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Outsourcing Loses Its Lustre for the Forest Products Sector

Some ideas take such a strong hold on society that they become standard in the lexicon of business executives. Outsourcing, for example, has become such a fundamental part of a company’s business plan for the past decade, that one might be hard-pressed to remember a time when business executives considered outsourcing a novel, if not progressive idea. Yet, as with all business practices, prudence dictates that decision-makers ought to periodically revisit them, if only to see if they are worth continuing.

The merits of outsourcing (also called contracting out) have long been enumerated, chiefly that it saves companies money and resources that can be directed elsewhere, notably at its core profit-producing businesses. Moreover, such faith in the idea greatly explains why American, European and Canadian companies have increasingly been looking to outsourcing as a way to conduct business. Globally, outsourcing activity has been estimated at $500 billion a year, the greatest amount dedicated to serving the voracious needs of information-technology (IT), which Gartner Group, an IT research firm, predicts will jump from $293 billion in 2003 to $429 billion by 2008.

To be sure, outsourcing has increased in the last 20 years, initially as an answer to recessionary pressures, and later as a quick-fix solution to poor management practices. This is borne out in a study completed by two academics, Patrice Jalette of Universit de Montral and Peter Warrian of the University of Toronto. They found that the number of collective agreements containing some provision for contracting out in Canada jumped from 37.7% to 55.3% between 1986 and 1998. Equally important, the number of workers affected by such agreements rose from 42.9% to 62.6% in the same period.

Yet, outsourcing has its vocal critics, notably organized labour. For example, outsourcing was cited as one of the chief reasons behind a seven-week work stoppage in Finland. The issue will raise its divisive head once again, to be sure (see sidebar, Outsourcing will become more contentious).

“Everyone is under such competitive pressure that the temptation to leap into outsourcing blindly is so great,” Warrian says. “Contracting out is a viable management tool, and when it is intelligently done, it can work. Yet, for too many companies it has become an easy and outwardly simple strategy to reduce costs.”

If that is indeed the case, many companies are asking whether outsourcing has reaped the benefits that so many of its proponents have put forward, chief of these, profitability and productivity. Like many large cultural shifts in management practices, it takes years to sift and analyze data on whether a management practice is working as expected.

Results vote against outsourcing

Well, some conclusive numbers on outsourcing are finally in. Deloitte Consulting, one of the world’s largest consulting firms, recently conducted a multi-client global study on the efficacy of outsourcing. In its recent report, “Calling a Change in the Outsourcing Market,” published in April 2005, the consulting firm compiled data from 25 large global organizations, including those in the manufacturing, transportation and consumer business sectors.

Its conclusion might be a decisive blow to outsourcing. “The world’s largest companies have engaged in outsourcing for a variety of reasons: to reduce costs, expand capabilities and increase flexibility,” the report writes. “However, contrary to the optimistic portrayal of outsourcing by vendors and the marketplace, outsourcing is an extraordinarily complex process and the anticipated benefits often fail to materialize.”

The numbers tend to prove that contention, which is bad news for proponents of outsourcing. Among the report’s primary findings are the following sobering statistics:

* A Dun & Bradstreet survey shows 20% of outsourcing relationships fail in the first two years, and 50% within five years.

* A PA Consulting Group Survey of executives at 116 organizations in Europe, North America and Asia shows that 66% reported that business benefits were either partially realized or not at all.

* A DiamondCluster International Survey showed that 78% of executives had to terminate agreements early due to poor service, a change in strategic direction, or costs.

* Between 1997 and 2005, 38 of 50 problem deals totalling more than $27 billion, resulted in litigation or termination.

One thing that stands out is that outsourcing has its limitations, to put it mildly. One mistake that companies routinely make is to outsource its problem business units or operations to an outside vendor, in a sense handing it off like a troubled youth to an aunt to try to rehabilitate. “That’s a mistake,” says Scott McLean, a management consultant, for PricewaterhouseCoopers in Vancouver. “Don’t go looking to outsource a mess. First, fix up the mess and determine whether you want to operate that business or sell it.” The object lesson is that if you outsource a failure, it will become a bigger, more costly, failure.

Such failures are most glaring in large multinational companies that have decided to outsource a significant part of their information-technology services (IT), often to nations like India, with the expectation of cutting costs and increasing productivity. Foreign firms have to contend with cultural and language differences, no easy matter. (see PPC, May 2005). “Now, many companies have decided to bring IT back in-house,” Warrian notes. They have not been satisfied with the quality of service.”

Hire a good contract lawyer

There are things that firms can do to mitigate problems. For one, firms can make sure they have a well-written outsourcing agreement between organization and vendor. In a good contract, the vendor should understand and acknowledge what is important. The contract ought to include terms and conditions like performance standards, termination clauses and detailed expectations. The more detailed the contract the less possibility of misunderstanding and poor performance. (see sidebar, Rules of outsourcing.)

The language of the contract is highly important because human nature and good intentions often collide in a nasty, often unexpected, and emotional manner. As in marriage, not all relationships in business work out, despite the best of intentions at the beginning of the relationship. “Companies typically go in trying to find ways to work together, McLean says, “but they often don’t do enough homework on the termination clause should things go awry.”

Such termination clauses become more essential when the contract is long-term, as was the case in the 1990s, when organizations signed contracts with their vendors that in some cases were for 11 years. This is arguably a long time in today’s competitive and ever-shifting business climate.

Other issues particular to Canadian companies must be emphasized. In Canada, a highly unionized nation, the pulp and paper industry has to base its decisions not only on economic parametres, but also on how unionized workers will accept outsourcing or contracting out. Although contracting out has been around in some form for 50 years, its recent upward trend in the last 20 years has angered unions.

“We are generally opposed to outsourcing and contracting out,” says Brian Payne, president of Communications, Energy and Paperworkers Union of Canada, which represents 50,000 pulp and paper workers. “It’s a sore point, and it always has been a sore spot.” The reasons, simply enough, centre on job security for its members, many of whom reside in communities where the mill is the largest employer. (In the U.S, outsourcing has become a huge political issue, as the nation loses manufacturing jobs, mainly to China.)

Or as U of T’s Warrian puts it: “Contracting out is seen as a direct threat on the jobs held by union members of the bargaining unit, and in some cases considered a threat to the uni
on’s viability.”

Forthrightness, however, can ease the tension, says McLean of PwC. “Management of the company deserves the union atmosphere it fosters. In other words, if you would like a collaborative workplace, build an open relationship with the unions.” On a good day that leads to dialogue with the unions, and in time, acceptance.

“Then the unions will see the process as more than anti-union animus,” Warrian says, “but as a need for specialized skills or equipment that does not have to be threatening to its union and members.”

In a good management-union environment, management notifies unions in advance of its intentions to contract-out a service, and explain in detail why and how it will be implemented. “This approach gives unions time to organize a bid on the service, should it wish to do so,” Warrian says.

Tread carefully

No doubt, outsourcing has always been a contentious issue with unions, notably in the last decade as employers look for ways to save money. The forestry industry has increasingly contracted out such services as maintenance, payroll, data entry and other administrative functions as a way to centralize operations. However, as management studies show, outsourcing, if poorly done, results in more problems than originally anticipated. “If you have a hodge-podge of suppliers, which are not managed properly, quality suffers,” Payne points out. As well, companies might end up paying more for services that it contracted out. (see sidebar, Where are the savings?).

Payne cited numerous cases where outsourcing failed to deliver the goods. In one case, a mill outsourced a metal sub-assembly, and when the supplier delivered it to the mill for assembly, it didn’t fit. Such fiascos ended up costing the mill more money to correct the problem than if it had kept the work in-house. While one can argue that such cases are rare, they do occur, and at great cost to a company’s bottom line and workplace morale.

To be sure, the benefits of outsourcing are not what companies initially thought they were, to say the least. It was only a few years ago that companies were talking about the possibility of having a mill run with only a few employees – a so-called virtual mill — and the rest run by outside vendors up to thousand of miles away. “No one today talks about virtual mills,” Warrian says. “If you have a virtual mill, you have virtual profits.”

Outsourcing might be one of those ideas that sound wonderful, until you try it. Yet, despite its blemishes and complexities, outsourcing or contracting-out is here to stay, but not as the grand management tool it was considered a few years ago. “Contracting-out will be a tool in the management tool-box, but it will not be the whole garage,” Warrian points out. “It will never be a substitute for intelligent management, which includes an intelligent relationship with your workforce.”

Perry J. Greenbaum, a freelance business and technology writer, can be reached at pjgreenbaum@gmail.com.

Outsourcing will become more contentious

Outsourcing will likely become a more divisive management-labour issue in the next decade, even in union-friendly Finland. When the Finnish pulp and paper workers went on strike in 2005, outsourcing was one of the chief points of contention.

The dispute pitted large companies like Stora Enso, UPM-Kymmene and M-Real against the powerful Finnish Paper Workers’ Union and 24,000 of its members. In many ways, the dispute was an age-old battle on how companies ought to become more competitive.

The seven-week shutdown, which ended in July 2005, cost Finland an estimated $2.1-billion in export earnings. During the strike, UPM-Kymmene Corp. and Stora Enso Oyj said they were losing millions of dollars a day. The forestry sector accounts for 8% of Finland’s GDP and 25% of all exports.

The two sides signed a three-year agreement, putting outsourcing on the margins, at least until 2008.

Rules of outsourcing

Outsourcing can be effective. Here are some things to know:

* Fix Problems In-House: Do not contract-out business units that are non-performing or have problems. First, fix the problem in-house, and, if necessary, hire more people. It is also important to decide which specialized and specific functions are important for the organization.

* Understand the Process: Do not outsource processes that you do not fully understand. If you do, you will not know what to demand from vendors and how much to pay for the services.

* Analyze Contracts: Be careful about signing multi-year contracts (six to 11 years). The longer the term of the contract, the greater the risk, since the company loses its flexibility in a shifting marketplace. During negotiation with the vendor, find out the hidden costs. One of the greatest issues that companies face is a lack of transparency in a vendor’s costs. Often vendors add hidden costs or additional costs after the deal is negotiated.

* Maintain Core Functions: Do not give up your core functions or what academics call institutional knowledge or thought leadership functions. For example, do not give up decision-based processes, which require management training and skills.

* Train Your Staff: Maintain the skills needed for these core functions through education and training of your workforce. It is always easier, and likely less expensive, to train someone who is already working in your organization.

Where are the savings?

Rafts of studies show that contracting-out results in a decline in quality, and an increase in costs. To counter the quality problems, companies then place more employees to oversee the project and the vendors, a process which undeniably adds dollars to the final cost of the service. “Studies show that the cost of oversight ranges from 10% to 60% of the contract cost,” says Peter Warrian, an adjunct professor at University of Toronto’s Centre for Industrial Relations. “The long-term savings rarely conform to the initial estimates.”

The problem lies in human nature. “Contractors tend to lack the motivation to perform better than necessary,” Warrian says. As the thinking goes: “Do the bare minimum at the lower price, and then raise it to a price at least equal to what the company was paying before it was tendered for bid. Then, once the contract is up for rebid, companies are in some ways stuck with that vendor.

This became evident in the 1990s, when some Canadian municipalities started outsourcing such services as public transportation and garbage collection. The data shows that initially such services are cheaper, but over time, outside contractors bid the price up. “At the end of the day,” Warrian says, “You might not be making any savings at all.”