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Managing Risk to Maximize Value in Business Process Outsourcing: A Process Oriented Approach

Apr 06, 200512 mins
CSO and CISOData and Information Security

By Deepa Mani

Anitesh Barua

Prabhudev Konana

Andrew B. Whinston

Department of Management Science & Information Systems

Creating Value through Business Process Outsourcing

The past decade has seen the rapid growth of Business Process Outsourcing (BPO) as a key operational driver for cost savings, productivity increases, and competitive differentiation. As the scope of BPO has expanded to include a wide range of organizations and industries, so has its use and objectives. BPO is fast gaining ground as a powerful organizational lever used to achieve a diverse set of tactical and strategic business objectives, including increased revenue, reduced time to market, and organizational transformation.

Despite its increasing popularity in the management toolkit, BPO is still an evolving phenomenon of which much remains to be understood. The variety of relationship structures that characterize the modern BPO landscape, while illustrative of the market’s maturity and BPO’s fit with diverse organizational objectives, also emphasize the difficulty in supplier choice and the idiosyncratic challenges that user firms face during design and management of a BPO relationship. It is imperative that a BPO relationship be aligned with the user firm’s unique business context. Further, sustainable gains from BPO can be realized only through active, ongoing management of the BPO relationship. This is emphasized by the dynamic business environment that characterizes modern firms. As the competitive strategy of the outsourcing firm evolves in anticipation of shifts in environmental factors, the outsourced process also changes to align with the new competitive balance, highlighting the need for flexible and adaptive outsourced task environments.

Researchers at the McCombs School of Business are working on empirical studies (“Global Sourcing and Value Chain Unbundling”, “An Empirical Analysis of Information Processing Requirements in BPO Relationships”) that investigate key decision variables in the choice of BPO relationship structure and form. They argue that the primary questions that managers must address to design and effectively manage a BPO relationship include the following:

  • What are the unique operational risks and challenges associated with outsourcing a particular business process? What demands does the outsourced process place on agent capabilities?
  • What governance model will help the firm address these challenges and architect a sustainable relationship that meets its outsourcing objectives?

These questions reflect the need to gain a deeper understanding of operational difficulties associated with outsourcing, and the importance of creating efficient contracts and relationship structures, including information resources and capabilities that enable execution and ongoing management of BPO relationships. Strategic BPO spells change in the way a firm does business. A fine-grained response to these questions enables managers to form a more accurate opinion of the level of complexity and change management effort required to transition to an outsourcing model.

Sidebar: Merrill plays it right with BPO

One of Merrill Lynch’s largest outsourcing initiatives comprised the complex restructuring of its wealth management workstation platform designed to provide the firm’s financial advisers an efficient, fully integrated desktop that incorporates market data, financial planning tools and CRM capabilities (CIO Magazine, September 15, 2003).

Executives at Merrill argued that the integration effort would reduce the cost of equipping financial advisers with better, faster information, and raise the cost of entry of being a financial advisory firm, thereby generating competitive advantage. The outsourced process was strategically important and marked by strong interdependencies with other organizational processes. There also existed interdependencies between components of the outsourced process. Merrill adopted a partnership approach to its outsourcing strategy. It tested competing vendor capabilities before narrowing down Thomson Financial as its solution partner.

Thomson Financial coordinates a variety of sub-contractors such as Dell, HP, AT&T, etc. for this project. Given the strategic importance of the process, the contract with Thomson provides for flexibility to adapt to changing business, process and user needs. Also, the contract, in addition to specifying SLAs and performance bonuses, links compensation to measures of customer satisfaction. The contract is supplemented by a tight relational association between Merrill and Thomson. The project involves frequent interaction and communication between the firms, and is marked by the sponsorship and participation of senior management at both firms. On the operational front, the process is owned by both firms, and employees work in tandem under the guidance of Merrill’s managers.

Senior management asserts that this partnership model, involving shared responsibility for the success of the platform, is central to realizing expected benefits from the project. It might be too early to judge whether Merrill’s approach to strategic outsourcing has paid off.

However, commenting on the status of the project, which entered the user acceptance phase in early 2004, Merrill’s CTO, John Killeen, remarked in an interview with Wall Street & Technology: “We are making the right progress…The fact that we have something that we can put in front of the Financial Advisers and we’re in our user acceptance testing – it all bodes well”.

Focus on the Process

Outsourcing managers and providers often design a BPO relationship based on broad outsourcing objectives such as cost reduction to the exclusion of important operational parameters. A closer look at characteristics of the outsourced business process is central to identification of procedural issues in management of the BPO relationship. It helps managers form an accurate picture of information requirements and operational risks in the relationship, which ultimately influences the design of efficient governance models. A business process is embedded within an organizational context including the industry in which the firm competes. Therefore, although a business process may enjoy similar functionality across firms, the process attributes described below will likely differ across firms, thereby influencing the choice of outsourcing contract and relationship form.

Process Interdependence: The level of interdependence between the outsourced business process and other organizational processes influences disaggregation of the process into coherent tasks and consequent modular design of the BPO relationship. In such case, uncertainty and contingencies in the outsourced transaction environment impact the functionality of other processes in the core organization and vice versa. Therefore, such processes require investments in technology and capabilities that facilitate frequent communication and interaction between the outsourcing firm and the provider. Further, the lack of modular design and standard interfaces between the provider and the core organization introduce the risks of strategic information loss and costly process integration. Finally, process interdependence determines the number of internal stakeholders and sponsorship involved in effectively transferring value from the outsourced task environment back to the organization, and consequent chains of command in the BPO relationship. An interactive television and service provider outsourced its telephone-based technical support to a telecom firm. However, the tight linkages between technical support and other customer care departments such as billing resulted in large communication and coordination costs that led to operational inefficiencies. Further, the lack of shared ownership of all interdependent dimensions of the process adversely affected customer value. Consequently, the firm rescinded its contract. The subsequent BPO relationship that the user firm architected was characterized by an integrated communications infrastructure that allowed the provider to take ownership of the user firm’s customers. The provider was responsible for all dimensions of customer care including billing, connectivity, usage, and technical support. Such reconfiguration in the relationship structure resulted in an increase in both, operational efficiency and customer satisfaction.

Process Volatility: Volatility in the outsourced process is defined by the variability in inputs and outputs to the process as well as diversity of work practices used to transform inputs to outputs. It usually stems from uncertainty in the business environment and shifts in the firm’s competitive strategy that responds to such uncertainty. For example, a mobile service provider who frequently introduces innovative services in line with volatile shifts in consumer preferences and competitor actions will require corresponding changes in its billing process. If such process is outsourced, the BPO relationship must be flexible and adaptive to accommodate such volatility in the transaction environment. Also, volatility in the outsourced process precludes a clear definition of operational objectives, metrics and service standards in the outsourcing contract. This, in turn, results in higher costs of coordination, adaptation and performance evaluation.

Process Specificity: Specificity refers to the extent to which the outsourced business process is specific to the firm, and/or requires resources and skills that are specific to the firm. Business processes with high specificity entail significant learning costs since the provider has to acquire a deep understanding of process functionality, workflows and organizational context. These costs of learning and knowledge transfer are markedly higher if process knowledge is tacit and embodied in human capital. In such case, the intellectual assets in the process may be difficult to protect through formalized contracts and involve the risk of loss of strategic firm knowledge, human capital and competitive differentiation. Such processes may require collaborative relationships marked by joint ownership. For example, a manufacturing firm outsourced the development of its online supplier training module to a technology firm. The module and related capabilities were highly specific to the user firm. It was inefficient for the provider to assume ownership and risky for the user firm to abdicate ownership. Accordingly, the two firms formed a joint venture to successfully develop, enhance and maintain the application.

Strategic Impact: An important concept that binds the above process attributes is the strategic impact of the outsourced process. It is likely that a strategically important business process shares strong interdependencies with other business processes in the firm and is marked by relatively higher volatility and specificity. A process of strategic importance enables the company to provide a “fundamental customer benefit” and make a contribution to perceived customer value. Such processes in the firm are substantially superior to those of competitors and help the firm create new products, services and process improvements in the future. The risks associated with such information- and knowledge-intensive business processes include information poaching and loss of competitive advantage. This is especially pronounced if the provider services other clients in the same business domain as the outsourcing firm.

Designing the Right Partnership Structure

A holistic analysis of the above process attributes helps the user firm define the operational challenges and risks involved BPO. This, in turn, is necessary for identification of consonant provider capabilities and design of efficient governance models including the underlying contract and relational dimensions (See Figure 1). In this context, it is essential that there exist communication channels between risk assessment, provider selection, contract negotiation and relationship management teams in the firm. This ensures common knowledge of BPO needs, a more complete articulation of the value equation and the incorporation of appropriate levels of flexibility in the BPO relationship required to adapt to the needs of dynamic business models.

The first element of the governance model that addresses BPO risks is the outsourcing contract. An analysis of process attributes is essential to understanding the limits of the contract. For example, in the case of outsourced processes characterized by high levels of volatility and/or interdependencies, it will prove difficult to effectuate an arms length contract with clearly defined performance measures, service standards and associated penalties. In such case, relational contracts or an ad hoc collaborative approach to contracting that is incentivised and sustained by the future value of the relationship is more appropriate. This is also true of strategically important business processes where traditional outsourcing objectives such as cost efficiencies are supplanted by more strategic ones such as increased revenue, faster time to market, and organizational transformation. Given the impact of such processes on customer value, efforts must be made to link provider compensation to end user satisfaction. Further, the governing contract must be flexible and negotiable to adapt to changing business conditions and create a sustainable relationship. Also, in the case of strategic outsourcing, the provider must pay attention to process innovation and improvement, quality management, and enhance its competitive capabilities towards realizing the BPO vision. In such case, the actual contract which specifies the structure which companies must opt for – equity arrangement, revenue sharing, etc., must be complemented by the second element of the governance model – relationship management. The contractual emphasis of controlling uncertainty and protecting against risk shifts to the relational emphasis of managing uncertainty and incentivising the provider.

Relationship management, which refers to execution of the contract to specify the operational strategy and elements of day-to-day interactions between the firms, is relatively more difficult than contract development itself. Knowledge of process attributes helps to define the depth and breadth of the relationship. In complex process environments where outputs and desired behavior are not easily specified, contractual task allocations and specifications are negotiated and renegotiated frequently. Therefore, if the operational management of the outsourced process poses significant challenges, as indicated by its attributes, the provider should morph into a collaborative partner involved in the strategic vision for the BPO relationship. The outsourcing firm must experiment with incentives by investigating provider behavior that they propel, create and document shared principles that capture key business goals and guide interactions, and establish incentive structures that link outsourcing performance to intangible benefits such as recognition. Pure performance controls give way to coordination, joint action and commitment of outsourcing partners. Such relationship forms foster learning and knowledge transfer in strategic, specific business processes, engender trust between partners, and support flexible contracts and business models that are capable of evolving over time.

The Bottom Line

Strategic outsourcing involves a fundamental change in the way a firm does business. A holistic examination of attributes of the outsourced business process provides insights into the degree of change effort required to transition to an outsourcing model, and helps the outsourcing firm systematically execute a governance structure that delivers expected value from the BPO strategy.