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Financial costs associated with business process outsourcing (BPO)

27 Comments · Business outsourcing

The financial costs associated with BPO are ongoing, as long as the project is active. Each project phase has predictable costs that can be forecasted, budgeted, monitored, and mitigated.

In addition to these phase-specific direct project costs, each BPO initiative has a variety of less obvious yet insidious hidden costs.

Project managers will do well to include these costs in their analyses because many initiatives accumulate unanticipated costs that can prove to be threatening to projects-and careers.

In the next section, the direct and hidden costs associated with each phase of a BPO project are examined. We also discuss mitigation tactics that can be used to control costs in each phase.

Phase 1: Analyze Opportunity
The first direct cost to consider in the analysis phase of the BPO Life Cycle is associated with the internal staff that will be enlisted to conduct the analysis. Organizations should use a team approach to identity and select BPO opportunities.

Organizing a BAT means that employees from diverse units will take time away from their normal duties to serve on the team. The time these individuals spend away from their normal dunes is a direct cost.

Costs associated with removing individuals from their normal job functions can be calculated in several ways.

One standard method is to count the hours spent on the BPO analysis for each BAT member (and anyone else they bring in on a transitory basis) and multiply this figure by the hourly wage for that individual.

The result of this calculation is then attributed to the BPO project. This approach is often referred to as transfer pricing. For instance, if the HR director is on the BAT and she has an hourly wage at $75, that figure would he multiplied by the number of hours she dedicated to the BPO analysis team (BAT).

The product of this calculation would be attributed to the BPO project. Project managers commonly use what is called a task based costing estimate to forecast personnel costs associated with a project.

This technique is commendable but may not tell the entire story. For instance, it is inevitable that BAT members will spend hours outside at their formal meetings thinking about BPO, analyzing opportunities in their minds, and talking with others informally about what the BAT is doing and learning.

These extra hours are usually not calculated and attributed to the project. A technique that can be used to account for this hidden cost is to apply a standard multiplier to the hours that are logged as officially attributable to the BPO project.

For instance, a person may spend one hour outside formal meetings working on the BPO project for every two hours spent in formal meetings.

A multiplier of 1.5 would capture that informal project time and provide a more realistic estimate of actual costs.

In general, a multiplier between 1.0 and 20 applied to formal meeting time is appropriate in estimating BAT member time spent on the BPO project during the analysis phase.
 
Another direct cost associated with the BPO analysis phase involves third-party professional support that may be required to assist the team.

BPO consultants, market research specialists, and change-management consultants are just some of the outside professionals the BAT may want to consider utilizing. This cost can be estimated at the beginning of the project using several heuristics, including:

? Prior BPO knowledge among BAT members and the organization as a whole
? Organizational history with BPO, reengineering, or other transformational change programs
? Top management support for BPO in the organization

The BAT member knowledge of BPO is a factor because lack of such background will usually require investment in outside support.

It is simply unrealistic to expect individuals with no BPO knowledge an experience to be effective BAT members.

Thus, training and preparation costs should be estimated. A good rule of thumb estimate is one week of person-time for each BAT member to read, review, and discuss what BPO is and how it can be utilized by the organization.

Organizational history with major change efforts can also reduce the costs of the BPO analysis. Firms that have such a history, whether with reengineering, TQM, or something else, will likely be better suited for the self-examination process that is required for effective BAT performance.

Prior history with transformational change, especially if such change had positive consequences, can ease the burden of the analysis process.

Individuals throughout the firm will be more willing to cooperate and work hard to analyze BPO opportunities it they believe that the process will result in positive changes.

Estimating the costs associated with a lack of history in transformational change will be a subjective affair. In general, the analysis phase cost estimates should include an extra week at BAT member time it the organization has no history with transformational change.

Top management support is critical to the success of any organizational transformation. Individuals enlisted to be members of the organization’s BAT must perceive that they are empowered to dedicate their time to the analysis process.

If top managers badger them about time spent away from their central duties, they will feel conflicted and the BPO analysis process is likely to take longer and be less effective.

Top managers must clear the space necessary for BAT members to undertake their analysis, while maintaining reasonable expectations about performance in their regular duties.

Hidden costs associated with the BPO analysis phase include those that rise from a lack of organizational capability to analyze the BPO opportunity. Reliance on third-party consultants to assist with the BPO analysis is common and in many cases recommended.

Nevertheless, overreliance on consultants can lead to additional project costs throughout the implementation, transition, and maintenance phases of the BPO initiative.

To avoid these hidden costs, BAT members and others should strive to learn as much as possible from the third-party professionals.

Failure to concentrate on organizational learning and building a knowledge base for managing BPO projects will lead to additional costs at some point in the project. Hence, the organization should seek to develop BPO champions within the organization.

These champions will be responsible ton absorbing, analyzing, communicating, and documenting knowledge gained from third parties and through the BAT’s internal research process.

The opportunity costs associated with the analysis phase-as with all phases of the BPO Life Cycle-center on employee time and organizational resources that could have been put to some other use.

Opportunity costs are notoriously difficult to measure. However, organizations should directly confront the issue of whether it makes sense to pursue BPO opportunities prior to and during the analysis phase.

At this point in the BPO Life Cycle, commitment is still relatively low and a decision to cut losses and exit the project would not be as difficult as later in the project. Beyond this point, it gets increasingly difficult to shut down the BPO initiative and accept the sunk costs.

Costs associated with the BPO analysis phase can be mitigated through a variety of tactics.

For instance, the exercise of mapping organizational processes in the interest of determining their suitability for BPO also reveals opportunities for reengineering.

Processes that have gone unexamined for a period at time almost assuredly have become bloated and inefficient in a number at ways, same subtle and same not so subtle.

The process maps developed during the analysis phase should be used to catalyze reengineering efforts directed at those inefficient an unproductive processes that are not outsourced.

The organization will derive benefits from the analysis phase if it is prepared to use its findings for organizational improvement regardless at whether a BPO project is initiated.

The organizational learning that is a consequence of process mapping is not confined to BAT members. The BAT should invite participation from individuals working within processes to assist with the napping.

These individuals can he encouraged to initiate changes to process inefficiencies when they return to their wonk units.

Another cost mitigation tactic that can be applied to the analysis phase includes the potential tam a general elevation in wonk productivity levels as a natural result at organizational self-examination.

The phenomenon of increased performance as a result of being observed is commonly referred to as the Hawthorne effect. The reference is to the famous studies conducted between 1924 and 1932 at the Hawthorne plant of Western Electric, wherein employee performance was increased merely because of the presence of the researchers.

Organizations can encourage operating performance improvement during the course of the BPO analysis based on this effect.

Communicating the process improvement objectives of the analysis phase to everyone in the units under scrutiny is a means of circumventing the potential for fear-induced performance declines.

Getting people involved in the change effort is a classic technique to mitigate the hidden costs associated with the common human tendency to resist change.

The result of the BPO analysis phase is a decision about implementing a BPO project. Implementing a BPO project has several subphases associated with it, including:

? Identifying a suitable outsourcing vendor/partner
? Negotiating a contract
? Establishing a project map for the transition

Phase 2: Vendor Selection
One of the first decisions any organization must make after identifying a BPO opportunity is whether to hire a third-party intermediary to assist with the vendor selection.

The decision about whether to use an intermediary during vendor selection can be an important one.

Obviously, conducting the vendor selection in-house can reduce costs in the short run, but that choice may add costs in the long nun. Especially for large and complex outsourcing initiatives, the vendor selection phase can be time-consuming and highly detailed.

Third-party intermediaries that specialize in request for proposal (RFP) drafting, distribution, and response evaluation can reduce the time it takes to identify a suitable outsourcing vendor and allow internal staff to stay focused on internal issues.

For companies that decide to manage the vendor selection phase in-house, financial costs will include the time spent in crafting an RFP, distributing it to vendors, managing and responding to queries, and evaluating the completed proposals.

Every RFP generates questions from potential responders. And the international distribution at many BPO RFPs raises the likelihood of misunderstandings and requests for clarification.

Staff time will be needed to held questions-some legitimate, some maddeningly trite on irrelevant- from all over the world. A fair response process that limits the potential for liability requires each inquiry to be managed with equal care and interest.

Depending on the complexity of the BPO project, it could take anywhere from a month to several months to write a comprehensive RFP-one that clearly articulates the scope of the BPO initiative, the expectations for service delivery, the qualifications at the outsourcing firm, and the range of services that will be needed to fully outsource the process.

On the vendor side, responding to the RFP can also be a time-consuming and labor-intensive process.

As such, the responder may require additional information and clarification throughout the response period. The response phase oft the RFP process may take another one to three months.

All told, it may take anywhere from two to six months or longer for the RFP process to be completed. Of course, at the end of that process the initiating organization will have an inbox full of complex and comprehensive proposals.

These proposals each must be examined to identify which at the potential vendors is best suited to carry out the BPO initiative. For many outsourcing RFPs, there may be upward of 50 proposals from highly qualified vendors.

If the initiating organization is merely seeking the low-cost provider, the process of selecting the vendor may (emphasize may) be made easier.

Nevertheless, event that approach to vendor selection can be deceiving. For example, a vendor that submits the low-cost solution may have scrimped on certain critical services or it may have suggested reduced service levels. Evaluating proposals on price alone may in fact bead to higher costs later.

The process of evaluating the RFP responses from potential vendors can take month or anger. Typically, the evaluation process moves from scrutinizing the written proposals to actual meetings with the leadership teams of the top candidates, including site visits. These meetings can add another month to the selection process because some of the vendor facilities may be in faraway corners of the world.

Organizations that manage the RFP process in-house should assume that the process can take anywhere from three to six months, depending on the complexity, scope, and range of services involved in the project.

They should also assume that the process will occupy 50 percent or more of the work time for at least one management-level individual during the process.

Hence, estimating the cost of in-house management of the RFP process begins with the east of one-half to one person-yean of management-level personnel. The cost estimate does not end there, however.

The decision to in-source the RFP process carries hidden costs associated with the risk of going it alone.

No matter the experience at the individuals managing the RFP process, going it alone likely means additional costs associated with writing an incomplete RFP, establishing an ineffective response-management plan, and selecting a less-than-optimal vendor.

Each of these is a reflection of the fact that RFP writing, distribution, and management is not par of the initiating organization’s come competence. This hidden cost can be estimated based ao the relative experience of the project’s lead individual(s).

An inexperienced project leader could double the costs of the implementation phase over the east of using a professional service provider. A highly experienced leader may increase costs by far less, but such a person probably commands a far higher salary. The Case Study points out that GE Real Estate hired a manager who dedicates half his work time to managing the BPO at the organization’s offshore outsourcing relationships.

Phase 3: Contract Development
The principal cost of the contact development phase concern those associated with negotiating a contract with the vendor.

It is highly recommended that the BPO buyer wonk with an experienced legal team when developing the BPO contact.

There is simply too much at stake in the specification of services, deliverables, and remedies to cut costs in this area.

Here, we simply suggest a rule of thumb contracting cost estimate. The rule is that contracting costs, in terms of internal time and legal review, should be less than 5 percent of the size of the outsourced project. Thus, a $1 million project may have contract development costs up to $50,000.

Hidden costs associated with contract development include the dangers inherent in failing to specify appropriate penalties, remedies, and exit strategies.

These ticking-time bombs don’t go off unless something goes wrong during the transition or operating phases of the BPO Life Cycle.

Since not every contingency can be covered in a BPO contract, general problem-resolution terms should be included along with more specific problem situations and types.

A legal team with experience in BPO can be vital to help buyer and vendor alike avoid downstream cost-traps via carefully constructed contract terms.

Ongoing BPO project needs and requirements will evolve over time and the scope and nature of the buyer-vendor relationship must adapt as well.

The typical BPO relationship will last four to six years and will involve ongoing negotiations and deal making.

Each of these encounters presents the possibility of incurring undue costs resulting from poor negotiating skills, an incomplete on poorly designed original contract, or a rotating bead-person tango by either the BPO buyer or vendor.

Poor negotiating skills can lead to less than favorable terms on changes in the original contracts or in the provision at new services.

Poorly crafted original contracts can lock in an organization to low service levels or draconian pricing.

A rotating lead person by either party can mean a loss at organizational learning and a need to return time and again to the fundamentals underlying the relationship.

This process is time consuming and can eat the cost advantages that are commonly part of a BPO relationship.

Stability in the buyer-vendor relationship is built on the foundation of a carefully constructed contract.

Hidden costs associated with a poor contact can destroy a relationship. BPO buyers shouldn’t scrimp on direct contract development costs and risk the potential for project-threatening hidden costs in the later stages at the BPO Life Cycle.

Phase 4: Transition
The transition phase is one in which the business process that formerly had been handled in-house is wholly or in part shifted to the outsourcing vendor.

The costs associated with the transition phase are driven by five primary characteristics at the BPO buyer-vendor relationship, as illustrated in.

The “asset ownership and location” driver concerns which firm will be better able to leverage people, technology, and other assets for competitive advantage, and where those assets should be located.

In some situations, a BPO buyer may want to retain all or part of its existing assets to continue to develop internal competence in a process.

For instance, a firm may elect to outsource a pant at its call center to a vendor as a means of freeing internal call center staff time to make improvements to the in-house operation.

The decision about how asset ownership will be allocated between buyer and vendor has direct cost implications.

For instance, by outsourcing asset ownership, an organization can turn capital into expense: Assets that had previously required maintenance and continuing investment of time, money, equipment, and people are converted into a variable or fixed cost on the income statement, depending on the type of BPO contract.

The decision about where assets will be located also has cost implications. Retaining a process on the buying organization’s premises usually means that the transition can be completed more quickly than moving assets off-site, but not necessarily.

There are many advantages to keeping assets on-site. One of these is that it is far easier to retain existing personnel, many at wham would he unwilling to relocate to the vendor (especially if the vendor is overseas).

Employees involved in a process that has been outsourced can become productive members of the vendor organization, but the transition must be handled with care.

It is not unusual for the BPO buyer to experience attrition, stuff cuts, and reassignments during the transition phase.

The vendor will often reengineer the outsourced process, reducing inefficiencies and enhancing individual productivity levels.

This means that staff who remain may harbor lingering fears for their own job security-fears that may show the transition and affect productivity. Proper management of the in-house transition to vendor management and process ownership will reduce these potential costs.

Regardless of whether the process remains on-site or is moved off-site, there will be a need to transfer process-related information, knowledge, and controls.

In addition, during the transition phase it will be necessary to establish information exchange and data interface protocols that mesh the existing standards and information management architectures at each firm.

It is nearly inevitable that this integration process will have a variety of workflow disruptions.

Data needed for routine day-to-day tasks may be unavailable from time to time during the transition. New interface procedures, such as logins or passwords, may create confusion and frustration.

The better the organization communicates with employees about these potential disruptions and their duration and scope, the less costly the transition phase will be.

Depth of relationship refers to the costs associated with developing and maintaining a strategic relationship with the vendor.

We discuss the nature of a strategic relationship between buyer and vendor in detail in the “Strategic Costs” section that follows. Here, we mention only that a commitment to developing a strategic relationship will be more costly depending on the expectations for value expected.

The greater the value expected to be extracted from the relationship, the more time and resources will be required to develop and maintain the relationship.

The breadth of the relationship between buyer and vendor meters to the range of processes that are outsourced.

In some cases, organizations outsource multiple functions to a single provider. On other occasions, multiple providers are used for a range of different processes.

The decision about the breadth of processes to outsource to a particular vendor has both direct and hidden costs.

In fact, working with a single provider for multiple processes may reduce costs as familiarity and trust develop over time. At the same time, the potential costs associated with vendor failure increase as dependence on the vendor increases.

A potentially significant cost associated with the transition phase of the BPO initiative is based on the need ton third panties to assist in the integration at the vendor and initiating organization’s systems.

For instance, it may be necessary to bring in specialists it the two firms have complex databases built on different platforms.

This is more likely if the initiating organization has legacy systems that have not been upgraded in several years or if it has homegrown applications that are known to only a handful of individuals.

The vendor should be expected to provide transition management expertise for most systems, but it cannot be expected to have expertise to manage a smooth transition if the initiating organization has outdated or, at least, very old databases and information architectures.

In that case, third parties may be necessary to assist in upgrading and migrating the buyer organization’s data to the vendor’s system.

Hidden and opportunity costs associated with the transition phase center on the effects of outsourcing a process on employees who work outside the process. They may experience a period of adjustment as the process is transitioned.

Adjustments include not only the need to understand and work with a reengineered process but also the need to interface with new people and unfamiliar systems.

As usual for organizational change of this magnitude, some people will take longer than others to ad just, and some will simply resist the changes altogether.

In general, organizations initiating a BPO project can expect some productivity dropoff in personnel who wonk internally with the outsourced process.

Of course, the expectation is that after the period of adjustment, the productivity levels will reach their previous norms and may reach new highs as the efficiencies of the newly outsourced process kick in.

Transition phase costs are mitigated by the fact that the BPO decision has been taken and the wheels of change have been set in motion.

This negative effect is usually reversed once the decision to change has been made and the organization is clearly pursuing its new objectives.

Those who had resisted the change will either adjust or, at least, stop resisting. Resistance to organizational change-or, for that matter, to nearly any type of personal change-usually reaches a peak just before the decision to move forward.

Once the decision is taken, the mental energy that had previously been applied to blocking an resisting the change is now committed to adapting and adjusting to the new way of doing business-or to moving on to a new employer.

Other cost mitigation strategies during the transition are associated, again, with whether the process is handled internally. Internal management of the transition increases the organization’s operational capabilities far additional BPO projects or other major change efforts.

The transition phase is characterized by complexities of integrating management styles, information systems, and work cultures.

Third-party consultants can assist in making the BPO transition easier and less time-consuming. In the short run, hiring third-party support for the BPO transition can reduce costs.

Organizations that are initiating BPO tam the first time may want to hire a service provider, but they should assign a high-ranking insider to work closely with the consultant to siphon off the knowledge that can be used to manage subsequent BPO projects internally.

Phase 5: Operate
The operating phase of the BPO Life Cycle meters to the period when the contract is being fully implemented and performance expectations drive the relationship.

Among the endpoints that should be monitored as part of an ongoing BPO initiative, include both financial and productivity ratios.

Financial ratios that should be monitored range from standard return on investment (ROI) no margin enhancement. Depending on the intentions at the BPO project, the financial ratios to be monitored will vary slightly.

As mentioned, some BPO projects are undertaken primarily for cost-reduction purposes and others primarily for strategic advantage purposes.

Cost-reduction BPO projects are intended to enhance margins through reduced overhead, a feat that can often be achieved within a period of 6 to 12 months after commencement of the contract.

In contrast, strategic BPO attempts to leverage the world-leading capabilities of the outsourcing partner and will focus more on new revenue over margin enhancement.

BPO implementation will not only have a financial impact on the organization but also a productivity impact. The productivity impact, it must be noted, will likely reach beyond the unit or function that is targeted for the outsourcing project.

Most BPO initiatives result in some job displacement or layoffs within the organization. Other employees will be concerned about whether their unit is a BPO target in the future.

Employees who are concerned about the security of their jobs are likely to demonstrate a dropoff in productivity-at least in the short term.

Productivity measures used to control the BPO initiative must account for these short-term fluctuations in overall productivity while keeping track of long-term objectives.

The distinction in metrics between cost-reduction BPO and strategic BPO is less pronounced tom productivity that it was for financial indicators.

Productivity measures are fairly consistent for the organization regardless of the cost-cutting or strategic initiatives undertaken. Several important productivity metrics that organizations can use to control a BPO initiative include the following:

? Output/employee
? Overhead cost/unit of output
? Output/capital expenditure
? Output/asset

These standard productivity measures will enable the firm to assess the pre- and post-BPO impact. The measures must each include a time element to account ton short-teem variation.

It would be a mistake to pull the plug on a BPO initiative based on early returns that showed a dip in overall organizational productivity. Such fluctuation should be anticipated and accounted for before launching the project.

Still normalization or improvement in productivity should be expected within a pre-established period and adjustments made to the BPO initiative if those targets are not being met.

Financial Performance Metrics
Cost- Reduction   BPO Strategic BPO
ROI    ROI
Net Margin   Gross Revenue
Sales/Employee  Market Share
Inventory Turns  Customer Acquisition Cost

Qualitative measures of the BPO initiative are far-reaching, including internal, external, and vendor-related metrics.

Internal qualitative metrics will focus on a variety of issues concerning the negative health of the organization.

Effectively managing the BPO rollout will require data collection before, during, and after the process. Before the process begins, organizations should collect data on several characteristics of the internal environment, including the following:

? Employee knowledge of BPO
? Employee understanding of organizational strategy
? Employee morale and sense of job security
? Employee capacity to deal with change

These various data points will help establish appropriate information and communication programs during and after the BPO implementation process.

For instance, if it is determined that employee knowledge of BPO and its potential to help the organization is low, the organization may benefit from training programs aimed at reducing the knowledge gap.

Research has clearly shown that people are more productive and likely to pitch in throughout a change process if they understand the rationale and direction of the change.

External factors to monitor for a BPO initiative include issues related to customers, competitors, and shareholders.

Organizations as a general rule should be colleting data regarding customer satisfaction, so we will not allude to it here as a new metric to monitor.

We do stress the importance of maintaining a close watch on customer satisfaction levels during the BPO implementation process, regardless of whether the BPO initiative involves a customer-facing function.

Of course, normal variations in satisfaction levels should not precipitate corrective actions, but variations beyond the norm must be carefully analyzed in case action is required. The latter is especially important if the BPO initiative involves a customer-facing process such as a call center or help desk.

If the organization has undertaken a strategic BPO initiative, competitive response will be a crucial external variable to monitor. Strategic BPO is undertaken precisely to gain and, ideally, sustain competitive advantage.

Competitors will respond to new moves within the industry, especially those that live potential market-shifting or disruptive capability.

Organizations initiating BPO for strategic reasons will be wise to establish a rollout strategy that keeps them beneath competitors’ radar screens, at least until a defensible position has been established. Careful monitoring of the competition can help determine whether the rollout strategy is working.

Organizations should also monitor the reactions of shareholders and other major organizational stakeholders to the BPO initiative. Because mast investors have a conservative streak, extensive reengineering or restructuring that includes a technology component may meet with anxiety and doubt.

Clear understanding at stakeholder knowledge at organizational strategy before and after the BPO initiative has begun can help circumvent unnecessary roadblocks that may arise as people hear about the outsourcing project.

The final qualitative data points that must be collected and assessed during the operating phase involve those between the organization and the BPO partner. This complex relationship will evolve oven time as the BPO partner performs on its contract.

Underlying each BPO partner relationship are the so-called service level agreements (SLA) that specify actions that will be taken to ensure customer satisfaction.

Organizations often have only a few individuals who have read and understood the SLAs. In the event that something goes wrong-and it always will-the SLAs will detail how to make corrections.

Organizations should carefully monitor performance on the SLAs-both its own capacity for enforcing them and the vendor’s capacity for responding to problems.

The costs associated with non-performance are obvious-direct loss of business. There are also hidden and opportunity costs associated with slow response times, including customer dissatisfaction if the outsourced process is customer facing, employee disgruntlement, and a loss of confidence and trust between buyer and vendor that may adversely affect the future of the relationship.

The BPO buyer must ensure that it is monitoring the “temperature” of the BPO relationship and that it can respond if things begin to go awry.

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