Outsourcing is an overused and misunderstood word. For some people it is movement of labor off shore. For others it is the hiring of a specialty firm to do some task. Many people think of this as something that has recently appeared and didn’t happen “in the good old days”. I’d like to set the record straight. Outsourcing is something that was at the very basis of free market capitalism. Adam Smith envisioned specialty firms springing up and doing some task for the market better fast cheaper than they can do it themselves. Throughout the industrial revolution this happened. Companies bought parts from other companies that made those parts as a primary business. Large companies have lawyers on staff but employ law firms to handle peak loads or provide advice in specialized areas. There are lots of examples.

Outsourcing is the contracting with another entity to perform a process. Many firms have sprung up in the last decade. All these firms achieve value for their clients using one or all of three different value propositions. They are:

1. Process Excellence
2. Economies of Scale
3. Lower Labor Costs either through lower labor rates or elimination of labor.

In developing its offering, the outsourcer has invested the capital, developed the controls, established the operating methods to make some process have a lower cost and higher quality of output than the process you are currently using.. This allows his customers to take advantage of the offering without spending much time or capital on it and do the process cheaper and better than the customer did it before.

Process Excellence is arguably the most important of these 3 value propositions. If an outsource provider can do some process at world class quality levels, then it will always have customers. Most outsource providers recognize this and go out of there way to cite the quality of their offering. Sometimes they get a little carried away. Many recent contracts have been to “lift and shift” or move an existing process to a low cost labor area. By definition and contract, the process has not changed, so the process is of exactly the same quality as it was before. In contrast, many outsourcers offer claims processing services. These services often are much better than the clients processing in terms of time to adjudicate and accuracy of payments. The existence of a better process cannot be kept a secret and the users of a process will be aware and frustrate if a companies’ process is not of a quality they know exists. An outsource provider makes this process a market offering and with a truly excellent process has continual demand.

Economies of scale is a fairly straight forward idea. The outsourcer is consolidating several like operations. So even if they are “lift and shift” there are always certain experts that are under utilized and can be used across contract. In addition IT and other assets can often be shared effectively and the cost spread across more users. The outsourcer always looks to gain these saving and can pass it on in his pricing or in the case of scarce resources can make sure they are available to their customers.

Labor cost is the value proposition that has been discussed the most often in the last decade. Many people equate outsourcing and off shoring thinking that the labor cost is the only value proposition. The ubiquitiousness of the internet has made it possible to move many functions anywhere in the world. In the nineties companies were all implementing “shared service centers”. The underlying value was in standardizing a process , and more fully utilizing a fragmented workforce. Around 2000 AD it became apparent that you didn’t need to do this consolidation at your corporate headquarters, but you could do it somewhere in the world where labor was much less expensive. The issue that always seems to come up is should I move my process as it is and then optimize it, optimize it and then move it or optimize it as I move it. This is somewhat analogous to the dive in or ease into the pool decision. The answer depends on your risk tolerance and the need to recognize the benefits in you income statement.

Ideally, you should be looking to use a provider whose solution will provide all three value proposition. A simple answer is to get the provider to price the output of the process and then pay a simple price times quantity delivered. However these contracts are rarely that simple. However it is always good for the customer and the outsource provider to understand what is the value proposition that is being contracted for. Many relationships become troubled when the buyer and the supplier have different views of the benefits expected.