How to Decide If Outsourcing Helps Your Strategy – The Financial Horseman

Deciding if you should explore outsourcing should start with your business strategy. Surprisingly, many businesses do not have an explicit statement of strategy and a set of initiatives that will realize it. When these businesses decide to pursue outsourcing it is with an idea that they will gain some advantage. These motivations may be from an exquisite gut knowledge of what carries their business toward a well-understood, but unwritten vision. A well-stated business strategy contains a set of strategic objectives that are then realized by strategic initiatives.

Written or closely held, strategy is the place to start with why and then what you outsource, and, ultimately, to whom you outsource. Let’s examine the 4 Horsemen of Outsourcing again and see how this can bolt into your strategic planning at the point of deciding how to realize your strategic objectives. We will start with the first Horseman:

The Financial Horseman

If your strategic initiatives have a financial element, evaluate outsourcing options against your strategic objectives. Consider any financial component of your strategic objectives. Outsourcing can result in more than reducing expenses with the result on operating margins. It can improve return-on-investment and return-on-assets by reducing investment and assets. Outsourcing can improve cash flow and directly improve income

1. Expense Reduction

Can you meet your expense reduction targets through outsourcing some or all supporting business functions? First-time buyers of outsourcing might see as much as 20% savings in an area like IT. Processes and services that are currently outsourced are not likely to see nearly as much of a savings (assuming you have a good working relationship now).

These savings are achieved from good service providers that have assembled services that are delivered with economy of scale as a key advantage. These economies exist from wide spread of capital, highly efficient operating models, and focused staff competencies. Generally, these economies are not practical for most companies to build and exploit. Managed service providers exploited them because these operating models are themselves center to their value chain.

Some service providers have built operating models that are highly adaptable to a client at the start of a contract. But to maintain a promised savings, they will lockdown the offerings and thereby restrict future flexibility. Were your business to remain static and predictable this may work, but with the current velocity of change in most economic climates these days, even 36 months or less of locked down service may reduce the savings or even increase costs simply from the lost flexibility during the contract period. As an example of a difference between service providers, consider the company that set a contract in 2012 for 8 years. Assume that contract to include a heavy server consolidation and virtualization program. 6 years later, in 2018, the costs for that in-house, non-cloud IT server farm are running high compared to the options associated with public cloud. The lesson is that you might be able to gain the benefits of a new outsourcing to the degree that technology and the marketplace have improved costs.

We will be addressing the different types of service providers, their advantages, and their limitations in another blog entry. Watch for it on our blog.

As some final advice for the cost savings motivation, be careful when it appears to be the only one. A singular focus on expense reduction can have negative consequences. Among them are a terrific constraint on any innovation streams that enable your business to stay current with your market peers, or even, potentially, the loss of a major competitive advantage due to business inflexibility. Watch for our blog on keeping innovation accessible in your outsourcing contract.

Expense reduction as a motivator should be fully visible on pro-forma profit and loss statements for the contract period; be sure to track the direct (hard) and indirect (soft) benefits during the contract, ensuring that the proposed savings are truly realized.

Do not forget to reduce detectable direct savings with the costs associated with vendor oversight and contract governance. Watch for those hard to anticipate costs associated with corporate environment disruptions. Comparative statements for the service contract period should indicate improvement in the expense line with related improvement in cash flow, profit, and margin.

2. Converting Capital Expense

Do you need to convert capital expense to an operating expense stream, one that is ultimately adjustable to the demand for your own products or services or some other driving variable? If you are already capital skinny in areas like IT that are supporting your main business, this motivation may not be enough by itself to drive you to outsourcing. For example, you are capital skinny if all your compute and storage is drawn from the public cloud.

Executing on this approach will require a service provider that is willing to “acquire” your current assets and either lease them back as part of the agreement, or dispose for you as they free up. Advantages arise when the business model of a type of service provider invokes a change in the way an asset is booked, used, depreciated, or disposed. There are some vendors that seem to have cracked the code on how to dispose of unwanted equipment at a profit.

Since your intention is to convert capital, there is, of course, the two-step conversion approach. First you procure services from a vendor that can provide services to those you are getting from your capital (e.g. facilities, servers, storage). The second step is simply disposing of your now-unneeded capital expense items (e.g. selling real estate or equipment) on your own. The test here is whether you want to perform the conversion transactions. In a complex set of transactions, you could have numerous transactions like a sale-leaseback of a data center as well as the outsourcing services contract. In any case, consider if you want to then manage and monitor the rents, leases, and maintenance yourself.

The biggest challenge in initiating this arrangement is agreeing on the basis for asset valuation, and terms for the subsequent purchase of the assets. For older assets that have been written down or completely written off, this will not be an issue. Where this can cause contention is when those more recent investments have a higher book value than what the vendor believes that they can offer. Hint: check the street value before you go into negotiations in this area, and insist on at least that value.

One caveat before making this your motivation: if some capital asset is core to your business make sure you consider the consequences of losing control of that asset. Also ensure that all your interests in that capital are reflected in the terms of your contract including service level agreements, access control, and decisions on maintenance and replacement that reflect the consequences for a service provider failing to be a proper fiduciary of your interests.

Finally, the process of converting capital expense to operating expense tends to reduce the actual expense reduction opportunity from a deal. There is a cost to conversion that is felt in the service provider’s total price. Be diligent to compare this to an option where you hand over no capital assets to the vendor but instead dispose of them yourself.

Capital expense conversion is generally detectable as a shift of assets off the balance sheet with a resulting elimination of depreciation and maintenance in the income sheet. The income sheet will show an increase due to the outsourcing contract. Theoretically, return-on-assets tends to be unaffected by this approach, BUT the likelihood of savings and pricing seen from competitive bidding can improve it nicely. In the absence of savings (see #1), profit margins may suffer except when high depreciation costs are avoided. And depending upon local accounting rules, a long-term contract may appear as a liability. So, make sure your lawyers are engaged with your financial accounting team during the evaluation of your outsourcing strategy and vendor offers.

3. Eliminating Capital Assets

Do you need to eliminate capital assets entirely? Outsourcing is a means to eliminating the assets when the service provider has the wherewithal to absorb or remission the assets. Examples include contracts that incorporate larger objectives of physical facility or real estate consolidation, or finer grain objectives such as compute and storage consolidation or virtualization.

Often the entire transaction will include some element of disposal cost, but often this entire component of an outsourcing transaction can eliminate capital better than simple asset disposal. Depending upon the financial capacities of the service provider, the recovery of costs from asset “elimination” can be rolled into the continuing services. As a result, there is an overall financial savings.
In some sense, this is like the capital conversion strategy. The difference comes when examination of the capital to be eliminated shows it to be unproductive or unneeded. By example, I (George) have seen over the years of rapidly advancing compute and storage virtualization, one company’s brand-new data-center stood only 25% occupied. Technology had overtaken a heavy server consolidation program while the new data-center was being built and new systems then relocated. The company now had a huge new data-center that cost millions more than it justified.

The resulting strategy was to outsource the IT environment with a contract that included the sale of the facility to the service provider. From the vendor point-of-view, buying the data-center was a requirement to “winning” the contract. Of course, there were other means of disposing of the data center. It could have been sold to a pure data-center company. But the opportunity for best price on the sale were where the buyer stood to gain business of their own.

Eliminating capital assets has some similarity in the financial statements to capital conversion. There is typically this elimination of unneeded assets, any reserve for maintenance, and the resulting elimination of depreciation. BUT, there is no offsetting increase in operating expense. Return-on-assets improves, and margin improves (from reduction in depreciation and maintenance).

4. Accessing Cash

Do you need cash? Outsourcing has been used to generate enormous amounts of cash. Consider the late 1992 strategic outsourcing contract between McDonnell-Douglas (MDC) and IBM. In mid-December of 1992, the US aircraft manufacturer and defense contractor entered into an outsourcing contract with the early IBM outsourcing unit, ISSC. The contract was initially worth about $3B USD for IBM. The arrangement was among the mega-deals of outsourcing’s early days and included all McDonnell-Douglas IT systems, processes, and operational staff except for the McDonnell-Douglas’ systems integration unit which MDC later sold off separately.

The transaction included a purchase by IBM for nearly $350M in McDonnell-Douglas IT and real estate assets used to provide the contract’s IT services. This was at the end of a year when the jet maker was going to have to take a $150M USD write-off for its C-17 program and when it was struggling to keep its MD-12 and MD-11 jumbo jet programs alive. The cash enabled the aerospace company to offset the write-off and maintain focus in 1993 on the jumbo jet program and several military jet programs including the C-17 cargo jet and the Hornet fighter aircraft. The transaction demonstrates that a financial motivation for outsourcing can be other than cost; in this case, it was cash.

The transaction enabled MDC to more than off-set the huge write-off with a huge cash sale of property. Assets left the balance sheet with a related out-year operating expense increase. The accounting treatment was complex with the mix of asset transfers, staff transfers, and office/IT equipment transfers. Some were treated as capital asset sale, some were as expense reduction. In the end, the financial shift for the company was so dramatic that the company moved off the precipice of bankruptcy to a place of improving fortunes; IBM held the facility during its contract with MDC and utilized it as a services delivery facility for multiple clients for several years.

MDC’s approach was a deliberate monetization of an entire supporting unit of McDonnell-Douglas. It was more than just a capital conversion process. It essentially exchanged an entire division and the services it provided to the rest of MDC for cash and a long-term IT service contract.

Summary

The financial motivations that drive towards outsourcing are not just cost savings. They can be elements of a complex financial strategy that incorporates several financial objectives. In our experience, cost savings is the easiest to envision and pursue. The others require a solid understanding of the corporate environment financials and company strategies – near-term and short-term. These approaches require the awareness and complete evaluation of a deal from a total cost perspective over time including commitments in the contract and the costs to wind-back the contract at the end. Make sure your financial people are fully engaged early; encourage them to evaluate all financial angles beyond the income statement including the effects on the balance sheet and the cash-flow statement. And make sure these objectives are well framed before you engage vendors. As you engage vendors, you will need to make sure that they have the means to bring to the table especially if they must bring in outside partnerships to meet your objectives.

In this blog series we are looking at breaking down the 4 Horsemen of Outsourcing. This was part 1 of 4 working through each of those major motivation groups. Stay tuned for close looks at the motivations coming from a need for capability, catalyzing change, and meeting geographic and timing needs beyond a business’ normal reach.