Transformational Outsourcing

Outsourcing isn’t what it used to be. When executives began outsourcing substantial portions of their operations more than a decade ago, they did it to offload activities they declared to be noncore in order to cut costs and improve strategic focus. Today, however, companies are looking outside for help for more fundamental reasons — to facilitate rapid organizational change, to launch new strategies and to reshape company boundaries. In doing so, they are engaging in transformational outsourcing: partnering with another company to achieve a rapid, substantial and sustainable improvement in enterprise-level performance.

This concept has gained some currency recently in the technology press.1 The media have reported, for example, about the many outsourcing vendors that are touting their work as transformational — even though in most cases it is not. Unfortunately, media hype just confuses executives about what the term means and how the approach works. Another red herring is the emphasis on technology as a means of achieving transformation through outsourcing; many technology manufacturers and consulting firms have made grand claims on technology’s behalf. But while new technologies are often needed, the defining factor in transformational outsourcing is executives’ commitment to use the approach to change their organizations.

Transformational outsourcing is an emerging practice, but the track record of companies that have engaged in it is impressive. In a study of 20 companies, 17 have been in place long enough to show results. Of that group, 13 have achieved dramatic, organization-level impact. (See “About the Research.”)
To the extent that other companies can replicate such success, transformational outsourcing will be a more effective way of improving performance than major internal change initiatives, mergers and acquisitions, or joint ventures. The key issue is new capabilities. In undertaking an internal initiative, a company has concluded that it lacks an important set of skills — otherwise it would not be seeking transformation. But it often proves too time-consuming to develop the skills internally. In an M&A scenario, the company acquires the capabilities it lacks, but cultural clashes often interfere with its ability to use them effectively. An acquiring company seldom, for example, puts executives from the acquired company in charge of its own organization in order to learn from them. Similar cultural impediments make it unlikely that a company will transform itself with the expertise it gains in a joint venture.

But transformational outsourcing places the power to bring new capabilities to the organization squarely in the hands of executives who have and value those capabilities. In other words, the outsourcing partner provides a management team that is experienced in the capability that the organization seeking change needs. And those executives are empowered by the outsourcing process to implement the practices they bring with them.

Not all transformational outsourcing initiatives are alike. It is possible to identify four broad categories from the research on 20 companies that have attempted the practice. (See “The Four Varieties of Transformational Outsourcing.”) Startups, stagnant businesses, those that have fallen from glory and others may all be well suited to a strategy that is based on out-sourcing to achieve radical change.

Scaling Up Fast: Ambitious Startups

It may seem odd to think of transforming something that hadn’t previously existed. And it’s true that such language doesn’t fit such startup businesses as the neighborhood pizza shop or corner dry cleaner. But certain kinds of businesses have much bigger appetites: They want to get an innovative new model to market first or to set an industry standard or to take on entrenched industry leaders. They fear they will be overtaken by larger companies with more market power if they move slowly. In order to launch and scale up rapidly, they need “big change fast” — and they can’t do that without help.

Consider TiVo Inc., the startup that launched what it called the personal video recorder in 1999. The technology allows users to record up to 80 hours of television and replay it at their convenience, without having to bother with digital storage media or arcane VCR programming codes. The system can even track down favorite shows despite schedule or even network changes.

The company’s goal was to take this new market by storm, but it couldn’t do it alone.2 TiVo’s leaders believed that speed was essential, so they turned to outsourcing. TiVo signed up such manufacturing and marketing partners as Sony Corp., Hughes Electronics Corp. and Royal Philips Electronics. The company outsourced distribution, manufacturing, the process of setting up retailers, public relations, advertising and customer support.

The way it outsourced customer support is particularly telling. Since TiVo’s product was an entirely new concept, the company knew it had to invest in helping each customer understand, install and use the technology in a way that specifically suited him or her. Ordinary call-center scripts and routine approaches wouldn’t do the job. TiVo needed distinctive customer support in force from the start.

TiVo therefore worked closely with a partner to establish processes and develop innovative training materials and incentives that would enable the customer-service agents to “think like a TiVo customer.” In addition, TiVo gave agents the product to use in their own homes. As a result, TiVo’s outsourced staff mastered the open-ended dialogues and investigative problem solving they needed to help customers. Using TiVo’s CRM application, they are able to feed a rich description of customer problems back to TiVo’s product-development and marketing organizations. Over time, they have cut the initial cost of support per subscriber by 94%.

The jury is still out on whether TiVo’s bid to take over the personal video recording market will work. While its sales have grown fivefold over the past year to almost $100 million, the company is not yet profitable, and competitors like Microsoft Corp. are salivating at the opportunity to join the feast. Whether TiVo will benefit from its first-mover lead is a question for its strategists. But it could never have executed its chosen strategy without relying on outsourcing.

Startups that seem to come from out of nowhere often use outsourcing to put well-oiled operations in place quickly and to pay for them “by the drink.” For example, TiVo pays its outsourcing provider for each call the contact center takes. In this way, a small but growing business gets the mature capabilities it needs to take on bigger, stronger competitors without having to spend scarce seed capital and scarcer management time building an organization from scratch. If the company takes off, it also has access to the outsourcing provider’s bench strength to support its growth. These advantages, however, come at a price. For example, the startup may spend more on processing customer orders than it would have if it hired its own staff. But when speed to market is pivotal, the benefits of flexible capacity and variable costs make outsourcing the right option.

Pathways to Growth: Crouching Tigers

Crouching tigers have big strategic aspirations that are being stymied by a deficiency in some key capability. The missing ingredient can be anything from marketing or product development to supply chain management or information technology, and crouching tigers need the hole plugged in order to grow. They want fast implementation just as ambitious startups do, but they want expertise even more. They do not necessarily want to reduce overall costs in their roadblocked function, but they do want to siphon spending out of tactical activities and direct it toward programs that will contribute to the strategy. They usually need access to new capital as well — either directly from the outsourcing provider or from a third-party financial partner that likes outsourcing’s risk profile.

Because the new capability must be tightly integrated into the tiger’s operation, such companies often prefer cosourcing rather than strict outsourcing. In other words, the provider takes over responsibility for the roadblocked function or process, but the retained employees remain on the tiger’s payroll. That puts the company in a better position to upgrade its internal capabilities and ultimately bring the operation back under its own control.

A good example of a crouching tiger that was transformed by outsourcing is Family Christian Stores Inc. (FCS). In 1992, when it was known as Family Bookstores, the company was an “under the radar” subsidiary within publishing giant News Corp. (Family Bookstores was owned by Zondervan, a subsidiary of HarperCollins Publishers, which was itself part of News Corp.) Les Dietzman, a retailing veteran with experience at Wal-Mart Stores Inc. and Dayton Hudson Corp., joined the organization to pursue a “higher mission.” He believed that the small Christian retailer could grow substantially under his leadership. By 1994, he had developed a vision for company growth, and he led a management buyout to get the authority to make it happen. At the time, Family Bookstores had 120 stores and $130 million in sales.

Dietzman believed that an absence of information technology was preventing rapid growth. In his mind, it was the foundation for everything he had to do: site selection, store management, supply chain management, pricing and management reporting. But Family Bookstores’ systems had been run by its parent company, and those systems were designed to meet the needs of a publishing company, not a retailer. To replace his publishing systems with a top-drawer, retail-oriented IT capability that would support the company’s growth would take an investment of $7 million — resources FCS did not have and, having not yet demonstrated its ability to grow, could not have borrowed easily from a traditional lender. So Dietzman turned to outsourcing.

He structured an innovative partnership with a provider that hired FCS’s existing IT staff and also recruited some new employees to take over the function. Under the provider’s leadership, the unit replaced every piece of hardware and software in the company over an 18-month period. It then operated, scaled up and improved IT support as the company expanded. Its leader sat on Les Dietzman’s executive staff and functioned as the company’s CIO.

The outsourcing provider also capitalized on its stature to help FCS pay for the IT transformation: It brought a financial partner into the deal that fronted the money for the project work, the software and the IT infrastructure. In turn, FCS paid off the $7 million loan over the seven years of the agreement with profits from increased sales — thus using its own growth to pay for the IT capability it needed. In the words of one executive, it was a “Cadillac deal for a reasonable price.”

How did Family Christian Stores fare? Today, it is the nation’s largest Christian retailer. It has grown from 120 to 330 stores, and its sales have tripled.

Crouching tigers are frequently small companies that rely on larger and more mature outsourcing providers for the skills they lack. But it can work the other way around as well. For example, in the pharmaceutical industry, many of the large companies that are facing empty product-development pipelines are turning to small biotech companies for drug discovery.

Catalyst of Change: Fallen Angels

Fallen angels are companies that have settled into the wrong performance trajectory and need strong action to change their tack. They use outsourcing to catalyze broad organizational change in the hope of regaining some of their past luster.

British Petroleum, now simply BP Plc, fits into this category. The company’s privatization had been completed in 1987, when the government sold its majority stake to the public, and rocky times followed. Between 1990 and 1992, BP eliminated more than 22,000 jobs, removed layers of management, slashed corporate headquarters staff and experienced its first financial loss in 80 years.

At that time John Browne led BP’s upstream oil-exploration business, BPX. According to one colleague, “He needed to shake up the organization to communicate that things were going to be radically different.” To redirect his organization, he cut staff and refocused capital expenditures in order to “spend less to find more.” In addition, he undid BPX’s hierarchical management structure and created separate business units, each with its own accountable executive. Instead of having control over only 40% of their spending, Browne’s autonomous “asset managers” had authority over 90% of their costs, and they had the freedom to do whatever it took to make money.

Browne also turned to outsourcing as a means of catalyzing change. He saw that finance and accounting were not areas in which BPX could create competitive advantage. In a bellwether deal, BPX consolidated all the accounting outposts that dotted its far-flung empire and outsourced the entire process. His immediate goal was to reduce costs by taking advantage of economies of scale, but his aspiration did not stop at the company’s borders. Browne reasoned that if he could get his competitors to use the shared service center too, his costs would improve even more.

And that’s just what happened. Ultimately six oil companies and several other services companies joined the North Sea finance and accounting center in Aberdeen, Scotland. Thanks to growing economies of scale, the center was able to reduce its prices for BPX and its other clients. By 1997, BPX had cut its finance and accounting costs in half, while its volume of work in those areas doubled, for a fourfold improvement in productivity.3

Unless it is done in a broader strategic context, the out-sourcing of noncore or no-longer-core activities is not transformational. It is an exercise in cost cutting, useful but not revolutionary. Within a broader context of change, however, it is an important part of the transformational agenda. Jettisoning such functions as finance and accounting sends a clear signal to the rest of the organization about where and how the company distinguishes itself. Just as surely as firing an executive who fails to meet his numbers, these actions help employees understand how to manage operations that don’t create advantage.

Fallen angels often look for other benefits from outsourcing. They can get clean, visible management information, for example, as Thomas Cook UK and Ireland did when its finance and accounting provider standardized processes that had been sprinkled across an organization built from acquisitions. For the first time, its leaders were able to see comprehensive performance results that were calculated consistently. In such cases, the senior team stops arguing about what operating margin “really” is because it is no longer in question. For the first time, they may be able to see which of their products or services are actually profitable. They can turn their attention to what they should do about it, while using financial slack to invest in innovation. And, unlike out-of-nowhere startups and crouching tigers, fallen angels are likely to keep outsourcing relationships in place over the long term because their costs and investment requirements remain lower than they would be if the companies were doing the work themselves. In addition, strong outsourcing partnerships can provide the fallen angel with a channel for innovation.

Radical Renewal: Born-Again Organizations

Organizations on the edge of survival need a radical renovation of critical processes and functions, and they don’t have many options. It’s not enough to catalyze change or clear away roadblocks to growth; they have to undertake end-to-end transformation to bring about a new life — to become born again, in effect. Outsourcing is one way to transplant the major organs while the patient is still ambulatory.

National Savings and Investments (NS&I), an agency of the British government, was an underperforming enterprise until it used outsourcing to redirect its trajectory. The agency’s role is to help fund the government through the sale of retail savings products, but by the mid-1990s, it was suffering from a consistent underinvestment in technology. In July 1996, when Peter Bareau took over as CEO, the organization was staffed with more than 4,200 civil servants who had an average tenure of some 20 years. Burdened with outdated legacy systems, NS&I had introduced only three new products in the past eight years. Bareau, an experienced banking leader who had come from Lloyd’s, described the challenge the agency faced: “If we didn’t dramatically lower costs, improve products, build a customer database so we could market better, change our image and add professional capabilities, our risk would grow and grow until there was no value left.”4

Customers had no trouble finding outlets to buy NS&I’s products — they were sold at the United Kingdom’s 19,000 post offices, for example. But the connection between the two government organizations was inefficient: The postal service transferred customer orders to the agency through a largely manual process, and as a result, 20 million of the agency’s 55 million annual transactions were not automated. And once a customer had made an initial purchase, it was not easy to make changes. Products and services were supported in three separate operational sites, but each site managed only one segment of the product line. For example, if a customer had invested in three or four products and wanted to transact some kind of business for each one, she would have to contact someone at each location, and she would likely have to conduct her inquiries through written correspondence since telephone support was minimal.

Facing a daunting challenge, Bareau and his team, with help from private-sector experts, set a new strategy for the organization. Mere survival was not the aspiration; instead, NS&I’s goal would be to leapfrog private-sector competitors in the personal savings market. A senior member of the team pointed out the depth of the challenge: “We didn’t have all the skills; we didn’t have the technology; and we were capital-constrained. It sounds perverse, but we even found it difficult to reduce staff numbers at the desired rate because we had limited financing available for redundancy payments. To succeed, we needed to transform the business very quickly in a way that was self-supporting.” Bareau and his team chose outsourcing as the only viable approach.

In December 1998, NS&I announced it would award a £635 million, 10-year contract to Newport Systems (not its real name). All of NS&I’s operations, customer service, technology and transactions processing, along with 4,153 largely unionized civil servants, would be outsourced to Newport, effective in April 1999. NS&I would retain 120 full-time civil servants on the payroll to handle strategy, marketing and product design and to manage the relationship with Newport.

For its part, Newport planned to implement an entirely new IT platform, including hardware, networks and software. It would transfer existing products to the new platform over the course of a year. At the same time, it would develop new products, implement new business processes, start call centers, train employees and keep the old systems running until all the migrations proved effective. In addition, Newport would be successful only if it could weld the NS&I staff who transferred into a team of committed, energetic employees.

Over the course of the next four years, Newport did indeed transform NS&I into an efficient, profitable operation. By the end of 2002, the organization had

• Delivered £176 million of added value from 2001 to 2002, against a goal of £120 million
• Reduced the staff by 50% through a combination of redeployment and voluntary release
• Introduced eight new or substantially improved products, at least one of which was the first of its type in the industry
• Established a single telephone number for sales and 24/7 service that allows customers to buy seven different products with a debit card over the phone
• Taken 1.7 million call-center calls in 2002, 90% of which were answered within 20 seconds by a person, not a machine
• Changed from an “isolationist, civil service culture” to a market-led culture

In its recent review of the initiative, the U.K.’s National Audit Office counseled both NS&I and Newport to remain vigilant in order to sustain and improve the benefits that had been achieved. But it congratulated the organization for delivering substantial savings to British taxpayers and summarized, “NS&I could not have achieved as much without [Newport].”5 Transformational outsourcing made possible the radical renewal that was needed to save the troubled agency from possible extinction.

Leadership Imperatives

Executives have to lead a transformational outsourcing initiative much differently from the way they would manage conventional outsourcing. Best practices for the latter include getting the best deal upfront, executing a smooth transition and using simple performance incentives. Some of these practices would actually undermine a transformational program. Instead of playing by rules that don’t apply, leaders of a transformation should consider the following advice:

Craft a business model, not a deal.

A good deal satisfies the parties the day it is signed. But the world starts to change the very next day, and even if the deal becomes less than ideal, the parties are often locked into the arrangement by the terms of the contract. Since transformational outsourcing focuses on producing change, not contracting to avoid it, its structure must be fluid. Partners in transformational outsourcing must design a business model that recognizes the dynamic process in which value is created over time. No one can predict all the changes that might take place, but a good model establishes structures and processes for taking advantage of change.

Striking a good deal relies on negotiating skill and situational leverage; crafting a good business model takes “whole of business” thinking. For example, when the state of Queensland in Australia outsourced all its IT activities in a single initiative, it evaluated potential partners not just on the cost savings they promised but also on their ability to drive economic development in the region. The resulting partnership generated far-reaching benefits for both the outsourcing provider and the state’s IT operations, while bringing in millions of dollars to the state’s economy.

Companies must also take care to identify the factors that could destroy value for both parties. When a large U.S. insurance company outsourced its IT infrastructure, executives assumed that the provider would be motivated to keep the technology up-to-date in order to continue to improve its own costs and profits. That turned out to be false: When the provider ran into earnings trouble, it valued short-term income so highly that even investments with a two-year payback looked unattractive. Executives seeking to transform their companies through outsourcing have to anticipate both the good and the bad that could develop in their engagement with partners.

Orchestrate a dynamic transition.

Most experts advise companies to aim for a smooth transition in outsourcing — the more invisible it is, the better. While appropriate for conventional outsourcing, that advice is not quite right for the transformational approach.

The leader’s role is to ensure that people in the organization recognize that the old ways have come to a stop. The reason for stopping must be compelling and proximate so the employees have no doubt that the results are worth the effort. In some cases, the motivation is organizational survival. As one executive explained, “What triggered us to transform? We were on the edge of the cliff, and everyone knew it.”

Stopping is important, but it’s only the start of change.6 For an organization to be effective, it must also be turned and restarted. Turning means establishing new expectations, new goals and new motivations. Vague statements about financial goals will not do the job. The leaders of both partners must help employees understand not only that things are going to be different, but also how they are going to be different. Employees who were buried in a company’s back office, for example, will instantly be in customer-facing positions when their function has been outsourced. Some may need coaching in order to master the new behaviors they will need to display to be effective in this new world.

Create momentum.

Just as in starting up a new business, the leader’s job is to get the flywheels spinning. To do that, leaders must create organizational momentum — a sense within the enterprise that the force behind the initiative is growing and that progress is accelerating. Leaders create momentum by orchestrating a continuing stream of meaningful accomplishments.

Effective executives kick off small, doable activities all over the organization to get things moving again. While training and setting organizational structure are important, they are not enough. Managers must focus on generating a pipeline of visible outputs, including products that make it into the marketplace. For example, NS&I’s provider started immediately to introduce new products that customers would buy. By doing so, it engineered a tangible accomplishment that marked a clear departure from the organization’s track record.

Manage the relationship like Chinese handcuffs.

No matter how clearly partners set expectations, define roles and specify outputs, there will be disputes — some of them quite acrimonious. When that happens, executives often adopt a “we versus they” adversarial approach and prepare to defend their terrain. Many pull out the contract in order to beat the other side over the head with it. In addition, a “miracles syndrome” makes this tendency even worse: Whenever executives pay for a service — even when they openly acknowledge they could not manage that service themselves — they immediately develop unrealistic expectations about what the provider can accomplish. When miracles fail to materialize, executives’ disappointment turns into recriminations, and the relationship slips into adversarial wrangling.

Leaders should manage their transformational outsourcing relationships like Chinese handcuffs, which go on easily but become tighter the harder one pulls at them. To stay on track for real change, CEOs move toward their partner, instead of away, and they coach their senior executive team to do the same. They open their books and their minds to other perspectives and their plans to creative joint solutions. NS&I, for example, outsourced operations and product development but retained the responsibility for product design. Executives found, however, that on its own the agency sometimes designed complex products that made it difficult for the partner to control costs. They resolved the problem by pulling closer, involving the partner’s development and operations experts in the early stages of product design.

Engineer commitment.

The conventional approaches to performance management in outsourcing are insufficient. Service-level agreements, penalty payments and even bonuses for overachievement provide incentives but do not inspire commitment. The last thing managers want are workers who are coin-operated. Psychological research shows that most people perform better when they internalize commitment and that most people internalize commitment better when external incentives are minimal.7 That is, people accept more responsibility for their behavior when they feel they have chosen their own course of action in the absence of strong outside pressures.

Instead of dangling big bonuses in front of individuals, executives get them to internalize their commitment. They describe their joint organization as elite and ask everyone to put his or her name and reputation on the line. They provide opportunities for partner employees to volunteer to meet challenging targets and recognize contributions when individuals excel. A simple approach — but one that works — can be seen in the case of an organization that holds contests about product knowledge between its own employees and those of its partner. By appealing to people’s natural sense of pride, the organization inspires commitment from everyone involved.

Finally, be careful what you wish for.

When transformational outsourcing programs fail, they do so not because of poor execution but because of errors in strategy. For example, the CEO of a large insurance company reasoned that his business would grow more quickly if it adopted new technologies and practices to make its independent sales force more effective. Lacking the skills to put those improvements in place, the company turned to an outside provider. Over the two years it took the provider to retool and retrain the agents, the industry changed — the most successful companies abandoned agents in favor of direct sales. The CEO had executed a transformation that took his company in the wrong direction.

Executives who turn to outsourcing for transformation actually get the new processes and systems they sign up for. It’s up to them to devise strategies that will take the company where it needs to go.

Fluid Change

As executives get more experience with outsourcing, they are learning the tool’s potential and beginning to wield it for more strategic purposes. Some will use it to shape and reshape their business models. Instead of massive, sweeping changes, many organizations will master the ability to use outsourcing to make continuous incremental improvements. But while the potential benefits are incontrovertible, the art of joining organizations with unique capabilities is extremely challenging and requires visionary leaders with strong hearts and a large capacity for hard work. By combining the tool’s execution effectiveness with their own growing skills in partnering, leaders who display those characteristics will have a practical and realistic road map at their disposal for building strategic flexibility.