the hidden costs of outsourcing

Whether it isachievedthrough out-

sourcing production orsome other businessprocess, expected costsavings is a commonjustification for mak-ing the outsourcingdecision. Yet many out-sourcing arrangementsfail to deliver the expected costsavings. Perhaps the explanationis that management is notconsidering the total cost ofoutsourcing.

UNDERSTANDING THE TOTAL COST

Just what is the total cost ofoutsourcing? At one level thereare the infrastructure costs tosupport the outsourcing arrange-ment. At another level are thebusiness risk factors that createadditional outsourcing costs.While process analysis andactivity-based costing tools canhelp identify the direct supportcosts, the risk-based costs aremore difficult to identify andquantify, and are the focus ofthis article.

At its core, outsourcinginvolves transferring ownershipof an organization’s businessactivities to another provider. In

its traditional form, the outsourc-ing arrangement involves pur-chasing component parts from anoutside manufacturer, but out-sourcing arrangements movedbeyond the traditional format tobecome a strategic tool. Taking astrategic approach to outsourcingrequires overall businessimprovement to achieve long-term strategic goals rather thansimply seeking cost savings.Such an approach allows management to focus on thoseactivities central to organiza-tional success. As outsourcingarrangements spread beyondmanufacturing outsourcing toalso include information technol-ogy (IT) outsourcing and business process outsourcing,managers may not see all thecosts associated with thearrangements. Managers mayneed a framework for decidingwhether or not to enter into anoutsourcing agreement. This arti-cle provides a strategic outsourc-

ing framework forhelping identify therisks, which representthe hidden costs of anoutsourcing arrange-ment.

Outsourcing is nota new phenomenon. Itemerged in the early1980s in response toeconomic pressures

including a recession, high infla-tion, and sharp interest-ratehikes.1 As outsourcing wasembraced by companies acrossmany industries, outsourcingmarket penetration grew, withdemand for outsourcing reachingan overall global value of $72billion in 2002.2 Clearly, manycompanies are benefiting fromthe use of outsourcing agree-ments, but outsourcing is notwithout risks, and these risksrepresent the hidden costs ofoutsourcing.

IDENTIFYING OUTSOURCINGRISKS

In an increasingly globaleconomy, outsourcing operations,particularly to low-cost countries,provides potential cost savingsfrom a variety of sources, includ-ing cheap raw materials, cheaperlabor, reductions in overalloverhead, and benefitting from

Many outsourcing arrangements fail to deliver theexpected cost savings. Why is this so? The authorargues that management hasn’t calculated thetotal cost of outsourcing, which includes yourrisks—and he shows you how to do it.

© 2008 Wiley Periodicals, Inc.

Paul E. Juras

The Hidden Costs of Outsourcing

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© 2008 Wiley Periodicals, Inc.Published online in Wiley InterScience (www.interscience.wiley.com).DOI 10.1002/jcaf.20428

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the external providers’ economiesof scale. Outsourcing can alsoprovide the additional benefit ofimproving financial flexibility byallowing companies to pay foronly what they need, therebytransforming fixed costs intovariable costs and reducing con-cerns over excess capacity. Thebenefit of this financial flexibilitylies in the fact that organizationscan make resource allocation andinvestment decisions based ondeveloping their competenciesrather than the general need toget the product or service out thedoor. Finally, by introducing anexternal supplier into its valuechain, a company may gainaccess to new technologies thatmight otherwise not be available,which could, in turn, createopportunities to develop syner-gies as each learns how theirpartner’s processes interact. Sucha benefit could allow a companyto jump on the fast track to innovation by focusing on thoseactivities that drive the organiza-tion’s success and further refinetheir competencies andstrengthen their competitiveadvantage.

However, the rewards of out-sourcing do not come withoutsignificant risks, and underlyingall outsourcing decisions is thereality that many recent out-sourcing arrangements havefailed. Exhibit 1 presents com-mon reasons outsourcing ven-tures fail. Although this listincludes the reasons why out-sourcing may fail, it also cap-tures the most significant risksinvolved in outsourcing: strategy,the selection process, contractnegotiation, implementation,postimplementation, and overallrelationship management.

A key issue is supplier selec-tion. One need only look at therecent product recalls rangingfrom children’s toys to pet foods,

or the concerns over foreign suppliers of prescription medica-tions, to realize that failure toconduct the necessary due dili-gence when selecting a suppliercan create a significant numberof risks in the foundation of thefuture outsourcing relationship.

Once a partner is identified,the next step is contract negotia-tion, and the legal implicationspresent a number of risks. Failureto be clear during the negotia-tions can yield an outsourcingcontract that does not appropri-ately capture what each partnerintends to gain from the outsourc-ing relationship and what theywill contribute in terms of time,materials, and other resources.The negotiation phase is also thetime to establish and agree uponan exit strategy to help ensure therelationship will end with mini-mal damage to the company.

While outsourcing arrange-ments present significant risksbefore the arrangement is evenexecuted, risks escalate afterimplementation because, by itsvery nature, a good is producedor a service is delivered outsidethe walls of a firm. A primaryrisk is an arrangement that limits

flexibility to adjust to fluctuationsin business needs. Additionally,outsourcing risks can arise whenarrangements do not fully addressoperational issues, agreed-uponservice levels, and technologyexpectations, as well as whenthey establish unreasonable time-lines for implementation of theoutsourcing arrangement.

The final category of out-sourcing risks is relationshipmanagement. An effective out-sourcing relationship requiresstrong communication bothwithin the outsourcing companyand between it and its supplier.An understanding of internalcosts on both ends and emphasison a long-term collaborationbetween the outsourcing part-ner’s parties are essential to thesurvival of the outsourcing rela-tionship over time.

STRATEGIC OUTSOURCINGDECISION FRAMEWORK

It is clear that outsourcing isa strategic decision that requiresforethought and planning, asopposed to using ad-hocapproaches to outsourcing thatare both shortsighted and

8 The Journal of Corporate Accounting & Finance / September/October 2008

DOI 10.1002/jcaf © 2008 Wiley Periodicals, Inc.

Common Reasons Outsourcing Arrangements Fail

• Outsource activities that should not be outsourced• Select the wrong vendor• Write a poor contract• Overlook personnel issues• Lose control over the outsourced activity• Overlook the hidden costs of outsourcing• Fail to plan an exit strategy

Source: Barthelemy, J., & Adsit, D. (2003). The seven deadly sins of outsourcing: Executive commentary.Academy of Management Executive, 17(2), 87–100.

Exhibit 1

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ineffective. This assessment isthe motivation for this articleoffering a framework for evalu-ating an outsourcing arrange-ment. The framework willaddress the risks articulatedwithin the Enterprise Risk Man-agement (ERM) IntegratedFramework proposed by theCommittee of Sponsoring Orga-nizations of the Treadway Com-mission (COSO) in its InternalControl-Integrated Framework.

Outsourcing of any processintroduces uncertainty, whichintroduces risk into the process.Drawing from COSO, “All enti-ties face uncertainty, and thechallenge for management is todetermine how much uncertaintyto accept as it strives to growstakeholder value. Uncertaintypresents both risk and opportu-nity, with the potential to erodeor enhance value. Enterprise riskmanagement enables manage-ment to effectively deal withuncertainty and associated riskand opportunity, enhancing thecapacity to build value.”3 TheERM Integrated Frameworkencourages a holistic view ofrisk management by identifyingall possible risk events, assessingthe likelihood and impact ofthose risks, and responding tothem through a combination ofavoidance, acceptance, reduction,or sharing.

The framework describesfour distinct but overlapping cat-egories of risk: strategic, whichconcerns the entity’s achievementof its overall mission and goals;operational, which addresses theentity’s use of people, processes,assets, and technology to achieveits objectives; financial/reporting,which emphasizes the reliabilityof the entity’s financial state-ments and reports; and compli-ance, which focuses on the lawsand regulations that affect theentity. This article articulates

considerations within the fourrisk categories through a seriesof specific questions that can beapplied to any outsourcingarrangement under consideration.The questions are organizedwithin six groups: who, what,when, where, why, and how(much), and then mapped to eachtype of enterprise risk. A briefdescription of the significance ofeach of the question groupings,in addition to an explanation oftheir relative order, follows.

Companies hyped up aboutthe benefits of outsourcing oftenfall into a copycat trap of out-sourcing simply because a com-petitor does. “Why” questionsseek to clearly identify theobjective of outsourcing a partic-ular process. Analysis of the whyis critical because the resultingdiscussion attempts to identifythe main reasons the company isconsidering outsourcing. Failureto identify whether its outsourc-ing strategy is core strategic oroperational will only result inunclear objectives and ineffec-tive measurement systems asoutsourcing becomes a morecritical part of the company’soperations. With these thoughtsin mind, there are three mainquestions every company shouldask to explicitly identify its pref-

erence and then move forwardaccordingly. The questionsappear in Exhibit 2.

“What” questions come nextbecause, after management deter-mines the objective of outsourc-ing, it needs to determine how tobest realize the potential benefitsby identifying what process orproduct to outsource. The whatissue comes with its own risks,and Exhibit 3 provides somequestions to help managementdecide what to outsource.

When determining what tooutsource, it is important thatmanagement think aboutwhether the outsourced productor process is tactical or strategic.A tactical process is likely to beuniform among competitors,while a strategic process createscompetitive advantage anddistinguishes the company fromothers in the marketplace. Out-sourcing a strategic process cancreate a competitor out of avendor, undermining the valueof an outsourcing arrangement.For this reason, outsourcingcompanies need to carefullyconsider the source of theircompetitive advantage beforedetermining what exactly theyare willing to transfer outsidetheir own walls, but such anarrangement can be successful.

The Journal of Corporate Accounting & Finance / September/October 2008 9

© 2008 Wiley Periodicals, Inc. DOI 10.1002/jcaf

Questions Related to Why You Should Outsource

Framework Question ERM Risk Assessment

What does the company seek to achieve Strategicthrough the outsourcing arrangement?

Has a convincing business reason for Strategicoutsourcing been developed?

Are the goals of the outsourcing arrangement Strategic strategic or operational in nature? Operational

Exhibit 2

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JCPenney, for example, out-sourced its inventory manage-ment function, from design tosales forecasting to store deliv-ery, to TAL Apparel, but onlyafter a high degree of trust wasdeveloped. This arrangementallowed JCPenney stores to cutshirt inventory levels in halfwhile improving responsivenessto the market.4

“Who” questions come nextand include the significant consid-erations and risks surrounding thepeople aspects of the outsourcingprocess, such as who is makingthe decision, who is the outsourc-ing vendor, and who will remainafter the transition is complete.Consideration of the who out-sourcing decision is criticalbecause it deals with the peopleinvolved in the outsourcingdecision and cannot be controlledas carefully as some of the otheraspects of the process. Appropriatequestions, and their related risks,can be discussed within foursubcategories: the in-house out-sourcing team, the surviving andterminated employees, and theemployees of the potential vendor.

The in-house outsourcingteam has a crucial role to playwithin a company, to effectivelydefine and carry out the com-pany’s outsourcing strategy. Forthis reason, it is essential that theoutsourcing team be composedof individuals representing allstakeholder groups.

On another note, outsourcingusually results in one of two out-comes for employees: they aretransferred to another role withinthe company or they are let go.Whether employees are movedinto new jobs or are terminated,plans for their transition shouldbe carefully laid out to makesure the process is as smooth aspossible. Additionally, employ-ees that survive the outsourcingmay be demoralized, which canlead to the risk of employeeturnover and operational ineffi-ciencies. As a result, this riskshould be thoughtfully consid-ered and an appropriate responseshould be formulated.

Finally, the outsourcingarrangement will involveemployees at the outsourcingvendor, which has its own set of

issues and risks. Exhibit 4 con-tains who-related questions thatcan help management thinkthrough these issues.

An outsourcing strategy can-not be effectively implementeduntil it has been articulated, sothe “how (much)” questionscome next. The outsourcingagreement should provide for allthe logistics contained in thearrangement, including who willdo what, how payment will beexchanged, and when the transi-tion will take place. How(much)-type questions concernhow the outsourcing strategywill be determined and the out-sourcing arrangement imple-mented, as well as how costs willbe appropriately captured andmeasured. Because it is often theimpetus for making the decisionto outsource, the cost dimensionof outsourcing does not deserveto be buried deep within this dis-cussion. For the sake of organi-zation, however, it is appropriateto classify it with the other how(much) considerations.

Any statements the outsourc-ing company has made about its



Questions Related to What to Outsource


Can the process or activity to be outsourced be discretely identified? Strategic OperationalAre the product specifications/process descriptions available and easy to follow? OperationalHas the provider been trained on the unique issues associated with the outsourced Operational

product or process?Has the potentially outsourced process been benchmarked against “best in class”? Operational

If so, have any potential improvements been made before handing the process off to an outsourcing provider?

Is the outsourced process one that provides a competitive advantage, or one that Strategiccan be easily duplicated by competitors?

Exhibit 3

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anticipated contributions shouldbe incorporated into the out-sourcing agreement. Likewise,the outsourcing company shouldcarefully review the agreementto ensure that it is not agreeingto provide services it has notplanned to provide. Finally, anycompany considering outsourc-

ing should first formulate anoutsourcing strategy and thentest the comprehensiveness ofthat strategy because the timespent up-front to define thearrangement will be significantlyless than the time it takes tountangle a misunderstandingdown the road. The how (much)-

related questions appear inExhibit 5 and address suchdiverse issues as how the out-sourcing arrangement will beimplemented, how costs will bemeasured, and any concerns overtechnology migration.

Some of the most significantrisks associated with outsourcing



Questions Related to Who Is Involved in the Outsourcing Agreement


Have all relevant parties been consulted in arriving at the decision to outsource? StrategicDoes the potential outsourcing initiative have the full support of senior management? StrategicHas someone been elected to play “devil’s advocate” in order to ensure that all sides Strategic

of the issue are considered?Has the outsourcing team been allocated adequate resources, in terms of both dollars Operational

and skills, in the process of selecting a vendor?Has a dedicated outsourcing governance organization/relationship management Strategic

team been formed to monitor and facilitate all outsourcing arrangements?Have all potential outsourcing vendors been considered, or has the company limited Strategic

itself to “sole-source” outsourcing?Have explicit criteria been defined for selecting the outsourcing vendor? StrategicHas a thorough and complete financial due diligence been completed on Financial/Reporting

the potential outsourcing provider? ComplianceHas an assessment of the potential vendor’s reputation taken place? StrategicIs the culture at the outsourcing provider supportive of quality-minded and Strategic

ethical operations?Have all capacity issues (and limitations) been addressed with the outsourcing vendor Operational

prior to execution of the agreement?Does the outsource provider have the skills necessary to carry out the arrangement? Operational

If not, can those skills be easily trained?Is the potential outsourcing provider working with any other companies? If so, what Operational

other demands on their time exist? Has the full outsourcing arrangement been planned and articulated before an Operational

announcement is made to employees?Does the outsourcing arrangement provide for employee transition plans? OperationalHow are the risks associated with in-house survivors of outsourcing being addressed? OperationalHave employee communication issues, such as how to schedule meetings, Operational

evaluate performance, and escalate critical issues, been addressed?What particular steps have been taken to improve communication within a Operational

cross-cultural environment?Have applicable employment laws been considered and addressed? Compliance

Exhibit 4

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involve the “where” dimension.Much of the outsourcing cover-age in recent years has focusedon moving operations to low-labor cost countries like Chinaand India, but there are other

options that vary based on acompany’s outsourcing needs.One consideration is diversifyinginto several countries to mini-mize political risks and ensuresecurity of labor supply. For

these reasons, a company’s deci-sion whether to outsource to oneor more countries should be animportant consideration in devel-oping its outsourcing strategy.Another important consideration



Questions Related to How (Much)


Has a concise outsourcing strategy, including specific process requirements and Strategicservice expectations, been developed?

Are the goals and benefits expected to be realized from the outsourcing arrangement Strategicthoughtfully articulated? And is the potential vendor made aware of those goals and objectives?

Has the company made express statements about what it expects to contribute in Operationalterms of time, equipment, inventory, etc.?

How will the outsourcing arrangement be structured in order to get the greatest Strategicbenefit without jeopardizing a company’s strategy?

Does the outsourcing agreement provide for flexibility in terms of business Operationalrequirements and needs? In particular, does it address change orders?

Have any “shortcuts” been taken in drafting the outsourcing agreement? StrategicHow have information technology needs been addressed within the Operational

outsourcing agreement?Will the outsourcing company and its providers’ systems be able to effectively Operational

interface?Will appropriate controls be put in place to safeguard the security and confidentiality Operational

of transmitted information? ComplianceHow will customer service and customer expectations be addressed within Strategic

the outsourcing arrangement? OperationalWhat is the sourcing company’s intended exit strategy, and how will it minimize Strategic

damage if the outsourcing arrangement sours? OperationalWhat is the estimated total cost of outsourcing? Does the outsourcing agreement Strategic or Operational

truly capture all costs?How will the continuing costs of the arrangement be managed, and are they Operational

appropriately accounted for in arriving at the initial decision to outsource?If outsourcing to a faraway country, how will shortages and stock-outs, Operational

as well as the inevitable obsolete inventory, be handled?Is there a clear basis for measurement? How will the company know if the Strategic

outsourcing arrangement has achieved what it set out to achieve?How will the benefits of continuous improvement and productivity gains be Strategic

shared between the outsourcing provider and the sourcing company? OperationalHow will “lessons learned” from mistakes in the past be translated into improvements Strategic

for future outsourcing relationships? Operational

Exhibit 5

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is whether the process is heavilyautomated or labor-intensive.Companies have outsourced allkinds of processes and products,from plastic toy assembly to tele-marketing to payroll processing,each of which requires differentskills and manual processing.Integral in the “where” decision,therefore, is identification of therelative requirements for manualversus automatic processing,which relates to operational risk.

The risks associated with anylocation option are as diverse asthe countries themselves, butthere are common threads that canbe addressed through the ques-tions that appear in Exhibit 6.

The final dimension of theoutsourcing decision is capturedin the “when” category of consid-eration. These questions addressthe general timeframe and a vari-ety of other issues relevant to thetiming of the outsourcing process.Outsourcing involves significantrisk for all parties involved, andthus warrants adequate considera-tion. The crucial element in thisaspect of risk assessment is that ittakes place before any exchangeof money, processes, or otherresources. Failure to fully under-stand the operations of its out-sourcing partner can lead tomuch larger problems upon dis-covery of unfavorable policies orprocedures. Another time-relatedquestion relates to whether theentire process is outsourced atonce or in stages. This considera-tion relates to assurances that theoutsourcing company’s operationswill not be negatively affected bya business interruption. Thewhen-related questions appear inExhibit 7.

RISK MANAGEMENT, NOT RISKAVOIDANCE

The business questions pro-posed in the preceding exhibits



Questions Related to Where to Outsource


Will all outsourcing activities be Strategic concentrated in one country, or will Operational the risk be diversified across countries? Compliance

Have the environmental factors specific Operationalto the outsourcing provider’s locale Compliancebeen considered?

Is the process heavily automated Operationalor labor-intensive?

Exhibit 6

Questions Related to When to Outsource


Is the current business environment Strategicsupportive of expanding operations? What is the future outlook for the outsourcing company’s industry?

Has a thorough risk assessment taken Strategicplace before making the decision to outsource?

Will the entire process be outsourced Operationalat once? Or will it be implemented in stages, such as handing off sourcing, then assembly?

How long will it take, from the initial Operationalstages of the outsourcing arrangement,until implementation and full production through the outsourcing provider?

Is the timeline for implementation of the Operational outsourcing arrangement reasonable in Strategiclight of the needs and requirements of both parties?

In the event of an emergency, what kind Operationalof contingency/disaster recovery plan is in place?

Exhibit 7

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focus on identifying where risksmay exist. The purpose of identi-fying potential risks is not toavoid them, but to understand thepotential threats and be able toproactively manage the risks. Asnoted earlier, the COSO state-ment clearly indicated the need toidentify risks and manage them toenhance the entity’s capacity tobuild value. Identifying the likeli-hood of a risk event occurringand the potential impact of suchan event should also be part ofthe process of finding a way tocontrol risks. The combination oflikelihood and consequencesgives weight to each potential

risk factor, which means not allthe risks identified through theproposed framework should begiven equal consideration bymanagement. Guidance for thisweighting process is the final toolfor the proposed framework andappears in Exhibit 8.

REVEAL THE HIDDEN COSTS

Summing up, outsourcingoffers potential benefits that canaccrue as management uses theentity’s resources to further itsobjectives. The decision frame-work presented in this articleprovides a way for managers to

help identify and weight therisks associated with attainingthese rewards, which represent ahidden cost of outsourcing. Theframework presents a series ofbusiness questions by the typeof the information they seek togather—why, what, who, how(much), where, and when—andtheir accompanying ERM riskcategory. Although this frame-work is not comprehensive, itdoes provide a reasonablestarting point for the majorissues companies need to con-sider when deciding whether, orhow, to outsource and shiftmanagement’s approach to



Weighting the Risk Factors

Exhibit 8

Risk event

Risk identified from answering the various questions

Likelihood of occurrence 1–10, with 1 being least likely

Estimate the likelihood of an adverse event occurring

×Significance of consequences

1–10, with 1 being least significant

For each risk, identify the potential impact on the attainment of organizational objectives

=Relative weight

Result between 1 and 100

Risk:

Significant increase in salary levels

10 Alison Damast (Happy

days for India’s new MBAs.

BusinessWeek, May 5,2008, p. 18) reports starting salaries for new MBAs in India rising between 20% and 30%.

× 3 Perhaps the higher

salaries reduce the desirability of selecting India, but salaries would still be lower than other locations with a similar talent pool.

= 30

Example: A company is considering outsourcing financial services operations to India because of the lower cost ofMBA salaries. The risk of increasing salaries may be extremely high in terms of the likelihood of the event happening,but the significance of the consequences could mitigate the overall impact of the risk.

Just focusing on the risk (increasing salaries) and ignoring the interaction of likelihood and significance of the conse-quence might lead to an inappropriate decision regarding this potential outsourcing agreement.

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outsourcing from that of a“quick fix” to more of a long-term strategic solution. Answer-ing these questions will enablemanagement of the outsourcingcompany to better identify therisks in its outsourcing relation-ships and better identify poten-tial costs both now and in thefuture.

NOTES

1. For more information, see Schneider, J.(2003, April 27). A brief history of out-sourcing. Retrieved October 22, 2005,from http://www.sudhian.com/showdocs.cfm?aid=373.

2. For more information, see Chamberland,D. (2003, July/August). Is it core strate-gic? Outsourcing as a strategic manage-ment tool. Ivey Business Journal Online.Retrieved October 23, 2005, from http://

www.iveybusinessjournal.com/article.asp?intArticle_ID=431.

3. For more information, see the executivesummary at http://www.coso.org/publications.htm.

4. For more information, see Kahn, G.(2003, September 11). Made to measure:Invisible supplier has Penney’s shirts allbuttoned up; From Hong Kong, it trackssales, restocks shelves, ships right to thestore; Inside a “radical” power shift. WallStreet Journal (Eastern edition), p. A1.



Paul E. Juras, PhD, CMA, CPA, is a professor in the Calloway School of Business and Accountancy at WakeForest University. Dr. Juras has published numerous cases and articles dealing with cost management andperformance measurement in both service and manufacturing settings. His primary teaching areas aremanagement accounting and strategic cost management. He can be reached at [email protected].

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the hidden costs of outsourcing

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