News

Posted On: 08/04/2005

The Pitfalls of Offshoring

PharmaManufacturing.com

By Gregg Carlstrom, Contributor

Offshoring is becoming a popular cost-cutting tactic for thousands of businesses — but a major U.S research firm warns those companies may be overlooking hidden costs.

The New York-based Conference Board is conducting a study on the risks and potential pitfalls involved in outsourcing business functions. Last month, researchers issued the first in a four-part series of reports, “Beyond Costs: Financial and Operational Risks.” The study found many companies overlook the complexity of moving their operations overseas.

“All too often, companies forge ahead, overlooking such critical factors as service, labor, and other costs (both on- and offshore), management expenses, and taxation in the destination country,” the report notes.

The report adds that many companies over-estimate how much money can be saved by moving business operations abroad. The expectation is that offshoring can save as much as fifty percent. But companies have upfront expenses — training and capital improvements — and that initially can shrink savings by as much as half. The authors say it takes time to realize the full benefits of offshoring.

“After a relatively short training and operational period, offshore employees generally make fewer errors, handle transactions faster, take more initiative, and are eager to learn and get ahead,” says Ton Heijmen, a senior advisor to the Conference Board.

And many companies see no benefit at all. Twenty percent of offshoring operations don’t produce any savings; for another ten percent, offshoring actually yields a loss.

The study also weighs the benefits of outsourcing through a third-party firm rather than a subsidiary operation. There are advantages to each, according to the authors. A third-party firm doesn’t require as much management and long-term investment; but those firms take a share of profits, leading to a smaller bottom line for the parent company.

More details on the report are available at the Conference Board’s website, www.conference-board.org. Below is an official summary of the report from the board:

---

Mounting competitive pressures are spurring more companies to take key business operations offshore, but high failure rates continue to plague these efforts, according to a report released today by The Conference Board.

The report, Beyond Costs: Financial and Operational Risks, is the first installment in a four-part research series on offshoring trends. The series is designed to help companies weigh the financial, economic, and social costs and benefits of offshoring. It focuses on the pitfalls and unanticipated risks of an offshoring move.

Offshoring operations are being heavily driven by a desire to cut costs and improve competitiveness, usually in response to a competitor’s offshore move. But all too often companies forge ahead, overlooking such critical factors as service, labor, and other costs (both on- and offshore), management expenses, and taxation in the destination country.

Many other companies, however, are quickly rejecting offshoring, worried about costs and other complications. These companies, The Conference Board study reports, are often missing out on burgeoning opportunities in new emerging markets.

While some studies show that offshoring can save companies 45-55 percent in raw cost savings, net savings are more likely to be in the 25-45 percent range. But, as service improves, savings often become more significant, says Ton Heijmen, Senior Advisor to The Conference Board on Offshoring and Outsourcing. “After a relatively short training and operational period, offshore employees generally make fewer errors, handle transactions faster, take more initiative, and are eager to learn and get ahead.”

Watch Your Wallet When Offshoring

Scope and service levels are the key determinants of price, but the actual quoted costs can vary widely from market to market — and the growth in some popular offshore destinations makes costs a moving target. Companies often fail to develop a comprehensive baseline cost from which they can measure and plan for cost reductions. In addition, many hidden and sometimes unanticipated costs can wreak havoc with calculations and are a major reason why so many projects fail to deliver the hoped-for savings. Some of the key mistakes companies are making include:

• Underestimating the complexity and cost of managing offshoring contracts;
• Being unrealistic about timing in getting the offshore operation up and running;
• Failing to account for critical upfront investments;
• Ignoring the raft of (sometimes hidden) transition costs.

When companies offshore through a third-party firm, the company must often make significant initial investments to provide the service capabilities the company requires. Who makes these investments (the company or the provider) and how these investments are amortized will, in part, dictate the duration and terms of the contract – and the timing of cost reductions. Small and middle-market companies should consider opting for standardized offerings with a third-party provider, which makes offshoring more cost-effective, while also lowering the risks of underperformance.

The cost savings that a subsidiary (captive) operation yields can be greater than those achieved through a third-party provider (for which a company must pay the built-in profit margin). But the potential for higher savings must be offset against the increased management attention and ongoing investment in the operations (especially technology) that a subsidiary operation requires.

The report cautions companies that third-party providers are often less motivated to push process improvements that a company would make over time. This can raise costs and lower long-term savings that offshoring is meant to deliver.

Critical Do’s And Don’ts

The report deals extensively with practical implementation issues, offering executives ways to weigh the many options. It examines the pros and cons of different service delivery models and outlines the new business processes companies need to put in place to manage offshoring activity, regardless of service model.

It also assesses the many operational risks, ranging from geopolitical, security and intellectual-property, and infrastructure risks to the level of government support, local business environment, and quality of third-party providers. Any one of these factors can have a major impact on the success — or failure — of an offshoring plan.

Elements of a proper transition plan should include a governance framework, knowledge transfer plan, disaster recovery plan, and change management program. The report also analyzes the components of a secure contract — to prevent legal disputes — and examines conflict resolution and legal recourse (such as arbitration) in the event such a dispute occurs.

“Operationally, the report suggests that detailed due diligence of the service delivery options, potential locations, security considerations — both physical and informational — governance provisions, and Sarbanes-Oxley implications is essential in deciding whether or not offshoring is the right move,” says Janice Koch, author of the report.

Future reports in The Conference Board’s offshoring series, "Thinking Offshoring Through: A Framework for Decision Makers," include: "The New Corporate Reality: External and Market Considerations" (part 2); "Aligning the Organization: Management and Human Resource Concerns" (part 3); and "Offshoring in Perspective: Trends, Impacts, and Implications" (part 4).