Some Reasons For and Against Contracting Out Business Functions
Yes, every person at some point in their life contracts out work that they could, if they wanted to, do themselves. Rotate tires on your car? Change oil? Auto shops. Yard work at your house? Hire gardening firms. Need to repair a sink, dish washer, broken pipe? You hire a plumber.
These are all examples of contracting out what you could do yourself. However, there is a very distinct difference in all but the last of these situations: they do not routinely occur.
The fact that what is being contracted out is NOT done on a routine basis is the best justification to contract out work. This is an important distinction.
Why is it happening? To appease Wall Street, companies in the sluggish U.S.
economy have resorted to a strategy of widespread cost-cutting as a way to
make their earnings look more attractive. Management's actions to reduce costs
quickly were predictable: Because employee salaries make up a significant percentage
of operating costs, replace those employees with cheaper offshore labor to
increase the profits.
However, like all over hyped management innovations, offshore outsourcing is bound to reach a short-term peak, especially in information technology. We have reached this conclusion by looking at the cycle followed by previous process-improvement innovations such as Total Quality Management, reengineering, and Six Sigma.
— Ravi Kalakota, Marcia Robinson. Article Feb. 27, 2004 on Informit.com
The last example mentioned above, the plumber, it is a function where, at times, specialized equipment is needed in order to accomplish the work. Maybe a hack saw, a torch to sweat solder, special gaskets, or ceramic patching materials, or even pipe cutters may be needed in order to accomplish a plumbing task let alone special fittings and adapters to join pipes together. They also have to know building codes to ensure that the work is lawfully approved by a government office. Some differentiators which helps a person decide in contracting out to someone else to do work for them is if you need to purchase equipment to do the work, need a specialized skill, as well as the frequency of use of this equipment/skill. If something is only used once every few years, and it costs $300 to purchase (and stored when not in use), is it worth having that item over the next 30 years and doing the work yourself or is it easier to pay someone to do the work for you knowing that they have all the equipment needed? (And of course time.)
In a forum a member was asking for examples in order to compare a professional woodworker building a desk, purchasing an ready made desk, and building a desk on your own as a comparison against hire someone to build a web site for you. The comparison would be pointing out why people should hire a web designer instead of doing it themselves. This is what I submitted:
To continue using your example of building your own desk versus purchasing an off the shelf versus having someone else build a custom desk to fit your needs.
Build your own: You must know about all different kinds of wood out there to choose the right one PLUS extra items - which one wears the best over time, the density of the wood, how well does it soak in stains, paint, preparation needs, will it withstand abuse or does it need extra protection in order to withstand the industrial wear.
Tools to not only do basic cuts but sand, paint, join the pieces. Dovetail? Do you need a plainer to take out the high points of the wood: Which router bit to use for the edges? Do you have the right one? Drill press to align the holes perfectly? Butt joins with brass screws, nails? carriage bolts, miter joints? Drill bits to match the screws? What to use on which part of the desk to ensure strength but not excess bulk? Are we building metric or SAE? How many trips to the hardware store before you get everything you need? How much time wasted going again and again to get what you need to finish. How many times in the future will you be using everything you bought? How much time do you have to learn how to use each tool correctly and in the right sequence before you start?
Will it fit? How much space will be "dead space" in your room since it may not fill up the space you allocated for it? Can it be moved elsewhere after assembled? If you need to expand can it easily be modified without breaking it to do what you need to have it accomplish now? Does it work the way you do or do you have to change your work to match the space it has? Is the fit and finish to your liking? Can it be sanded and repainted in the future? Particle wood or solid? Veneer? How well was it really constructed? Can it be returned? How much assembly required on your part?
Person who is building the desk does it day in and day out and knows and has all the tools needed to build it. Knows what wood will work best where and what kind of joints work best for what particular area. Can be designed to be expanded from the beginning as needs grow. Will work with the client to ensure the drawing and the mockup will suit what the person has in mind and matches what has been conveyed in words to the mental image the user has. Has worked enough to know what each portion of work really entails (time and materials) and the impact a seemingly simple change can make on the project. Has contacts in the field readily available to answer technical questions. Keeps up with changes and standards to ensure compliance with regulatory requirements and industry best practices. You are paying for their expertise so you do not have to become an expert yourself in a field you do not work in (or want to) full time.
From the above you should be able to substitute the appropriate software programming (or SEO!) tasks as a comparison of why to hire.
That is the essence of contracting out work.
In the above yard work sample the homeowner is the one who checks to see what is being paid for is really done to their satisfaction. If it is not then the people are called back to redo it or some other firm is hired. The burden of checking on the work, determining if what is being charged for the work is competitive, (competitive and having a reasonable price sometimes does not exist) handling the payment is all done by the homeowner. There is no one to delegate it to.
In a business environment there are many more people involved when contracting out.
When a business decides to contract out various functions and they do a cost study many companies completely ignore the "soft" costs of hiring outside firms when doing their analysis.
Contracts have to be created and reviewed (lawyers), designated people have to review the work they are doing on a regular basis to ensure they really are doing the work requested. Purchasing has to be involved to pay them, expenses or requests not specifically covered in the contract has to be approved and then acquired (and that means people have to review the request and go about getting the materials needed). All of these are rarely mentioned when someone suggests that a function be contracted out. Each of these requires people time — money — to accomplish.
What is also never mentioned is the cost of losing expertise when a function is out-sourced. How can a person who has never done X accurately judge if the contractee is doing a good job?
Decades ago almost every job had a progression. You started out at the lowest rung of any job then "learned the ropes" and progressed up in pay, knowledge and responsibility (unless the "Peter Principle" kicked in.). Thus, if a person was in charge of X they would have had all the prior knowledge of performing X from when they were the workers. If, as managers, they kept aware of what the people below them were doing and how things have changed, then they were able to tell if X was being done correctly. This "institutional knowledge" all disappears after 10 years of contracting out any technical function.
In other cases, a project can come in to spec but still be way off the
mark. This isn't a problem specific to offshoring, but to outsourcing in general.
— Patrick Meader. Article in February 2004 on Visual Studio's web site
Why is it happening? To appease Wall Street, companies in the sluggish U.S. economy have resorted to a strategy of widespread cost-cutting as a way to make their earnings look more attractive. Management's actions to reduce costs quickly were predictable: Because employee salaries make up a significant percentage of operating costs, replace those employees with cheaper offshore labor to increase the profits.
The real costs of going offshore
Software 2004 "offshoring" panel March 8, 2004, 10:50 AM PT 44 minutes 55 seconds on ZDNET.COM. "Offshoring" is the term du jour, but the process it describes is complicated and riddled with pitfalls. At the SandHill Group's Software 2004 conference in San Francisco, a panel of senior executives share their experiences and warn that the total costs of ownership can be higher than expected.
When a technical function is performed by a contractor and the contractor is changed to a different one for any variety of reasons how are the workers retained?
Sometimes the new contractor is forced to hire the old contract workers at a higher pay. Why? The new contract will require them to have a staff of knowledgeable workers. The most knowledgeable ones are the ones who were doing the job before contractors were switched. Thus, even if the new contract is cheaper than the old one, but the same people had to be hired at more pay, which means less people have to be working in order for the contractor to make money.
This also means that unless precise figures on response times to fix (or even recognize) a problem, staffing levels desired (and needed) plus myriad other issues have to be precisely detailed out way in advance in the written contract or else the contractee will suffer. The contractor is going to do exactly what is in the contract and nothing more unless they are paid extra (which also has to be detailed out in the contract.). Of course the people who would know how to write the contract correctly to come up with the precise figures no longer exist at the company! No one has done that function there for years so people doing the writing have no clue as to what the job really entails and so the contractor has the upper hand.
Governments have always contracted out various functions throughout history. Living in the United States, and being a Federal Government employee means that I am more familiar with U.S. contracting history than other nations, however history is replete with examples.
In ancient times whole armies were contracted out. Professional soldiers were hired to either fight for or supplement a nations ability to wage war. Better known examples exist from the Middle Ages. The Swiss Pikemen were known for their battle prowess and were hired by most every nation in Europe at one time or another. Germany, France, Italy plus others tried to take take over Switzerland and were repulsed . Now, once the Swiss had won their permanent freedom, the Swiss has a great army and no one whom they wanted to attack and no one whom wanted to attack them (Attacking uphill in narrow valley that cannot be flanked is not very conducive to middle age calvary or infantry tactics. Still is true today.) So the Swiss hired themselves out fighting for nations as mercenaries. (At one point during the late middle ages whole groups of mercenaries were wandering around France, Germany, Italy, terrorizing both people involved in the wars and when not employed taking and sacking towns for profit.) The US Revolutionary war has Hession (German) soldiers fighting for the British. Even in fairly modern times mercenaries - - also known as "Soliders of Fortune" are paid to fight when a government does not have enough professional soliders of their own.
Most governments, however, have much more mundane reasons to contract out (in no particular order).
This is a very valid reason. A new project needs to be accomplished in a very niche field and that skill has never been seen as needing people full time in the Government to accomplish it due to its rarity. If the need is new, and it needs to occur continuously without ever ending, then having this contracted out until skilled people are hired and trained is valid. Then the contract should end.
This is harder to accomplish in modern times than before. New rules (which increase the cost to the Government by the way) is to prevent appointed or salaried workers to steer government contracts to specific firms as a reward for supporting a politician is much more difficult. This reward varies widely by country. In many "Third World" counties this is still normal operating procedures. Dictatorships and countries that do not have a strong troika set of Government branches it also occurs regularly. In the USA it is very difficult (thought not impossible) to ensure a firm gets Government contracts as a reward for prior or future political help.
This is a very nebulous area. Currying favor of voters is never a sure or lasting gambit for any politician. Contacting out is a way of telling voters that a politician is "shrinking" the size of Government. In every case (as far as the USA styled government are concerned) it is shrinking of DIRECT employment of people by the Federal / State / Country / City government. The actual number of people working is always higher but Government officials only report the number of people directly paid by the government and do not count the workers doing work via service contracts. Thus they buy votes by giving out selected statistics of number of workers. (Which is a very valid debating tactic. This means, of course, that "the people" have to know of this tactic and have to ask how many people are working under all service contracts.) This is very prevalent in the Federal Government.
The best examples of valid reasons to contract out specific tasks can be seen by using the example of the US Federal Government when it contracted out to build dams in the 1930s, 40s, 50s, and 60s. The skill needed is very specific, there is no need to continuously hire people in perpetuity and train them in building dams on the public payroll (finite life of project; however there is a need to perpetually maintain and run them). The Great Depression started in 1929 so hiring outside firms was both politically reasonable (do not want to hire more employees and tell the nation that 50,000 more Federal employees were hired when no money is coming in to pay for them) and thus easier to contract out the work to firms who could build dams but it had a secondary desire to help stimulate the economy.
Now that is what the macro economics people always tell anyone why contracting out is so much better. You have to also look into all the items that are NOT mentioned.
The Government, in order to be fair, sets wages nationally. (Within the last 25 years or so they do adjust pay to compensate employees for local more expensive areas to live, but they never LOWER wages where it is cheaper than the what the average cost has been calculated at.) A private firm can set wages at the minimum level people are willing to come to work. In the middle of the Great Depression people will work at any price. Thus, these firms could pay people $5.00 a day and people would be happy to work. A Federal employee, if the government actually hired people to do the job, would be paid $10 a day (exaggeration, I have no idea what a Federal day laborer type person made in 1935. But the ratio would be quite accurate). There is also no medical benefits, retirement, leave or anything that is built into the private pay that IS there for the Federal worker. Thus, the job is accomplished at a lower cost and when it ends it does not have to fire workers or find other work for them to do which what would happen if they were directly employed by the Government. The Government, also in order to be fair, has to follow specific rules before doing a RIF - Reduction In Force. Which is the same as laying off people. In the 1930s the Government did not care if the workers are being exploited due to the depression crisis. It was trying to get people back to work and thus get more money in circulation and consumer consumption going again.
Now if a Federal worker was doing the job there would have been more more money spent to build any dam since they were paid more. However, the cost of construction would have also gone up lots more than just pay again due to rules governing overtime, leave, administration, and personnel in general. All the rules in the US Federal Government is there to prevent exploitation of workers and to prevent the people in charge of stealing, favoritism in awarding contracts, jobs and so forth. Thus, by trying to ensure fairness the cost of doing ANYTHING is always higher than the private sector.
The private sector can do pretty much anything in who they hire, fire, give contracts to, promote, demote, pay (up or down) and be legal when doing so.
But this being a "one time job" the need to go though all the expense to get people hired and then have to fire them a few years later is just not worth it.
The US Federal Government has really strange accounting. If you read the above comments on personnel you can see why: accounting rules are there to prevent fraud, theft, track flow of funds (trying to hold an office title holder accountable for where the money came from and went) but mainly to allow others to audit and see if people are following the rules.
Computers have allowed them to micro-manage funds down to the paperclip level and so, of course, they do.
The Federal government though has two pots of money. Capital and Expense. Unlike regular people who have a checking account and pay all bills out of it and manage money dynamically, the Federal system assigns money to one of these two accounts:
Capital: tangible goods above a certain dollar amount which usually means buildings and equipment of large dollar values
Expense: everything else.
If you run out of money in one account you cannot move money from the other to continue on. If you expect to replace a building but do not, the money that was allocated for it has to be returned to the general fund. But if you had to buy more goods in the course of doing your job that year and "ran out" in the expense account you cannot move money from capital account where millions are not going to be used to expense to cover for it.
Now also if you do not spend all your money in both categories in any one year congress will then CUT your budget down to what you actually spent. This means that if in one year you were expecting X to happen and it did not, the next year your budget is sliced by that X amount and when X happens now you have to plead to get more money from congress to cover it. And of course they will not since the budget is set in advance for the current fiscal year! Thus now you have to go back and justify why you need X amount of dollars to fix X! Never mind that the money was returned the prior year because X happened later than what you thought.
This means at the end of any fiscal year Federal agencies will spend EVERY DOLLAR they have in their budget since it they do not their budget goes down by that amount for the next year - - there is no incentive to save money since the next year they might need to have those "spare" dollars for either a long term project, a purchase is coming up during the next year, or crisis that periodically happens to any business. And government is a business.
The Federal work force has shrunk. Been documented to have gone down every year since the end of the Vietnam war. What is NOT stated that the numbers only reflect DIRECTLY HIRED people. People that are hired and paid directly by the Government. People paid by contract - in the expense account budget - are NOT counted.
Inside the expense category is where money is tracked for employee salary and benefits. However, any contract for any service are all lumped into the same services expense category. Thus, paying $996,000 for a contract to study a landfill project that actually employs 10 people is counted as the same type of expense as paying $996,000 to the city landfill. The 10 people in that study are NOT counted as being employed by the Federal Government!
Now what happens when whole FUNCTIONS are contracted out year after year after year? The money is all thrown into an expense category and none of those people who are doing that function are ever counted as being employed by the Federal Government. Even though they are now doing a function FOR the Federal Government that will NEVER END. Payroll shows that less money is being spent by that agency so everyone in power is happy. But the expenses is still the same - or higher. The number of FEDERAL people employed by the agency is what is advertised and reported up the chain so the politicians are all happy.
In the November 4th, 2003 issue of the Oregonian it was reported that BLM contracted out a study to a firm to figure out how to manage Steens National Refuge. They reported that the agency did not have the budget to do it themselves so they awarded a contract of $900,000+ to an outside firm. Think about this. They had no money to do the study in-house but they had $900,000 to pay someone else to do it. Where did that money come from!!!!???? Ah, accounting tricks. This money was budgeted that in expenses OUTSIDE of payroll. All Government agencies have a limit on the FTEs - Full Time Equivalent - - i.e.: the maximum number of people allowed to be in that agency but there is NO LIMIT to the number of people they can contract out for. Thus, this agency is FORCED to spend money on an outside firm to do what they normally do due to political limitations on the number of people they can directly hire into the Federal Government.
What is NOT mentioned is who supervises the work these outside people do? How do they know they are doing a good job? How do they ensure what is being done is really wanted done? They have to hire people that do nothing but supervise and review all the outside contractors. Now the contractors have their own supervisors so now you have TWO sets of managers overlooking the same people to ensure what was asked for is done. Remember, the government runs on checks and balances and you cannot give all the responsibility and control to a SINGLE person since that can lead to fraud, waste, favoritism etc. So you have to have multiple people watching and reviewing.
Also, unless something is specially named in a contract IT WILL NOT BE DONE.
If you are at work on a project and your boss comes along and says "we need to add X" into this you say "okay, will take an extra week" he says okay and you go on. But, when contracted out the firm will say "X?" Well we have to renegotiate the contract and get paid X more to add that in. Oh, and yes, we need another person to do that so you have to add X more dollars to cover the salary also add that into the contract since we did not initially hire anyone with that skill. Oh, and BTW this means we will need another supervisor since that puts the ratio of workers to supervisors out of spec that was in the contract" and so on.
You also have to have on board people to write the contract in the first place and still others negotiate the terms with them.
On CNET News.com site on March 4, 2005 the published a review
of Garter reserarch report which stated that contracting
out services cost more than doing them "in house".
"Gartner also said 80 percent of organizations that outsource their customer management operations purely to cut costs will fail to do so, while 60 percent of those who outsource parts of the customer-facing process will have to deal with customer defections and hidden costs that outweigh any potential savings offered by outsourcing."
With any function contracted out the skill to do that in-house is also gone. Initially the people watching over the contract will have the skill to understand what is going on and ensure that what is being asked for is being done. But, over time, since no one IN government is doing that job, eventually you will get to the point that no one in-house has any idea if what is being done is being done correct or not! The skills learned from doing that function "from the ground floor" is no longer there in-house. Someone would have to be hired from outside who knows about X in order to know if the contractor is really doing the job correctly. Now how often would a manager tell his boss that they must hire a new person to supervise contractors under him since he nor anyone else in his department knows what they do is really valid or not?
Course this is when you contract out to management firms to manage the contracts you have contracted out.
As of 8 March 2005.