Differentiating between “core” and “strategic” activities is never as important as in outsourcing. As this author points out, if it’s “core” then outsource it; if it’s strategic, manage it internally. Below, he describes how to determine the difference.

The growth of the global outsourcing market in the past few years has been phenomenal, and all indications are that the pace will continue unabated for years to come. The Sourcing Interest Group (a leading forum for the exchange of information between those involved in the sourcing of information technology, business processes and corporate support services) pegged the global outsourcing market at $72 billion (U.S.) in 2002 and it has predicted that the figure will rise to $100 billion (U.S.) in 2005.

Outsourcing has been around for a long time, but much of the action until the late 1990s was focused on informational technology (IT) outsourcing. The goal then was often largely restricted to achieving operational efficiencies. The past four to five years, however, have witnessed the rapid growth in Business process Outsourcing, to areas such as manufacturing and product design. With Business Process Outsourcing, the goal is typically longer-term and focuses on the realization of overall business benefits, whether enhancing an organization’s competitive position in the marketplace or improving shareholder returns. A recent Accenturesponsored IDC Canada survey noted that over 90 per cent of the Canadian executives surveyed who currently outsource said they expect some degree of change in business processes through outsourcing (“Outsourcing-Shared Risks and Shared Rewards,” Accenture, 2003). From its earlier days when it was viewed as little more than a ho-hum tactic aimed at reducing costs, outsourcing has now matured into a strategic management tool.

This article is divided into three parts. In Part I, we explain the essence of strategic outsourcing; in Part II, we examine a methodology for linking outsourcing to business strategy; and in Part III, we look at a case study in progress of a large strategic outsourcing relationship.

1. The essence of strategic outsourcing

What distinguishes an outsourcing arrangement from any other business arrangement is the transfer of ownership of an organization’s business activities (processes or functions)-or the responsibility for the business outcomes flowing from these activities-to a service provider. In a typical outsourcing arrangement, the people, the facilities, the equipment and the technology (the Factors of Production) are also transferred to the service provider, which then uses the Factors of Production to provide the services back to the organization. The people are often transferred to the service provider, but this is not always the case.

An outsourcing arrangement can be either “tactical” or “strategic.” An outsourcing is tactical when it is driven by a desire to solve a practical problem. For example, a company may find that its payroll clerk is not able to process payroll changes, cheques, tax returns and make the required accounting entries on time. The company concludes that although the payroll clerk is competent, there is too much work for a single person. The company outsources the payroll process (including the clerk), and ends up with all of the payroll work done on time and at a lower cost. As a result, it achieves a net gain in operational efficiency. Similarly, if an organization outsources its IT infrastructure so it can save five to 10 per cent on the cost of operating that function, the outsourcing is purely tactical.

“Strategic” outsourcing, on the other hand, is not driven by a problem-solving mentality. Instead, it is structured so that it is aligned with the company’s long-term strategies. The changes that organizations expect from strategic outsourcing vary and can include anything from

(a) achieving a gain in competitive advantage,

(b) spending more time on those activities that are truly central to the success of the organization,

(c) repositioning the organization in the marketplace, or

(d) achieving a dramatic increase in share price

It may include any combination of the foregoing, and others. The common denominator of strategic outsourcing is that the organization is externally focused. It embarks on the outsourcing with a view to achieving concrete results in the marketplace. While the focus is external, the strategic focal point of the organization may evolve during the course of the outsourcing relationship. For that reason, it is important to build-in the required degree of flexibility in the contractual documents so the parties can realign the strategic intent for the benefit of the organization that is outsourcing. A properly structured governance model will help make the appropriate adjustments.

In strategic outsourcing, the optimal relationship usually approaches a joint-venture/strategic alliance-type arrangement. The traditional customer-supplier relationship is typically inadequate for strategic outsourcing, as it often fails to allow the parties to address key business considerations and requirements. A structure that approaches a partnership-like arrangement-where the organization that is outsourcing and the service provider see each other as equals engaged in a common enterprise-tends to allow the service provider to deliver greater value during the course of the arrangement. This, however, is not an easy course to chart for many large organizations. As Peter Drucker notes about large companies in his most recent book: “They’re used to giving orders, not to working with a partner, and it’s totally different. In an alliance or a joint venture, you have to begin by asking, ‘What do our partners want? What are our shared values and goals?'” (Managing in the Next Society, St. Martin’s Press).

The accepted wisdom is that organizations should not outsource activities that are “core” to their business that is, those activities that are tied up in the organization’s identity-and that only “non-core” activities should be outsourced. Distinguishing core from non-core is not always easy, however. The notion of “shared-core” business activities illustrates the point. The concept captures the grey zone between core and non-core activities and was conceived as a tool to help decision-makers relinquish “ownership” of business activities that otherwise might have been classified as core, but which have had a history of underperforming internally.

What attributes make core activities so important that they should not be outsourced? In their article “Linking Outsourcing to Business Strategy” (Academy of Management Executive, Vol. 14, Nov.4, November 2000), authors Richard C. Insinga and Michael J. Werle make a distinction between “core” and “strategic” activities. A strategic activity, they argue, is one that confers a competitive advantage on an organization and should not be outsourced. We now briefly examine a methodology that can assist organizations in reviewing their functions and processes in order to determine what activities are not true competitive differentiators, and therefore obvious candidates for outsourcing.

2. Linking outsourcing to business strategy

Outsourcing has been around for a long time, but it is only in the most recent past that it has become known by that name. A classic example is Coca-Cola. By the late 1890s, Coca-Cola had already established itself as a highly successful soft drink company, but the firm was looking to extend its business across new markets. Although bottling was then considered an emerging source of competitive advantage, Coca-Cola decided that it did not have the capital, the time or the expertise to produce its own bottles. Production methods for bottles at the time were primitive, the result inconsistent, and quality control was a significant concern. Coca-Cola chose to license a group of independent bottlers to whom it sold its syrup while imposing strict quality controls. In the next several decades, Cola-Cola was able to achieve its key strategic business objectives, including vastly expanding its market and protecting its good name. By outsourcing the non-core business function of bottling its products, Coca-Cola was able to focus on its core business objectives (such as maintaining high product quality, protecting its brand and growing market share).

By the late 1970s, however, bottled products had developed into a significant competitive feature. While Coca-Cola’s competitors were making significant headway in the bottling of soft drinks, the company’s independent bottlers were not improving their business. Coca-Cola was losing market-share to its main competitors. In 1979, the company responded by taking steps to buy out several of its bottle-making alliance partners so it could develop its own internal capability in what had become a strategic area.

In “Linking Outsourcing to Business Strategy,” Insinga and Werle sketch out a methodology to assist organizations in aligning outsourcing to business strategy. The methodology helps organizations conduct a systematic review of their internal business activities by establishing a consistent strategic basis for the decision-making process.

The authors highlight two factors for assessing whether outsourcing is appropriate: (a) the extent to which the function or process contributes to the organization’s competitive advantage, and (b) whether the organization has the strength to perform it internally. The methodology is based on these two factors and helps answer the broader key questions: Which of the organization’s functions and processes should remain in-house? What is the organization’s competitive essence or true core? And, for those activities that can be performed externally, what form of relationship is best?

(a) Contribution to competitive advantage

Whether an activity adds to an organization’s competitive advent age must be measured in the marketplace, in accordance with a valuation metric that the authors rank from “none” to “absolutely” (as represented in the figure below). This metric assesses activities that are separated into four major categories of strategic importance, ranging from “key activities,” which are more apt to add the greatest strategic value to the organization, to “commodity activities,” which are readily available in the marketplace and contribute no strategic value to the organization. Key activities should generally be performed in-house while others become prime candidates for outsourcing.

(b) Capability to perform internally

Whether an activity can be performed well internally depends on an organization’s internal resources. Those resources are measured against a valuation metric that the authors rank from a “weak” to a “strong” capability (as represented in the figure below). While this metric cannot be measured in the marketplace, it should be measured as objectively as possible. Note that the matrix also includes gradations within certain cells, reflecting the fact that being at the top of a cell leads to a recommended course of action that is different than if the activity is pegged at the bottom of the same cell.

This two-dimensional matrix helps assess whether a particular activity should be outsourced. The criteria on the matrix help decide whether an activity is both key to the organization and an important source of competitive advantage to it, and therefore worthy of being performed in-house. If it is found that an activity only provides an egligible (if any) competitive advantage to the organization, depending on the organization’s ability to perform it in-house, it is more likely to be outsourced outright, or handled through some type of third-party relationship.

As was shown in the Coca-Cola illustration above, in the late 1890s, bottling was considered an emerging strategic factor, but the company deemed that it was unable to perform satisfactorily the bottling function in-house. According to the methodology, the optimal course of action then was for Coca-Cola to enter a partnering or collaborative relationship with a third party. This is what the company did. By the late 1970s, however, because bottling had become a matter of greater strategic competitive advantage-qualifying as a “key” activity on the matrix-the company reacted by looking to build an internal capability, putting the move somewhere in cell 2 of the matrix.

Note that despite its usefulness in identifying candidates for outsourcing, the matrix runs the risk of encouraging a siloed view of the organization, as it tends to overlook the potential for synergies between the various functions and processes. The strategic value of outsourcing is of course best captured through a fully integrated analysis that avoids discrete, unbundled solutions.

3. A case study

An illustration of a strategic outsourcing arrangement involves J. Sainsbury’s plc, a U.K. food retailer with approximately 150,000 employees. By the spring of 2000, the company’s profits had fallen by 40 percent from the previous three years, its competitive position in the U.K. was rapidly declining, and its share price was falling dramatically. The company was facing major competitive threats from new entrants, and its once-loyal customer base was dwindling rapidly. Sainsbury’s was looking to increase shareholder value and rebuild its customer relationships. The company wanted to free its managers so they could focus on more strategic, higher-value activities. For example, it wanted to allow its managers the time to develop deeper relationships with customers. Cost-cutting alone was not going to be enough.

Sainsbury’s decided to take steps to turn around its business and refocus itself strategically.

The company entered into a $2.7-billion (U.S.) seven-year outsourcing arrangement with Accenture. Accenture took over all aspects of Sainsbury’s IT infrastructure, including 800 employees, which resulted in immediate savings of $50 million (U.S.) per year. The service provider is now building new IT systems and working to streamline many of Sainsbury’s business processes. Without transforming its business, the company determined that it could not support the demands associated with modern retailing and growing customer expectations. To succeed, the company must transform itself in almost every way, from the way it operates internally to the way its deals with its customers, and it must work in a close cooperative relationship with its service provider. As Blake Hanna, managing partner – Financial Services Canada, Accenture, observes, “A critical success factor in shaping Business Process Outsourcing arrangements is the degree to which the customer and the outsourcing provider have achieved alignment around business objectives. The more strategic the nature of the outsourcing arrangement, the greater the need to achieve this alignment.”

One early focus in transforming Sainsbury’s has been IT governance. It was recognized early on that IT spending was not producing optimal results and that IT was not regarded as a business enabler but as a cost centre. The company had insufficient control over much of the IT envelope, including IT spending; the impact of projects on future costs; the value generated from its third-party IT relationships; and the delivery of IT projects. There was also insufficient prioritization of projects, inadequate measurement of results, and few penalties for non-performance.

The company accepted that it had to bring order to its IT environment. Spending within the company is now controlled by a cross-business-unit management body so that spending decisions are not made in isolation. This integrated approach allows for a sustained focus on the overall business objectives. All IT spending is also evaluated against the strategic objectives of the company to ensure strategic consistency and a shift away from more tactical spending initiatives where cost overruns were the norm at the company.

New rigour has also been introduced to the IT decision-making process. Before being allowed to proceed, every project must be formally approved and supported by a business case showing current and future IT costs. Finally, decisions must be made by director-level personnel, as part of a team, and delegating IT decision-making down is no longer acceptable within the company. In short, steps have been taken to avoid losing the strategic intent of outsourcing. As Sainsbury’s transformation continues, store layouts will be modernized and new ways of working will be established, in accordance with the company’s re-set strategic business focus.

Assessing accurately where on the matrix the Sainsbury’s outsourcing falls would require examining each of the specific activities that make up the arrangement. However, the magnitude and the strategic orientation of the relationship suggest that many of the activities would fall within cells 5 and 6. As was noted above, a structure that approaches a partnership-like arrangement typically offers the greatest value to organizations engaged in strategic outsourcing, as it best allows the parties to address key business considerations during the term of the relationship.

That outsourcing can be strategic is not in doubt, but there must first be a recognition of the strategic value that outsourcing can generate. As Insinga and Werle note, a real risk is in losing the strategic intent of outsourcing in the day-to-day hustle and bustle of the organization’s operations. “At this level,” they point out, “the dominant success metric of outsourcing becomes lower cost, period. As such, the stage is set for classic sub-optimization at its worst.” To avoid losing sight of the strategic intent, therefore, it is important to institutionalize a robust decision-making process during the course of the outsourcing relationship that hard-wires the operations to the strategic.

About the Author

Denis Chamberland is a partner with the law firm of Gowling Lafleur Henderson LLP, where he is a member of the Technology, Corporate Finance, and Public M&A groups.