academy o/ management executive. 2003, vol. 17....

Academy o/ Management Executive. 2003, Vol. 17. No. 2

The seven deadly sins ofoutsourcing

Jerome Baitheiemy

Executive OverviewWhile outsourcing is a powerful tool to cut costs, improve performance, and refocus on

the core business, outsourcing initiatives often fall short of management's expectations.Through a survey of nearly a hundred outsourcing efforts in Europe and the UnitedStates, I found that one or more of seven "deadly sins" underlie most failed outsourcingefforts: (1) outsourcing activities that should not be outsourced; (2) selecting the wrongvendor: (3) writing a poor contract; (4) overlooking personnel issues; (S) losing control over(he outsourced activity; (6) overlooking the hidden costs of outsourcing: and (7) failing toplan an exit strategy (i.e., vendor switch or reintegration of an outsourced activity^.Outsourcing failures are rarely reported because firms are reluctant to pubJicize them.However, contrasting them with more successful outsourcing efforts can yield useful "bestpractices."

Outsourcing can be defined as turning over all orpart of an organizational activity to an outside ven-dor. In the services industry, outsourcing was tradi-tionally restricted to basic support activities. It wasalso primarily used when restructuring firms thatwere in bad financial shape. Today, outsourcing per-vades the management of most companies. It hasalso become increasingly clear that outsourcing ismore than a passing fad. According to a report fromthe Economist Intelligence Unit, 34 per cent of firmsoutsourced all or part of their information technology(IT) in 1997. The proportion was expected to reach 58per cent by 2010. Similar increases are expected foractivities such as telecommunications, accounting,and human resources.'

Empirical evidence suggests that carefullycrafted outsourcing strategies increase the overallperformance of the firm.̂ As the CEO of a medium-sized firm that had outsourced activities as diverseas IT, logistics, financial services, and facilitiesmanagement pointed out: "Outsourcing enabledus to double our operating income before tax whileour revenues remained stable." Outsourcing isgenerally considered as a very powerful tool to cutcosts and improve performance. Through outsourc-ing, firms can take advantage of the best outsidevendors and restructure entrenched departmentsthat are reluctant to change. Outsourcing can alsohelp focus on the core business. Since building

core competencies and serving customer needs iscritical to firm success, anything that detracts fromthis focus may be considered for outsourcing.^ His-torically, many activities were performed inter-nally because there were no outside suppliers. Thecontinuing growth of supply markets has providedthe opportunity to reassess which activities shouldremain in-house and which should be outsourced.''

While firms may now have the opportunity tooutsource, outsourcing initiatives do not necessar-ily fulfill all their expectations. For instance, threequarters of the U.S. managers surveyed by theAmerican Management Association reported thatoutsourcing outcomes had failed to meet expecta-tions.^ While literature on outsourcing has oftensought to draw lessons from highly visible compa-nies that have been successful in outsourcing, thisarticle sheds light on failed efforts.^ Failed out-sourcing endeavors are rarely reported becausefirms are reluctant to publicize them. Firms do notlike to report their failures because such informa-tion can damage their reputation.' However, valu-able "best practices" can be inferred from out-sourcing failures, especially when such failuresare compared with successful outsourcing efforts.

My study is based on an in-depth analysis of 91outsourcing efforts carried out by European andNorth American firms. Primary data was collectedthrough face-to-face interviews and a detailed

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questionnaire with managers in charge of out-sourced activities. While most current research onoutsourcing focuses on a single activity (typicallyIT), this article simultaneously deals with severalcrucial services such as IT, telecommunications,logistics, and finance (See the Appendix for moredetails on the empirical research). Through thissurvey, I found that the same mistakes underliemost failed outsourcing efforts. These mistakeshave been termed the seven deadly sins of out-sourcing. It is likely that firms will encounter eachof the deadly sins at some time during the out-sourcing process. Though the deadly sins are con-ceptually distinct, they are not mutually exclusive.Hence, they must be viewed as interrelated com-ponents of a complex system.

First Deadly Sin: Outsourcing Activities ThatShould Not Be Outsourced

In the early 1990s, the newly appointed top man-agers of a car rental company decided to outsourceinformation technology (IT) to reduce costs. At thattime, IT costs stood at 5 per cent of revenue, whichwas higher than the industry average (3 to 4 percent). Three years into the outsourcing contract, ITcosts stood at 10 per cent of revenue and the carrental firm could not get out of the contract. Accord-ing to the chief information officer: "The entire ITdepartment has been outsourced, but we shouldhave kept applications development and mainte-nance in-house. These activities are too close toour core business, and it's hard not to have totalcontrol over them . . . If the vendor goes bankrupt,all I can do is try to hire its former employees."

Insights for Managers

Outsourcing is often associated with automatic costreduction and performance improvement. Thisoverly optimistic view of outsourcing derives fromthe fact that most articles about outsourcing are writ-ten during the so-called "honeymoon" period (i.e.,just before or after the contract is signed). At thattime, the reported benefits are not actual but onlyprojected. This leads to a bandwagon phenomenon,where firms outsource to mimic competitors they ex-pect will be successful with outsourcing.^

Determining which activities can be best per-formed by outside vendors requires a good under-standing of where the firm's competitive advan-tage comes from. Resources and capabilities thatare valuable, rare, difficult to imitate, and difficultto substitute for lead to superior performance.^ Ac-tivities that are based on such resources and ca-pabilities (i.e., core activities) should not be out-

sourced because firms risk losing competitiveadvantage and becoming "hollow corporations.""^On the other hand, non-core activities may be out-sourced for two reasons. First, outsourcing non-core activities allows firms to focus on the activi-ties they do best and improve their overallperformance." Second, transferring non-core activ-ities to specialized vendors can help reduce thecosts and improve the performance of such activi-ties.'^

Determining which activities can be bestperformed by outside vendors requires agood understanding of where the firm'scompetitive advantage comes from.

In the middle of the 1990s, for instance, a high-tech firm decided to set up a new subsidiary toenter the Southern European market. This firm de-fined its core business as designing, manufactur-ing, and selling high-resolution color screens. Allthe activities that didn't belong to any of thesecategories (e.g., logistics, after-sales service, andvarious types of marketing activities) were out-sourced to outside vendors. This strategy enabledthe high-tech firm to enter the new market not onlyquickly but also at very low cost. This successfuloutsourcing effort can be compared with the caseof the car rental company above. Outsourcing ITapplications development and maintenance wasclearly a mistake. The car rental industry is ahighly IT-intensive industry where a good reserva-tions system is the key to competitive advantage.Therefore, the IT applications that underpin reser-vation systems were too close to the core businessto be safely outsourced.

As most activities have parts that belong to thecore business and parts that do not, implementinga core vs. non-core dichotomy at the firm leveloften proves difficult. Hence, the core vs. non-coredichotomy should rather be implemented at theactivity level.'^ For instance, an oil company de-cided to outsource IT. Several competitors had al-ready done so, and their endeavors weren't alwayssuccessful. As their lack of total success couldlargely be attributed to total outsourcing (i.e., out-sourcing the entire activity), the oil company care-fully separated core from non-core IT activities. Asthe IT outsourcing project leader put it: "The rec-ommendation to outsource was drafted by a studyfeam who examined the overall effectiveness of ITservice delivery and determined that only non-strategic commodity services could be outsourcedfo external third parties. This recommendation

2003 Barth4lemy 89

was then endorsed by a corporate council consist-ing of operating company presidents and corpo-rate executives." This company ended up outsourc-ing mainframe, telecommunications {LANAVANvoice and data operations, management, and sup-port), cross-functional (help desk, change coordina-tion, service coordination) and carrier services.Crucial IT activities such as application develop-ment and maintenance were kept in-house.

Second Deadly Sin: Selecting the Wrong Vendor

Acting on instructions from its U.S. headquarters, aEuropean equipment manufacturer outsourced itsentire logistics activity.''* The logic underlying thisdecision was the following. While most customerswanted increasingly small and frequent deliver-ies, the U.S. top management was not sure that theinternal logistics department of their Europeansubsidiary had a sufficient level of expertise toimplement a just-in-time organization. They alsoknew that a badly implemented just-in-time organ-ization results in tremendous costs. As the head-quarters asked for the move to be made veryquickly, the managers of the subsidiary had to finda third-party logistics provider, sign a contract,transfer the activity, and hand over the manage-ment, all within only six months. Shortly after thecontract was signed, things started going sour asthe third-party provider did not live up to expecta-tions. Goods were either delivered too late or notdelivered at all. There were large shortfalls in in-ventory. A benchmark study showed that this par-ticular subsidiary had the highest logistics costs ofall European subsidiaries.


Selecting a good vendor is crucial for successfuloutsourcing. In the case above, for instance, thethird-party logistics provider was selected be-cause it had offered the lowest bid. However, itsmain business was transportation. It did not havethe capabilities to manage a full logistics function,let alone implement a just-in-time organization.The client's requirements had been made clearfrom the outset, and the failure of this outsourcingeffort could essentially be attributed to a lack ofexpertise of the third-party logistics provider.

While one important argument for outsourcing isthat specialist vendors have lower costs than theirclients, it is important to note that firms do notnecessarily outsource to cut costs.'^ According tothe VP of supply chain management of a U.S. con-sumer goods firms, outsourcing logistics to a third-party provider is more expensive than keeping lo-

gistics in-house. Yet, the cost increase is more thanoffset by an increase in revenues and a reductionin opportunity costs. Revenues increase due to theability to implement innovative logistics practices,and economic value-added (EVA) measures im-prove because outsourcing avoids keeping fixedassets,'"''

Firms do not necessarily outsource to cutcosts.

The literature has identified numerous criteriafor successful provider choice.'^ A useful distinc-tion can be made between hard and soft qualifica-tions:

• Hard qualifications are tangible and can be easilyverified by due diligence. They refer to the abilityof vendors to provide low-cost and state-of-the-artsolutions. Important criteria also include businessexperience and financial strength.

• Soft qualifications are attitudinai. They may benon-verifiable and may change depending oncircumstances. Important soft criteria include agood cultural fit, a commitment to continuousimprovement, flexibility, and a commitment todevelop long-term relationships. Trustworthi-ness is an important soft criterion.'^ High levelsof trust are often associated with outsourcingsuccess.'^ In most cases, the client and the ven-dor have different business objectives that canresult in conflicts of interest. For instance, thebeginning of the contract is generally more ben-eficial for the client than for the vendor.^° Astime goes by, the contract becomes subject tonegotiation and misunderstanding. As one ofthe interviewees bluntly put it: "Outsourcing is aprofitable operation in the short run. It mustremain profitable in the long run."

The surest way to spot the best providers—on bothhard and soft criteria—is through first-hand infor-mation. A useful technique is to entrust a largenumber of vendors with commodity activities be-fore outsourcing more sensitive activities to thebest vendors.^' A manager from a large Europeanenergy firm reported: "We spent approximatelytwo years with small deals and a large number ofsuppliers, followed by one year taking a "strategicposition" and outsourcing to an alliance of a fewkey players." Not surprisingly, outsourcing turnedout to be a huge success in this firm.

First-hand experience is both a time-consumingand costly way to discover whether or not a vendoris proficient and trustworthy. An alternative and

90 Academy ol Management Executive May

less costly way is to use second-hand experience(i.e., to examine the vendor's reputation). A reputa-tion for proficiency and trustworthiness is a usefulasset that vendors care about because it helpsattract new clients.^^ However, issuing a RequestFor Proposal is often not enough to determinewhether a vendor has a good reputation. Inter-views with clients of potential vendors and indus-try experts are useful to learn about the technicalskills and the reliability of potential vendors.

Third Deadly Sin: Writing a Poor Contract

A European bank outsourced its entire telecommu-nications network \o cut costs and refocus on itscore business. This endeavor turned out to be acomplete failure with increasing costs and de-creasing service quality. The main reason for thefailure was that the management had rushed toenter the relationship with the vendor. Too littletime was spent on developing a good contract andseveral mistakes were made. The contract, thoughvery long, was not precise. For instance, the bankhad to pay extra fees even for basic services. Therewere no objective performance measurementclauses either. Fixed fees had been set when theclient's business was booming. As turnovershrunk, the ratio of telecommunications fixed feesto total revenue became increasingly large. More-over, the contract made it impossible to switchvendors even after the relationship with the incum-bent vendor had become increasingly sour.


Since the 1980s, vendor partnerships have emergedas a model of purchasing excellence. Partnershipsreplace market competition by close and trust-basedrelationships with a few selected vendors.^^ The no-tion that outsourcing vendors are partners and thatcontracts play a minor role was popularized by alandmark IT outsourcing deal. In 1989, EastmanKodak outsourced a large part of its IT operations toIBM, Digital Equipment, and Businessland. As therelationships between Eastman Kodak and its ven-dors were both cooperative and based on loose con-tracts, it has been wrongly inferred that tight con-tracts were not necessary to be successful withoutsourcing. However, there are pitfalls in partner-ship management.^^ A good contract is essential tooutsourcing success because the contract helps es-tablish a balance of power between the client andthe vendor.^^ Spending too little time negotiating thecontract and pretending that the partnership rela-tionship with the vendor will take care of everythingis a mistake.26 Drafting a good contract is always

important because it allows partners to set expecta-tions and to commit themselves to short-term goals.Moreover, it provides a safety net in case the rela-tionship fails.

Regarding the actual content of the contract, Ifound that the best contracts are simultaneously:

• Piecise. Ill-defined contracts often result in highcosts and poor service levels. Cost and perfor-mance requirements should be established fromthe outset and clearly specified in the contract.^^

• Complete. Writing a contract that is as completeas possible has two important benefits. First, themore complete the contract, the smaller the riskof potential opportunism of the vendor. Second,the more complete the contract, the smaller theprobability that it will involve costly renegotia-

• Incentive based. The contract should be writtento encourage the right behavior from the vendor.For instance, the vendor may get a bonus whenits performance boosts indicators of businessvalue. This incentive could help align the goalsof vendors with the business objectives of theirclients. The contract should also address howthe relationship will change over its life cycle.For example, unit-based pricing may be used atthe beginning of the relationship. The pricingcould switch to cost-plus as the relationship de-velops. The contract could eventually call for achange to a gain-sharing arrangement so thatthe client and the vendor have a joint stake inthe outcome.

• Balanced. In general, one-sided contracts do notlast long. Even a contract that is weightedagainst the vendor is not necessarily beneficialfor the client: service levels quickly drop, andthe vendor tries to win back some value by im-posing extra fees.

• Flexible. Due to evolving technology and chang-ing business conditions, medium and long-termoutsourcing contracts should not be written inan inflexible way. Flexibility clauses can helpboth parties accommodate to environmentalchanges.2^

The failure experienced by the European bank canessentially be attributed to a badly drafted con-tract that lacked preciseness (i.e., extra fees had tobe paid even for basic services), flexibility (i.e.,fixed fees had been set when the business wasbooming) and completeness (i.e., it was impossibleto switch vendors because extremely huge penal-ties would have been incurred). The bank learnedthe hard way. As pointed out by a manager:"Spend as much time as possible developing thecontract. A contract is an investment whose value

2003 Barthelemy 91

really becomes apparent if the relationship withthe supplier becomes sour."

Fourth Deadly Sin: Overlooking Personnel Issues

A European department store had to close for twodays because its 70 facilities management person-nel went on strike. The shutdown took place duringan important sales promotion and resulted in theloss of several million Euros. This strike was partlydue to constant rumors that facilities managementwould be outsourced. These rumors were essen-tially fueled by the fact that retiring facilitiesmanagement employees were never replaced.Basically, their colleagues were afraid of beingtransferred to the vendor (with lower pay and ben-efits) or being laid off.

Insights /or Managers

The efficient management of personnel issues iscrucial because employees generally view out-sourcing as an underestimation of their skills. Thismay result in a massive exodus even before anactual outsourcing decision has been made. Se-crecy in outsourcing feasibility and decision-making is very difficult, and open communicationis the key to managing personnel issues in out-sourcing. When attempts at secrecy fail, rumorsstart spreading. As soon as employees know thatoutsourcing is under consideration, counterpro-ductive anxiety arises and employees begin hand-ing in their notice in anticipation of outsourcing.

The efHcient management of personnelissues is crucial because employeesgenerally view outsourcing as anunderestimation of their skills.

Firms that contemplate outsourcing must facetwo interrelated personnel issues. First, key em-ployees must be retained and motivated. For mostactivities, outsourcing does not mean transferringall the employees to the vendor. When an activityhas been performed in-house for a long period oftime, firm-specific knowledge about how to run theactivity smoothly has accumulated. Employeeswho possess this firm-specific knowledge must beidentified. To keep them in-house, the manage-ment must be prepared to offer them higher sala-ries and benefits. Outsourcing has a negative im-pact on employees' sense of job security andloyalty even when they keep their positions withinthe firm. This may lead to decreased productivity

or even dysfunctional actions such as strikes. Newresponsibilities may be offered to secure the com-mitment of retained employees. Generally, theirrole tends to shift from service delivery to interfacewith the vendor and end users. This important shiftrequires new skills that can only be acquiredthrough considerable training and ongoing sup-port.

A second personnel issue is that the commitmentof employees transferred to the vendor must alsobe secured. As a manager in charge of a financeoutsourcing contract put it: "Retention of knowl-edge and skills is a key issue. Irrespective of theprofile of the service provider, the actual work isdone by individuals harnessing their skills, knowl-edge, experience, and the technology available tothem. If high staff turnover is experienced, then thequality of the work will deteriorate noticeably, par-ticularly in specialist technical areas and analyt-ical work." The outcome of an outsourcing effort ishighly dependent on the commitment of employeeswho have been transferred to the vendor. Employ-ees working in activities that do not belong to thefirm's core business are often given low-priority.Once they are transferred to specialist vendors,they may be offered opportunities for better careerpaths in what is regarded as the vendor's corebusiness. To many employees, vendor employmentis more attractive than continued employment inan organization where the outsourced activity isviewed as a mere utility.

Taking ethical considerations into account canhelp avoid most personnel issues related to out-sourcing.^'^ A utilities firm paid very careful atten-tion to its employees when the decision was madeto outsource 85 per cent of its IT budget to anoutside vendor. The CIO summarized: "We wantedto find a solution that was not detrimental to the ITemployees." In this deal, the vendor was contrac-tually asked to offer the same pay and benefits tothe 160 employees transferred to the vendor. Thevendor also promised to neither fire outsourcedemployees nor to transfer them to other accountswithout their approval. The outsourcing deal wasendorsed by the works council and finally turnedout to be quite successful.

At first glance, it seems surprising that firmsmay gain something from outsourcing if theymerely transfer their employees to the third partyand ask that they maintain the same pay and ben-efits. However, there is more to outsourcing thantransferring people and renegotiating their payand benefits. Multiple clients enable specializedvendors to operate at a scale unattainable by theirindividual clients. Because of the variety of theirclients, specialized vendors also have a depth and

92 Academy of Management Executive May

range of experience that an individual client can-not match.3i

Fifth Deadly Sin: Losing Control Over theOutsourced Activity

Outsourcing at a specialty retail firm had resultedin the total dismantling of the internal IT depart-ment. Shortly after the outsourcing decision hadbeen made, the CIO was left alone to manage thevendor. Outsourcing ended up as a downright fail-ure. IT costs increased by 20 per cent, and IT per-formance did not improve at all. The five-year con-tract was cancelled three years after it was signed.According to the CIO, outsourcing had resulted in"a total and dangerous loss of control over IT, in-ability to cope with the changing environment andcommand over the future." He also noted that"while there are important cost decreases at thebeginning of the relationship, extra costs arequickly incurred."

Insights /or Managers

When the performance quality of an activity is low,managers are often tempted to outsource it. If poorperformance is attributable to factors such as in-sufficient scale economies or a lack of expertise,outsourcing makes sense. If poor performance isattributable to poor management, outsourcing isnot necessarily the right solution. On the one hand,it is often easier to manage an outside vendor thanan in-house department.^^ Qn the other hand, out-sourcing entails great changes regarding the man-agement of an activity. With outsourcing, controlthrough direct ownership of assets and employ-ment of staff is replaced by control through a con-tract. Instead of issuing orders, managers incharge of outsourced activities must negotiate re-sults with vendors. They must also ensure the ef-fective use of the outsourced service by internalusers who are often reluctant to work with externalvendors.

For an outsourcing client, it is particularly im-portant to avoid losing control over an outsourcedactivity. Such a loss of control has two distinctorigins. First, the client may not have the capabil-ities to manage the vendor. Second, the client maynot actively manage the vendor. In the case of thespecialty retail firm explained above, two mis-takes were made simultaneously. The internal ITdepartment was totally dismantled, and the CIOwas not sufficiently involved in the managementof the vendor. He had very few contacts with thevendor's management, meeting them formally

once a month and informally less than once aweek.

When an activity is outsourced, it is crucial toretain a small group of managers to handle thevendor. These managers must be able to developthe strategy of the outsourced activity and keep itin alignment with the overall corporate strategy.While vendor management skills are very impor-tant, they must also be complemented with techni-cal skills. If no one in the company is able to assesstechnological developments, outsourcing is boundto fail. New employees may even need to be hiredto manage the outsourcing vendor. Outsourcingclients should essentially look for managers withprior experience in outsourcing or joint-venturemanagement, involvement in an outsourced activ-ity, and experience in leading cross-functionalteams.^^ When a department store outsourced partof its IT, 85 per cent of the IT employees weretransferred to the vendor. Half of the remainingpersonnel were dismissed shortly thereafter. Itturned out they were neither able to manage thevendor nor handle changes in the scope of theoutsourcing contract. They were replaced by man-agers with extensive experience in outsourcing.

When an activity is outsourced, it iscrucial to retain a small group ofmanagers to handle the vendor.

Outsourcing does not mean abdicating! A lack ofactive management must be avoided at all cost, asthe following example clarifies. A computer man-ufacturer outsourced a large part of its after-salesservice activity. Though the rationale for outsourc-ing was essentially cost reduction, a high standardof performance from the vendor was also impor-tant. In the computer industry, after-sales serviceis crucial, and the computer manufacturer did notwant to lose business due to its outsourcing ven-dor. The first way to deal with this important issuewas to devise a contractual clause stating that thevendor had to fix 85 per cent of the problems en-countered by end-users within a day. However, theinterviewee made clear that such a clause is use-less if it is not correctly implemented. As he ex-plained: "Without a constant monitoring of thevendor, its performance rate would decrease toaround 70 per cent [instead of 85 per cent]). Wecannot accept such a low rate because it wouldresult in a loss of business for us." While a goodcontract is necessary, good enforcement is alsoessential.

2003 Baithelemy 93

Sixth Deadly Sin: Overlooking the Hidden Costsoi Outsourcing

Table 1 compares the hidden costs of two logisticsoutsourcing contracts. The first case is a manufac-turing firm which outsourced a subset of its logis-tics activity: warehousing. In this firm, warehous-ing was considered a commodity. The second caseis a manufacturing firm which outsourced its en-tire logistics function. To take over this activity, thevendor had to acquire specialized knowledgeabout the business of its client and the idiosyncra-sies of its logistics activity.


Outsourcing clients are generally confident thatthey can assess whether or not outsourcing resultsin cost savings. However, they olten overlook coststhat can seriously threaten the viability of out-sourcing efforts.- '̂' Transaction cost economics(TCE) suggests two main types of outsourcing hid-den

• Outsourcing vendor search and contractingcosts. Search costs are the costs of gatheringintormation to identify and assess suitable ven-dors. Contracting costs are the costs of negotiat-ing and writing the outsourcing contract. Bothsearch and contracting costs are incurred beforethe outsourcing operation actually takes place;

• Outsourcing vendor management costs. Thesecosts have three different dimensions: monitor-ing the agreement to ensure that vendors fulfilltheir contractual obligations, bargaining with

vendors and sanctioning them when they do notperform according to the contract, and negotiat-ing changes to the contract when unforeseencircumstances arise. Outsourcing vendor man-agement costs are incurred while the outsourc-ing operation actually takes place.^^

TCE suggests that the hidden costs of outsourcingare essentially influenced by the idiosyncrasy ofthe resources underlying outsourced activities.^'^Specific physical resources refer to specializedequipment tailored to a single firm's requirements.Specific human resources refer to expertise thatemployees have acquired through years of train-ing and that is useful only in the context of a singlefirm. When idiosyncratic resources have beentransferred to an outside vendor, switching ven-dors or reintegrating the outsourced activity isquite difficult. As vendors know they cannot easilybe replaced, they may act opportunistically. Op-portunistic expropriation occurs when vendorsstandardize IT services instead of offering uniqueservices. While such commoditization enablesvendors to reap greater economies of scale, it alsomeans that the unique needs of their clients are nolonger met.̂ ^ Firms that select the right vendor andwrite up a good contract are less likely to sufferfrom the potential opportunism of their vendor. Agood vendor must be proficient and trustworthy{see second deadly sin). A good contract mustbe simultaneously precise, complete, incentivebased, balanced, and flexible (see third deadlysin).

However, searching for a reliable vendor and

Table 1The Hidden Costs of Outsourcing in Two Logistics Cases

Contract amountContract duration

Number of internal employeesOutside consultants and lawyersTotal search and contracting costFiatio of total search and contiacting cost

Low level ofidiosyncrasy (i.e., warehousing)

$1.5 million1 year

Search and contracting costs

40

$10,000to to(a] con(rac( amount 0.7%

Vendor management costs

High level ofidiosyncrasy (i.e..

entire logistics function)

$4 million3 years

54

$250,0006.2%

Number of employeesNumber of formal meetings per yearNumber of informal meetings per yearAnnual vendor management costsRatio of annual vendor management costs to total contract amount

214

$100,0006.7%

21212

$200,00015%


draiting a good contract is expensive. In the twocases stated above, search and contracting costswere nearly ten times higher for the entire logisticsactivity than for the warehousing outsourcing con-tract (6.2 per cent vs. 0.7 per cent). Vendor manage-ment costs were more than twice as high for theentire logistics activity as for warehousing (15 percent vs. 6.7 per cent).^^ The figures for the secondcase were high enough to nullify the cost savingsfrom outsourcing.

The hidden costs ol outsourcing are an importanttopic for managers because they can challenge therationale for outsourcing. It is also paradoxicalthat these costs are both necessary and detrimen-tal to the outcome of outsourcing efforts. Whilesuccessful outsourcing requires substantial spend-ing on vendor searching, contracting, and manage-ment costs, these costs can also turn potentiallysuccessful outsourcing efforts into a complete fail-ure. While carefully selecting the vendor and craft-ing contracts with well-articulated expectationsand clearly set performance measures is expen-sive, such expenses are necessary to keep vendormanagement cost at a decent level. Consideringthe potential impact of the hidden costs of out-sourcing, it may be worth the additional cost ofhiring outside experts. Such experts are familiarwith outsourcing and know how certain pitfallscan be avoided. Legal experts are useful when itcomes to writing the outsourcing contract and ne-gotiating with the vendor. Technical experts canhelp develop precise measures such as service-performance level.

The hidden costs of outsourcing are animportant topic for managers becausethey can challenge the rationale foroutsourcing.

Seventh Deadly Sin: Failing to Plan anExit Strategy

One retail company outsourced several IT activitiesthat senior management considered to be commodi-ties (data centers, applications maintenance, anduser support). However, outsourcing failed due tohigh costs and low performance. Though the vicepresident of information services wanted to get out ofthe contract, he was reluctant to cancel it. Indeed, heknew that a vendor switch would take over sixmonths while reintegrating the activities would re-quire as much as ten months. All he could do was to

renegotiate the contract, implementing a 15 per centreduction in services due to poor performance.


Many managers are reluctant to anticipate the endof an outsourcing contract. Therefore, they oftenfail to plan an exit strategy (i.e., vendor switch orreintegration oi an outsourced activity). For in-stance, the manager in charge of a facilities man-agement outsourcing contract stressed that "thisoutsourcing deal is based on a long-term relation-ship. A vendor switch is altogether out of the ques-tion." This attitude is a mistake because switchingvendors does not necessarily mean that outsourc-ing didn't work. Shrinking the vendor base andestablishing long-term relationships with a fewselected vendors is not always the best solution.

Actually, outsourcing relationships can be viewedon a continuum. At one end are long-term relation-ships where investments specific to the relationshiphave been made by one or both partners. There is aconsiderable advantage in recontracting with thesame vendor because switching vendors or reinte-grating the outsourced activity is very difficult.̂ ^ Atthe other end are market relationships where theclient has a choice of many vendors and the ability toswitch vendors with little cost and inconvenience. Inthis case, there is no real advantage in recontractingwith the same vendor. For instance, a firm in thecomputer industry successfully outsourced telemar-keting. The duration of the contract was only oneyear. Every year, the incumbent vendor's price andperformance were benchmarked against other ven-dors. If the incumbent vendor had not made the bestoffer, its contract would never have been renewed.

Managers who do not want to anticipate the endof an outsourcing relationship also have a ten-dency not to include material reversibility clauses(i.e., option to buy back premises and equipmentfrom the vendor) and human reversibility clauses(i.e., option to hire back employees from the ven-dor) in the contract. The absence of such clausesleads to weak power bases for any negotiationwith the vendor and makes it very difficult to backout of an outsourcing agreement.'" This is exactlywhat happened in the case of the retail firm de-scribed above. Even when an outsourced activity isnot very idiosyncratic, it is important to plan anexit strategy. Switching vendors or reintegratingthe outsourced activity was hardly feasible be-cause it had not been anticipated in the contract.

Table 2 summarizes the seven deadly sins ofoutsourcing and the lessons to be learned.

2003 Baithelemy 95

Table 2The Seven Deadly Sins of Outsourcing and Lessons Learned

Timetable Deadly sin Lesson learned

Original idea to outsoutce

Beginning ol the relationship

Outsourcing activities that shouldnot be outsourced

Selecting the wrong vendor

Writing a poor confract

Overlooking personnel issues

Losing control over the outsourcedactivity

Overlooking the hidden costs ofoutsourcing

Vendor switch or reintegration of Tailing to plan an exit strategythe outsourced activity

Only activities that do not belong to the core business canbe safely outsourced. The core vs. non-core approachcan be implemented both at the lirm and activity level.

Outsourcing clients should look for vendors that are ableto provide state-of-lhe-art solutions and are trustworthy.

The contract is the main tool to establish a balance oipower in outsourcing relationships. Good contracts havefour characteristics. They must be precise, complete,balanced, and flexible.

Loss of key employees and lack of commitment canseriously threaten the viability of outsourcing efforts.However, good communication and ethical behaviortowards employees can help avoid such problems.

In order to keep control over outsourced activities, clientsmust retain a small group of qualified managers. Anactive management of the vendor is also crucial.

The hidden costs (i.e., search, contracting, and managingcosts) can threaten the viability of outsourcing efforts.Hidden costs are likely lo be lower when commoditiesare outsourced.

The end of the outsourcing contract musi be planned fromthe outset. Building reversibility clauses into thecontract is crucial.

Outsourcing: Dangers and Opportunities

Historically, outsourcing was restricted to basicsupport activities such as janitorial services. To-day, outsourcing has extended to more crucial ac-tivities such as IT, telecommunications, finance,and logistics. Increasingly complex types oi out-sourcing have developed. For instance, the emer-gence of fourth-party logistics providers is a majortrend with U.S. auto manufacturers. General Mo-tors has a joint-venture with Menlo Logistics,called Vector. Vector is responsible for all out-bound logistics for General Motors. It operates as afourth-party provider that manages multiple third-party providers for GM.'*̂

Based on a survey of 91 outsourcing efforts, Iuncovered seven major pitfalls that can threatenthe viability of outsourcing efforts. As shown in theAppendix, statistical results confirm that the sevendeadly sins are good differentiators between out-sourcing success and failure. Several importantimplications can be drawn from the statistical re-sults:

• Some sins were "deadlier" than others. "Writinga poor contract" and "losing control over theoutsourced activity" had the largest impact onthe outcome of outsourcing efforts. On the otherhand, "failing to plan an exit strategy" was not agood differentiator between success and failure.

perhaps because planning an exit strategy onlybecomes necessary in the case of vendor switchor reintegration of an outsourced activity;

• Mistakes were made even in successful out-sourcing efforts. Mistakes such as "outsourcingactivities that should not be outsourced," "writ-ing a poor contract," and "failing to plan an exitstrategy" were the most frequent. However, mak-ing only one or two mistakes does not necessar-ily lead to failure.

"Writing a poor contract" and "losingcontrol over the outsourced activity" hadthe largest impact on the outcome ofoutsourcing efforts.

By contrasting successful and failed outsourcingefforts, I provided advice on how to avoid the sevendeadly sins of outsourcing. An important messageof this article is that some outsourcing efforts aredoomed to fail even before the relationship withthe vendor has actually started. When a firm hasoutsourced activities that should not be out-sourced, selected the wrong vendor, and written apoor contract, the likelihood of success is close tozero.


To be successful with outsourcing, iirms need toaccumulate the expertise required to avoid theseven deadly sins of outsourcing. Such a process isunfortunate both time consuming and costly.Throughout this research, I noticed that this exper-tise was rarely capitalized at the company level.This is unfortunate as my research suggests thatthe seven deadly sins are very similar from oneoutsourced activity to the other. Hence, I stronglybelieve that firms using substantial outsourcingcould gain a lot from setting up a department de-voted to capitalizing outsourcing management ex-pertise.'*^ Such a department may be charged withsharing and leveraging prior outsourcing experi-ence and knowledge throughout the company. Set-ting up a dedicated outsourcing function may be aluxury for small firms or firms that do little outsourc-ing. In that case, outsourcing-related informationmay be collected at the purchasing department level.

Outsourcing is a way for firms to cut costs, im-prove performance, and focus their limited re-sources on their core business. However, outsourc-ing can also be dangerous when it is not properlyimplemented. Firms must think seriously abouthow they will manage the deadly sins before mak-ing their actual outsourcing decisions.

Appendix: Information on Companies andOutsourcing Operations Profiles

My findings are based on an extensive analysis of the aca-demic literature and an in-depth study of 91 outsourcing caseswith various characteristics (see "Company profiles" and "Out-sourcing operations profiles"). Primary data were collectedthrough detailed questionnaires and interviews. There are twobroad types of outsourcing; (1) outsourcing as an alternative tovertical integration and (2) outsourcing as a means to verticallydisintegrate {i.e., outsourcing activities that were performedin-house). In this article, I focus on the second type of outsourc-ing. To detect announcements for outsourcing contracts, I con-ducted an exhaustive electronic search of two major databases:ABI/INFORM-GLOBAL and REUTERS. I was able to compile aninitial sample of 816 "vertical disintegration" outsourcingcases. Questionnaires were then obtained for 91 cases (yieldingan 11 percent response rate). Each questionnaire came irom adifferent iirm. The respondents were senior executives respon-sible for outsourced activities. Due to financial constraints, Icould only conduct interviews for approximately half the cases.Unless otherwise noted, all presented data and illustrations areirom this research project.

To assess whether outsourcing efforts were successes or fail-ures, I used a five-point Likert scale (Irom "not satisfied at all"to "totally satisfied"). Outsourcing efforts were considered suc-

cesses when managers were "very satisfied" or "totally satis-fied." They were considered failures when managers were "notsatisfied at all," "not satisfied," or "moderately satisfied." Usingthis methodology, 63 per cent of the outsourcing efforts wereconsidered successes and 37 per cent were considered failures.To check the reliability of my measure, I developed an objectiveindicator oi outsourcing success using nine binary items: (1)cost reduction. (2) ability to turn ilxed costs into variable ones,(3) control of expenses, (4) personnel management, (5) overallperformance, (6) access to better competencies, (7) access tobetter skilled personnel, (8) improved service quality, and (9)reallocation of resources to the core business. The averagenumber of objectives met was respectively 3.2 for outsourcingfailures and 6.8 for outsourcing successes. Results from anANOVA analysis suggests that this difference is statisticallysignificant (F - 16.1; p < 0.01).

The table below lists each sin in the first column, the number(and percentage) of failed efforts that committed the sin in thesecond column, and the number (and percentage) of successfulefforts that committed the sin in the third column.

Company profiles

Geographical origin

EuropeNorth AmericaIndustriesRaw materials and utilitiesManufacturingServicesFinance and banking

Number of employees< 1,0001,000-10,000> 10,000

Outsourcing operations profiles

Type of activity oufsourceci

Information TechnologyTelecommunicationsLogisticsFinanceOthers

Contract amount

<S10 million$10-100 million>$100 million

Percenfage o/ budget outsourced0-20%21%-40%41%-60%61%-80%81%-100%

Percentage of sample

7624

22412413

243838

Percentage of sample

547

177

15

383024

1112112343

2003 BarthSlemy 87

Deadly sin

Number (and percentage)of failed efforts thatcommitted the sin

Number (and percentage)of successful efforts that

committed the sin

26 (28%)8 (9%)

21 (23%)19 (20%)5 (6%)4 (4%)

33 (36%)

Results ofchi-square

test

/ = 5.46") ^ = 5.58") ^ = 16.40"i^ = 2.99*) ^ = 12.82") ^ = 2.60'y" = 0.70

Outsourcing activities thai should not be outsourcedSelecting the wrong vendorWriting a poor contractOverlooking personnel issuesLosing control over the outsourced activityOverlooking the hidden costs of outsourcingFailing to plan an exit strategy

50 (55%)27 (30%)63 (69%)35 (38%)34 (37%)13 (14%)41 (46%)

' p < 0.10, " p < 0.05, ' " p < 0.01.

Endnotes

' The Economist Intelligence Unit. 1999. Designing fomor-row's oiganisation. London.

-̂ Gilley. K., & Rasheed, A. 2000. Making more by doing less;An analysis oi outsourcing and iis effects on firm performance.Jouinai oi Management, 26(4): 736-790.

^ Quinn, J. B., & Hilmer, F. 1994. Strategic outsourcing. SJoanManagement Review, Summer: 43-55.

•̂ Jennings, D, 1996. Outsourcing opportunities for financialservices. Long flange Pianning. 29(3): 393-404.

^ Bryce. D., & Useem, M. 1998. The impact of corporate out-sourcing on company value. European Management Joutnal,16(6): 635-643.

^ See for instance Huber, R. 1993. How Continental Bank out-sourced its "crown jewels." Harvard Business Reviuw, January-February: 121-129; Cross, J. 1995. IT outsourcing: British Petro-leum's competitive approach. Harvard Business Review, May-June: 94-102; and McFarlan, F.. & Nolan, R. 1995. How io managean IT outsourcing alliance. Sloan Management Review. Winter:9-23. However, there are exceptions such as Ang, S., & Toh, S.1998. Failure in software outsourcing: A case analysis. In Will-cocks, L., & Lacity, M. (Eds.), S(ralegic sourcing of in/ormalionsystems.' Perspectives and practices. Chlchester: John Wiley.351-368.

' Sitkin, S. 1992. Learning through failure: Tbe strategy oismall losses. In Cummings, L., & Staw, B. (Ekls.), Research inorganizational behavior. Greenwich: JAI Press,

® Lacity. M.. & Hlrschheim, R. 1993. Thj information systemsoutsourcing bandwagon. Shan Management Review, Fall: 73-86; Loh, L., & Venkatraman, N. 1992, Diffusion of informationtechnology outsourcing: Influence sources and the Kodak effeci./nformafion Systems Research, 3(4): 334-358; and Ang, S., 8fCummings, L. 1997. Sirateglc response to institutional influ-ences on information systems outsourcing. Organizafion Sci-ence, 8(3): 235-255.

^Barney, J. 1991, Firm resources and sustained competitiveadvantage, journal ol Management, 17(1): 99-120. Classic refer-ences regarding the resource-based view of ihe firm includeAmit, R., & Schoemaker, P. 1993. Strategic assets and organiza-tional rent. Strategic Management Journal, 14(1): 33-46;Dierickx, I., & Cool, K. 1989. Asset siock accumulation and sus-tainability of competitive advantage. Management Science,35(12): 1504-1511; and Teece, D., Pisano, G., & Shuen, A. 1997.Dynamic capabilities and strategic management. StrategicManagement JournaJ, 18(7): 509-533.

'" The case of the U.S. consumer electronics industry is aclassic one. Poorly performing business units started outsourc-ing components manufacturing to Asian suppliers. Ai that time,mosi of them even had to teach their suppliers how to build thecomponents. As outsourcing resulted in lower cosis, it quickly

spread through the entire U.S. consumer electronics industry.Later, some U.S. manufacturers found out that their supplierswere unable or unwilling io supply them as requested. How-ever, ihe U.S. firms had losi their manufacturing skills andcould noi preveni the suppliers from entering downstream mar-kets on their own. See Beitis, R., Bradley, S., & Hamel, G., 1992.Outsourcing and industrial decline. The Academy oi Manage-ment Executive. 6(1): 7-22.

" Dess, G., et al. 1995. The new corporate archiieciure. TheAcademy oi Management Executive. 5(3): 7-20; Markides, C.1992. Consequences of corporaie refocusing: Ex anie evidence.Academy oi Management Journal. 35: 398-412; and D'Aveni, R.,& Ravenscraft, D. 1994. Economies of integration versus bureau-cracy costs: Does vertical integration improve performance?Academy of Management Jouinal, 37(5); 1167-1206.

'̂ Leiblein, M., Reuer, J., & Dalsace, F. 2002. Do make or buydecisions matter? The influence of organizational governanceon technological performance. Strategic Management Journal,23(9): 817-833; Poppo, L., & Zenger, T. 1998. Testing alternativetheories oi the firm: Transaction cost, knowledge-based andmeasurement explanations for make-or-buy in information ser-vices. Strategic Management Journal. 19(9): 853-877; and Silver-man, B., Nickerson, J., & Freeman, J. 1997, Profitability, transac-tional alignment and organizational mortality in ihe U.S.trucking industry. Strategic Management Journal, Summer Spe-cial Issue: 31-52.

'^Lacity, M., Willcocks, L., & Feeny, D. 1996. The value ofselective IT outsourcing. Sioan Management Review. Spring:13-25.

'•* Though transporiaiion had been ouisourced for a longtime, logistics was largely iniernalized in this firm.

'̂ For a thorough review, see Razzaque, M., & Sheng, C. 1998.Outsourcing the logistics function: A literature review. Interna-tional Journal oi Physical Distribution and Logistics Manage-ment. 28(2): 89-107.

'̂ Rabinovitch, E., ei al. 1999. Outsourcing of integrated logis-tics functions: An examination of industry practices. Interna-tional Journal of Physical Distribution & Logistics Management,29(6): 353-373.

" I am grateful to an anonymous reviewer for suggesting thisexample.

'̂ Trusiworihiness can be defined as the expectation ihat thevendor will not take advantage of ihe clieni even when theopportunity is available. See Zaheer. A., McEvily, B., 8E Perrone,V. 1998. Does trusi maiter? Exploring ihe effects of interorgani-zaiional and interpersonal trust on performance. OrganizationScience, 9(2): 141-159.

'̂ Mohr, J., & Spekman, R. 1994. Characteristics of partnershipsuccess: Partnership attributes, communication behavior andconflict resolution techniques, Strategic Management Journal,15(2): I3&-152.


™ At the beginning of the contract, the client receives a one-time capital payment and shifts the problems to the vendor.

^'Ring, P., & Van de Ven, A. 1992. Structuring cooperativerelationships between organizations. Strategic ManagementJournal, 13(7): 483-498.

^̂ Barney, J.. & Hansen, M. 1994. Trustworthiness as a sourceof competitive advantage. Sirafegic Management jouinal. 15(2):175-190.

^̂ Lambert, D., Emmelhainz, M.. & Gardner. J. 1999. Buildingsuccessful logistics partnerships. Journal of Business Logistics,20(1): 165-181; and Anderson, J.. & Narus, J. 1990. A model ofdistributor firm and manufacturer firm working partnerships.Journal of Marketing, 54(1): 42-58.

*̂ Ackerman, K. 1996. Pitfalls in logistics partnerships. Intei-national Journal of Physical Distribution and Logistics Manage-ment, 26(3): 35-37; and Lambert, Emmelhainz, & Gardner, op. cit.

" Saunders. C, Gebelt. M., & Hu, Q. 1997. Achieving successin information systems outsourcing. California ManagementReview, 39(2): 63-79.

^̂ Willcocks, L., & Choi, C. 1995. Co-operative partnership and"total" IT outsourcing: From contractual obligation to strategicalliance. European Management 7oLjrnaJ, 13(1): 67-78.

" Realistic measurement af outsourcing success is nevereasy. Indeed, the most Important measures of outsourcing suc-cess are often intangible.

^̂ Parkhe, A. 1993. Strategic alliances structuring: A gametheoretic and transaction cost examination of interfirm cooper-ation. Academy of Management Journal, 36(4): 794-829.

^̂ Harris, A., Giunipero, L., & Hult, G. 1998. Impact of organi-zational and contract flexibility on outsourcing contracts. Indus-trial Marketing Management, 27{5): 373-384.

^ See Henderson, M. 1997. Ethical outsourcing in the UKfinancial services: Employees rights. Business Ethics, 6(2): 110-124. According to this article, outsourced employees have thefollowing rights: right lo information, right to fair pay, right notto be fired, and right not to be discriminated against.

'̂ Alexander, M., & Young, D. 1996. Outsourcing: Where's thevalue? Long flange Planning, 29(5): 728-730.

^̂ Poppo, L. 1995. Influence activities and strategic coordina-tion: Two distinctions oi internal and external markets, Man-agement Science, 41(12): 1845-1859.

^ Useem, M., & Harder, I. 2000. Leading laterally in companyoutsourcing. Sioan Management Review. Winter: 25-36.

^* Maltz, A., & Ellram, L. 1997. Total cost of relationship: Ananalytical framework for the logistics outsourcing decision.Journal of Business Logistics, 18(1): 45-65.

^Williamson, O. E. 1985. The economic institutions of capi-talism. New York: Free Press; Williamson, O. E. 1975. MarJtef andhierarchies: Analysis and antitrust impiications. New York: FreePress; Masten. S., Meehan, J., & Snyder, E. 1991. The costs oforganizations. Journal of Law, Economics and Organization,7(1): 1-25; Dyer, J. 1997. Effective interfirm collaboration: Howfirms minimize transaction costs and maximize transactionvalue. Strategic Management Journal, 18(7): 535-556; Ang, S., &Straub, D. 1998. Production and transaction economies and IToutsourcing: A study of the US banking industry. MIS Quarterly,22(4): 535-548; and Barthelemy. J. 2001. The hidden costs of IToutsourcing. Sloan Management fleview. Spring: 60-69.

^̂ In the transaction cost economics (TCE) literature, vendorsearch and contracting costs are termed ex ante transactioncosts, and vendor management costs are termed ex post trans-action costs.

^̂ Williamson, O. E. 1991. Comparative economic organiza-tion: The analysis of discrete structural alternatives. Adminis-trative Science Quarterly, 36(2): 269-296; and loskow, P. 1988.Asset specificity and the siruclure of critical relationships: Em-pirical evidence. Journal of Law, Economics and Organization,4(1): 95-117.

^̂ Klein, B., Crawford, R., & Alchian. A. 1978. Vertical integra-tion, appropriable rents and the competitive contracting pro-cess. Journal of Law and Economics, 21(2): 297-326.

^^This difference is all the more significant as the hiddencosts of outsourcing are largely fixed. In other words, they arevery sensitive to scale economies. See Dyer, J. 1996. Specializedsupplier networks as a source of competitive advantage: Evi-dence from the auto industry. Strategic Management Journal,17(4): 271-291.

'^''Dyer, J., Cho. D., & Chu, W. 1998. Strategic supplier seg-mentation: The next "best practice" in supply chain manage-ment. California Management Review, 40(2): 57-77; Weiss, A., &Anderson, E. 1992. Converting from independent to employeesalesforce: The role of perceived switching costs. Journal ofMarketing Research, 29(1): 101-115; Klemperer, P. The competi-tiveness of markets with switching costs, fland 7ournai of Eco-nomics, 18(1): 138-150; and Porter, M. 1980. Competitive strategy:Techniques for analyzing industries and competitors. New York:The Free Press.

"' Greer, C, Youngblood. S.. & Gray. D. 1999. Human resourcemanagement outsourcing: The make or buy decision. The Acad-emy of Management Executive, 13(3): 85-96.

•"̂ I am grateful to an anonymous reviewer for pointing to thisimportant trend. A discussion of the relationship betweenMenlo Logistics and General Motors can be iound on www.vectors CM. com.

^̂ On a related topic, it has been recently shown that firmshaving a dedicated alliance function generate more alliancevalue than others. See Kale, P., Dyer, I., & Singh, H. 2002. Capa-bility, stock market response, and long term alliance success:The role of the alliance function. Strategic Management Jour-nal, 23(8): 747-768.

lerome Barthelemy is assistantprofessor of strategic manage-ment at ESSEC Business School(France). He holds a Ph.D fromHEC (France) and has beena visiting research scholar atthe University of California ofBerkeley. His research on out-sourcing has appeared in jour-nals such as MIT Sloan Man-agement fleview and EuropeanManagement Journal. Contact:

academy o/ management executive. 2003, vol. 17....

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