Procurement Outsourcing: Right for You?

Finding the answer requires an honest assessment of your internal capabilities vs. those of external service providers. If procurement outsourcing is right for you, there's a right way to go about it. This article is based upon the multiphase research study Outsourcing Strategically for Sustainable Competitive Advantage, conducted by the Center for Advanced Purchasing Studies (CAPSResearch).

By Joseph R. Carter, William J. Markham, and Robert M. Monczka -- Supply Chain Management Review, 5/1/2007

• Procurement at a Turning Point?
• Status of Procurement Outsourcing
• Developing a Strategic Prescriptive Model
• Identifying Good Outsourcing Practices
• Addressing the Execution Issues
• Challenge Existing Model

Outsourcing is a widespread practice in business today — and will continue to grow into the future. The reasons for and approaches toward outsourcing vary greatly from company to company. Some are doing so because of tactical considerations; they are outsourcing specific business functions such as accounts payable or customer service center operations to reduce costs. Others are taking a more strategic tack, including the outsourcing of sets of capital-intensive activities like manufacturing, distribution or IT, so as to grow without adding capital. Procter & Gamble took this approach when it decided to outsource manufacturing for some product lines to suppliers that had the capabilities in place to improve those products over time. Even more ambitious is the outsourcing of whole parts of the value chain to generate capital and create new options, as General Motors and Ford did by spinning off Delphi and Visteon, respectively.

This article offers perspectives on one often overlooked but potentially rewarding outsourcing option — the outsourcing of procurement activities. This is a strategic option and, as such, needs to be thought about strategically. To guide that process, this article examines five key issues that need to be addressed when considering procurement outsourcing:

• Evaluating the potential of procurement outsourcing.
• Developing a prescriptive model for successful outsourcing.
• Identifying good outsourcing strategy and practice.
• Exploring the range of procurement outsourcing options to gain advantage for your company.
• Addressing the execution issues.

The results of a major survey on procurement outsourcing conducted by the authors under the sponsorship of CAPS Research provide the basis for our discussion.

Clearly, significant differences exist between companies in terms of how procurement organizations support strategic business and technology objectives. In some organizations, procurement is deeply involved in the strategy-setting process; in others, the role is more limited and focused mainly on transaction activities. This parallels how organizations perceive procurement in general. Many still view the function in the traditional manner — as a transaction-oriented function that's a necessary cost of doing business. Far fewer see procurement as a generator of value to the business. Yet the leaders have convincingly demonstrated that this, in fact, is the case.

Many procurement organizations are approaching a turning point, similar to the situation faced by information technology departments several decades ago. More and more, the questions are being asked: What procurement-related activities are truly strategic to the business and should be kept in-house, strengthened, and built-upon? Conversely, what activities add little strategic value and are better accomplished by outsourcing specialists that can leverage their skills, expertise and sheer scale in a way that a single enterprise cannot?

Although outsourcing of procurement is not yet widespread, this and other research projects indicate that it is growing. How might this evolution proceed? The experience over the last 40 years in IT outsourcing can provide some valuable lessons learned.

In the 1970s and early 1980s, the broad availability of computing power seemed to hold great promise even as it created enormous competitive risks. At the time, IT was largely viewed as a significant competitive weapon that had to be fostered aggressively in house. But by the mid-1980s, that popular view of IT diverged rapidly, and three different paths or models for this function began to emerge:

• Develop into a strategic weapon.
• Become an internal utility.
• Transition to an outsourced service.

A combination of factors led different companies to pursue one or another of these paths. But in most cases, the IT executives had a strong influence on the path taken. They influenced their companies' decision-making processes based on their ability to demonstrate value and how well they were able to articulate a strategic role for the future. Similarly, today's chief procurement officers should strive to play a major role in determining the fate of their organizations.

With information technology, growth in outsourcing was triggered by the personal computer as small-scale computing came to strip away much of the traditional mystique from data processing. With procurement, a like trigger has yet to emerge — but there are some likely candidates. The increasing availability and power of internet tools, increased volume and quantity of information about supply needs and options, increasingly transparent market economics, global sourcing requiring in-depth country knowledge, and growth and capability of outsourcing firms...any one or a combination of these could well be the trigger that makes procurement outsourcing commonplace.

Alternately, the trigger could come about as a result of companies reaching a “tipping point” in their value chain structure. As a greater percentage of the value chain is outsourced and globalized, companies will be forced to rethink how they need to manage their portfolio of external supplier relationships going forward. Toyota is an example of a company that has done this successfully through internally driven approaches. As markets became global and hypercompetitive, Toyota was forced to manage through its Tier 1 supply partners into Tier 2, and in some cases, Tier 3 suppliers. The availability and ubiquitous nature of information exchange mechanisms that Toyota had in place allowed it to manage this complex supply network for strategic advantage. Other firms may have to consider using more external expertise.

What will the procurement organization look like in this new world? Exhibit 1 shows three potential paths, which parallel what happened in the IT space. The most rewarding path unfolds when the procurement organization takes on a “strategic weapon” role, combing the supply market for sources of customer-facing innovation and revenue generation and creating strategic cost advantage. (Dell and Cisco are examples of companies that have done this successfully.) Providing both strategic insight and technical capabilities to support their corporation's overall outsourcing decisions will be a key part of this equation.

For activities without a strategic impact (for instance, processing transactions or managing categories that have little influence on overall cost or customer satisfaction) the company could leverage an internal utility or adopt shared services approach that manages for optimal efficiency and cost. Under this option, the company still keeps the activities in-house, and relies on internal scale and scope to drive procurement effectiveness (vs. what might be available from procurement outsourcing providers).

Finally, in areas where the procurement organization adds no strategic value or the company lacks internal scale to operate at high levels of effectiveness, transitioning to an outsourced procurement service is the logical course.

What evidence of procurement outsourcing are we seeing?

As a part of the study Outsourcing Strategically for Sustainable Competitive Advantage, the authors asked 160 chief procurement officers (CPO's) to provide detail on the level of outsourcing for procurement and supply management across six main categories of expenditures: direct materials, MRO (maintenance, repair and operating supplies), indirect purchases, capital expenditures, services, and goods for resale. For each category, the CPO respondents were asked to indicate their company's current levels of procurement outsourcing and the expected levels within 18 months across three types of activities:

• Strategic procurement (category and commodity strategy, supplier selection).
• Supplier management (supplier assessment and evaluation, supplier development and supplier certification).
• Transaction processing (ordering, replenishment, payment and settlement, coding and catalog management and procurement information systems management).

The survey asked which specific activities they were currently outsourcing and which they planned to outsource within the next 18 months. The responses shown in Exhibit 2 confirm that procurement outsourcing is still not widespread. For example, MRO transaction processing is the most commonly outsourced procurement activity. Yet only 20 percent of companies currently outsource this activity, a figure projected to rise to just 33 percent 18 months out.

The percent of companies outsourcing procurement activities drops off significantly for categories tied more closely to the core of the business (that is, revenue linkages for direct materials and goods for resale, and business infrastructure for capital expenditures) and for strategic procurement and supplier management. In capital expenditures, for example, the current and projected outsourcing levels are mostly in the single digits.

Companies that have outsourced procurement activities reported that they had done so for a variety of reasons. These include to:

• Focus the procurement organization on important categories and higher value-added activities.
• Reduce costs of transaction processing.
• Tap into external category expertise and use the market leverage of the outsourcing provider.
• Reduce cycle time and improve sourcing efficiency.
• Gain access to information technology tools without major investment.
• Establish and develop minority suppliers.

Equally instructive, respondents cited a number of reasons for choosing not to pursue procurement outsourcing, such as:

• The company believes that procurement and supply management is a core competency.
• The company believes that the internal procurement function is performing at the same level as, or better than outsourcing alternatives.
• The company feels it has not done a particularly good job of managing procurement internally, yet does not want to risk giving its “mess” to someone on the outside.
• There are concerns over the risks involved in losing expertise and knowledge about the second- and third-tier supply markets.
• Lack of “outsourced supplier capability”
• The company is unwilling to give up control of /gains from future productivity initiatives in procurement.¹

There is no single right answer to the question of whether to outsource procurement. The reason: Every situation is different and every company will answer the critical questions surrounding outsourcing in different ways. Which procurement competencies are core? Which competencies are non-core? Should the company retain functions such as sourcing, supplier relationship management, and transaction processing or should these activities be outsourced? If the individual company determines that outsourcing is the answer, it then has to address another issue: Should the activity or activities be outsourced to a category-specific service provider, or a broad-based service provider that might be able to provide scale or other advantages?

In evaluating the outsourcing option, executive management in each company needs to assess the procurement organization and its activities against the company's broader needs and situation. Key questions to be asked in this regard include:

• How much value does procurement currently contribute to the business?
• What is it costing to deliver the current value contribution? What would it cost to increase that value by improving efficiency? What would it cost to attain world class levels?
• In what specific areas could an outside entity provide procurement services at a lower cost while increasing the value contribution over time?
• What are the risks of outsourcing procurement, and how can they be mitigated?
• Will the company lose competitive advantage and a core competency if procurement is outsourced?

If, based on the evaluation phase, the prospects for procurement outsourcing look positive, companies will need a structure for moving forward on the possibilities. Therefore, as a core part of our research project, the authors developed a prescriptive model to help guide companies toward superior results through the procurement outsourcing process. Drawing on our prior experience and research, we constructed an outsourcing model that incorporated three phases: strategy planning and analysis; contracting and relationship development; and implementation (see Exhibit 3).

We then identified 24 activities that related to the process of procurement outsourcing, and associate each with one of the three categories. We viewed these 24 activities as critical to achieving positive outsourcing results. The activities formed the basis for a series of questions in which the CPOs were asked to specifically rate the degree to which each activity contributed to achieving procurement outsourcing goals.

It's important to emphasize that the activities arrayed under each of the three phases are all closely interrelated and should be managed as an integrated group. Put another way, to be successful in your outsourcing initiatives you should not “cherry-pick” certain activities from the list. Although all the activities in the three phases play a role in performance, some make a greater contribution than others. The activities listed in bold in Exhibit 4 were ranked by respondents as having the greatest impact on performance, listed in order of relative degree of influence. Companies should give these activities within each phase special attention to ensure that they have sufficient staffing and funding, and are managed effectively.

For each of the phases in the three-phase model, CPO respondents also were asked to identify their best and worst case outsourcing experiences and to describe in their own words the most significant reasons for both. Representative verbatim comments provided by respondents. (In total we classified 70 positive outsourcing examples and 83 negative outsourcing examples into the three phases. In some cases, observations could not be classified because of insufficient information.)

Suggested best practices drawn from the verbatim responses and survey results are discussed below. In particular, we believe that to succeed in procurement outsourcing, firms must be effective in the following areas:

Strategy and Planning

• Cleary state and communicate the business case for procurement outsourcing. The business case must be based on fact-driven logic and internal alignment across functions and business units.
• Ensure that senior leadership at both the buyer and supplier companies provides ongoing support to the initiative.
• Establish and clearly communicate the scope of work, performance expectations, governance model, and project plan.
• Choose excellent suppliers and monitor their performance with appropriate measures.

Contracting and Relationship Development

• Select suppliers whose culture and philosophy are closely aligned with yours.
• Choose suppliers with proven performance capabilities — and can demonstrate that these capabilities will continue into the future.
• Establish clear roles, responsibilities, and measurements to track current and future productivity.
• Make excellent communication and trust a core component of all aspects of the relationship.

Implementation

• Put in place effective change management policies and procedures.
• Establish effective measures that closely track performance of both the outsourcing team and outsource partner in a way that makes both accountable for results.
• Formulate a transition strategy and detailed plan for moving the activities to the outside provider, ensuring that all necessary information is made available to the provider. Appropriate people from both buyer and supplier organizations need to drive continuous improvement with high levels of communication.

There is strong evidence that a company's performance on the factors included in the three-phase model directly affect the results achieved from procurement outsourcing. This is supported by advanced statistical analyses, which is available to readers in a detailed CAPS Research report that shows a significant relationships between performance factors in the three-phase model and the level of results achieved.² These findings are further reinforced by the CPO respondents' experience as documented in their own words.

Strategic planning and relationship development are essential building blocks to successful procurement outsourcing. But in the final analysis, the real measure of success is how well the initiative is implemented.

A major factor in successful execution entails enlisting the support and input from appropriate senior leaders from other parts of the organization. For example, the CFO should be concerned about ensuring appropriate risk mitigation strategies for the outsourcing effort. This is especially important as suppliers become more dispersed worldwide, often in low-cost and emerging countries. Other senior executives from research and development, engineering, manufacturing, logistics and so forth, also will be affected by procurement outsourcing. Their input must be solicited and they need to be kept abreast of ongoing developments.

Companies also must be aware of certain developments that may hinder the implementation process. For example, in outsourcing procurement of manufacturing parts, losing control over the cost and quality of second-tier supplier parts volume to an outsourced provider, while still doing business with the second-tier suppliers (which are first-tier in other areas), gives up leveraging opportunities.

In addition, procurement outsourcing may lead to a headcount reduction, another unsettling development. Further, the autonomy of functional units may be impacted by company-wide outsourcing strategies. Given the numerous functional areas that can be impacted in many ways, it is incumbent on firms to develop the best processes and involve the most appropriate people in planning the outsourcing strategy, establishing and managing the outsourced supply base, and implementing the outsourcing decisions.

Without the best processes, company-wide alignment, and management-supported implementation, companies will have difficulty surmounting the many barriers that can limit the procurement outsourcing effort. These barriers include, but are not limited to:

• Negative reaction to job loss at the local, regional, and even country level.
• Political responses limiting a company's competitiveness.
• Internal sabotage of outsourcing because of loss of status, prestige, headcount, and positions.
• Lack of measurable results.
• Perceived loss of core competency and increased risk.

Recognizing that these and other barriers exist, firms must establish at a strategic level the best processes and people to develop and implement procurement outsourcing strategies. Company leaders need to be fully engaged and aligned for the outsourcing initiative to be successful. Without these elements in place, the results will be less than desirable.

While tactical outsourcing of procurement activities will continue to generate benefits, the future will belong to companies that think and act strategically in this arena. Tactical outsourcing is a follow-the-leader approach; it is not a road to true competitive advantage. Strategic procurement outsourcing can create new ways to compete, and possibly even rewrite the rules for whole industries.

This article suggests clear opportunities from outsourcing a range of procurement activities and processes. But the biggest opportunities yet ahead come from thinking and acting more strategically about procurement outsourcing. To evaluate your company's position on the strategic spectrum, consider how well you're doing against this listing of generally accepted best practices. Specifically, does your company:

• Ensure that the executive committee, possibly up to the board of directors, regularly reviews strategic outsourcing options and decisions?
• Force itself to challenge and potentially significantly reduce its “core competency” space?
• Create business model (including supply chain) scenarios that differ radically from the current model?
• Scan for new technologies that could be a disruptive force on the current business model?
• Look for procurement outsourcing alternatives to create competitive tension with internal functions, operations, processes, and activities?
• Require regular competitive benchmarking of key operational, tactical, and business process activities?
• Investigate current and future new value contributions from supply markets?
• Focus on overall external value-adding capabilities of potential outsource partners (vs. just cost reduction)?
• Address supply network globalization from an outsourcing perspective?
• Link outsourcing strategy to business, technology, and industry rate of change?

To be successful in a fast-changing environment, companies need to challenge current business models. Procurement outsourcing is a prime example. By making the right decision regarding procurement outsourcing, companies can position themselves for market leadership and competitive success.