In the last decade, companies have discovered that outsourcing some tasks to cheaper locations is one way to deliver efficiencies and cut costs. But the simple act of outsourcing to a lower cost base has evolved into a complex process that can inflict considerable damage if not dealt with in a sophisticated and scientific manner. The damage can range from not achieving the expected cost savings to losing control to a third party, particularly when a company’s more essential processes are outsourced.

Questions concerning which business processes should be outsourced and whether the outsourcing should be done onshore or offshore require careful financial and strategic consideration, says Ravi Aron, professor of operations and information management at Wharton. According to Aron, most companies — about 60% of those who outsource — focus only on cost savings, and many fail to achieve those savings in addition to not taking into account other opportunities that outsourcing offers.

Linking Outsourcing to Revenue

As with everything that is complex, the best way to ensure successful outsourcing is to ask the right questions, Aron says. Before outsourcing a business process, an executive should ask, “How much does this process — compared to other processes — contribute to our product’s being better than the competition’s product?”

Evaluating and ranking each business process for its contribution to creating value for customers and to capturing that value for the company is a central part of a model developed by Aron to help finance executives make outsourcing decisions. Called the Revenue Distance model — since it measures the distance between a process and revenue creation — the tool offers a simple way for executives to put a comparative valuation on each business process that is a candidate for outsourcing.

In other words, Revenue Distance captures the importance of a business process to the company. Those that are ranked high are critical for revenue generation and thus are best held close to home, and those that have low rankings could be, and perhaps should be, outsourced, explains Aron.

A finance executive following the Revenue Distance method should first rank every process that is a candidate for outsourcing on a 1 to 10 scale as though only one question existed — How much does this process contribute to creating value for my customer? (One is most important; ten is least.) Next, rank the process for its contribution to capturing that value for the company. Add up the two ranks, and the resulting number is the Revenue Distance of that process.

“The smaller the number, the lower is the distance of the process from the point where money is made — that is, the smaller the number, the more critical the process, and it should not be outsourced,” Aron says. “We say that processes with moderate to large revenue distance are very beneficial to outsourcing,” he adds.

The Revenue Distance model also recognizes that the relative importance of value creation and value capture will be different for different industries. For instance, a company in a nascent industry would rank processes that help in value creation very high. For mature industries such as retail, banking and hospitality, however, value capture will be more important than value creation. Apple Computer’s iPod, for example, depends on the success of value creation, says Aron. The company is good at product design, and as such will not consider outsourcing any of its design processes. However, it can outsource its value capture processes, such as retail and distribution management. On the other hand, for a company like Dell, whose competitive edge is the way it manages its supply chain, outsourcing distribution is not a good idea, he points out.

To accommodate business processes which rank disproportionately high in value creation and not in value capture, or vice versa, Aron says the values for the disproportionate side should be weighted to prevent a skew in results.

Keeping It In-house at a High Cost

Not only will this exercise allow finance executives to determine what should be outsourced, but it will also reveal those processes that a company keeps in-house at a very high cost. Some of these processes enable the creation of value but are not crucial to beating the competition, Aron notes. For instance, in a financial services company that originates home loans, the processes of documentation, loan servicing, etc., are necessary parts of the business, but are not the differentiators which help it achieve a competitive edge. Therefore, such processes could be outsourced, explains Aron.

Very often, the Revenue Distance exercise reveals that more than 50% of business processes in a corporation are responsible for creating less than 25% of value, and that a handful of processes create a high percentage of value, he says. Thus, by keeping the majority of the low-value processes in-house, the company could be leaving a lot of money on the table as well as wasting managerial time and talent.

Aron gives the example of a large financial services company that had been outsourcing without going through the Revenue Distance exercise. It found that some processes were working out well, while others were prone to repeated and costly breakdown. However, after applying the Revenue Distance model, the company discovered that three out of the ten processes they were outsourcing abroad were not good candidates for outsourcing. Also, the company also found a number of other processes that should have been outsourced and have since reworked their outsourcing strategy.  

The Need for a Disciplined Approach

Using sophisticated tools such as Revenue Distance has become critical as companies now outsource not only information technology-related processes but also business processes. In fact, the most important trend in business process outsourcing in the last five years is that corporations have realized it is not a practical operations decision, but a highly strategic decision, he notes. “Depending on the scope and nature of the engagement there are several different people involved in the decision making. Very often it is at the highest level — the chief financial officer or even the chief executive officer.”

The trend has emerged for a number of reasons, including the recognition that outsourcing can now have a direct impact on business line objective. The strategic intent behind outsourcing has changed too. It used to be cost savings, but there are other virtues that companies try to harvest from outsourcing, including increased operational flexibility, says Aron. Also, there is the cost-quality frontier which favors one location more than the other: If a retail bank, for instance, is looking to lower transaction errors, it will be more cost effective to set up a shop in India, China or the Philippines where it could be staffed by workers with master’s degrees and financial or accounting backgrounds more easily than in the U.S.

Despite the increasing critical nature of outsourcing, only in the last two years have some discipline and formal rigor been brought into the process, Aron notes. The most common metric used is called a “zero one” approach which eliminates a process from outsourcing that could potentially cause the company to lose significant revenues if something were to go wrong. This model, however, results in several necessary but non-critical processes being kept in-house, leading to a big waste of managerial time and talent. The Revenue Distance model provides a concrete methodology for not only identifying what business processes can be outsourced, but also what is the cost of keeping them in-house, he notes.

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