000.1 That predicted growth was surpassed, with demand for outsourcing exceeding a global value of $100 billion in 2006. Clearly, many companies are benefiting from the use of outsourcing agreements. Outsourcing is not without risks, however, and these risks represent the hidden costs of outsourcing.

REWARDS AND RISKS

Historically, outsourcing decisions have been driven by potential cost savings, and it remains the motivating factor in the make-or-buy decision. Outsourcing operations, particularly to countries with lower costs, provides cost savings from a variety of sources, including cheap raw materials, cheaper labor, and reduction in overall overhead. Additional cost savings also can result from the external provider's economies of scale. Outsourcing also can help improve a firm's financial flexibility by allowing it to pay for only what it needs, thereby transforming fixed costs into variable costs. This financial flexibility enables organizations to make resource allocation and investment decisions based on developing their competencies rather than the general need to get their products or services out the door, and it reduces concerns over excess or idle capacity.

One type of outsourcing benefit that is becoming increasingly important can be broadly defined as "strategic enhancement." Through outsourcing arrangements, companies can gain access to new technologies that otherwise might not be available. Introducing an external supplier into a firm's value chain may also create opportunities to develop synergies as each party learns how its partner's processes interact. A company can jump on the fast track to innovation by focusing on those activities that drive its success, further refine its competencies, and strengthen competitive advantage.

The rewards of outsourcing do not come without significant risks. Beneath every outsourcing decision is the reality that many recent arrangements have failed. Table 1 presents common reasons outsourcing...

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