Hazard risks:

Natural and man-made risks can rise exponentially when crucial business services are outsourced to far-flung locations. The challenge is to identify the full range of potential issues upfront and approach them through a careful assessment of the levers available to mitigate potential problems. Among the most common hazard risks are these:

Workers' compensation surprises:

Depending on the wording of contracts, the vendor's employees might be considered leased employees of the client company. If so, numerous problems could surface regarding workers' compensation. Countries and states differ in their treatment of which company is the employer, with some conferring that status on both the buyer and the provider. If the buyer is not considered the employer, it may still be vulnerable to a lawsuit by an injured outsourced employee.

Errors and omissions coverage:

Offshore outsourcers may not carry the levels of protection against errors and omissions that major corporations expect of their service providers. In India, for example, Errors & Omission coverage is generally available only up to a $ 5 million limit. Those contemplating externalizing critical functions should insist on proper coverage by their suppliers. This may mean using specialist underwriters such as those in the London insurance markets.

Political instability:

Dealing with distant vendors gives rise to potential risks of expropriation, trade disruption, and exchange rate fluctuations that can have major impacts on a company's costs and supply chain performance. These risks are best handled via a combination of due diligence, splitting the work across several geographies, and insurance.

Natural disaster risk:

Fire, earthquake, and other natural disasters can disrupt activities at a vendor's location and cause the contracting company to lose income. The situation is worse if the vendor does not maintain adequate property insurance. The best response is, first, to maintain adequate amounts of "contingent time element" insurance under the property policy and, second, to have the vendor maintain adequate property insurance on an "all risks" basis, including business interruption coverage.

Strategic risks:

As the scope of outsourced activities has widened, outsourcing providers are more likely to affect companies' core businesses. Among the major risks are these:

Loss of control:

Attention to the outsourced activity may tend to lapse as knowledgeable staff depart for greener pastures or are laid off, leaving fewer people to keep up with advances in the functional area. At some point, the company has little effective control. JPMorgan Chase recently announced it would bring back in-house a major set of IT activities it had outsourced to IBM in a seven-year, $ 5 billion deal. The bank now feels it is critical to manage and control IT directly to gain competitive advantage. Some 4,000 IBM employees will be transferred back to JPMorgan just two years after the contract was announced. The cancellation penalties, missed opportunities, and other transition costs involved in such decisions highlight the value of careful analysis of objectives and options prior to launching any large outsourcing initiative.

Reputational damage:

Retailers such as Nike have been tarred with the “bad practices” brush because of their choice of product suppliers in China and Central America, while Wal-Mart’s brand has been tarnished by allegations of improper hiring by a subcontractor. Banks and other service businesses are just as vulnerable to perceived misdeeds by providers in distant geographies. These potential costs must be considered early to avoid costly surprises later.

Arrested evolution:

Business requirements inevitably change, and an outsourcing solution defined from a short-term, static perspective likely cannot respond adequately to rapid growth or new challenges. Companies thus may face a costly reassessment and complex transition of providers. This can materialize as an inability to serve new needs, to scale up, or to innovate.

Financial risks:

Through lower wage rates, economies of scale, and a specialist's expertise, outsourcing can deliver savings of 25% to 50%, after adjusting for incremental management and communications costs. But just as enterprise resource planning rarely lived up to the promised return on investment, outsourcing also holds numerous financial risks:

Unforeseen costs:

In the first moment of enthusiasm, managers rarely reckon the costs of evaluating vendors, managing major contracts, traveling to offshore sites, enhancing security, and paying severance for laid-off workers. In addition, standardized services rarely meet the needs of the business, and customized solutions by the vendor will likely add between 15% and 30% to the cost. Finally, exit costs can be substantial, as ending an arrangement prematurely exposes both buyer and provider to litigation. Managers should plan realistically for the full range of costs, creating detailed financial models and testing scenarios to make sure the decision will still look good if various factors go wrong.

Regulatory risks:

Restrictions on outsourcing motivated by protectionist instincts are appearing on state and local governments. Even without dramatic change, companies remain responsible for regulatory compliance in areas such as corporate accountability and privacy, and this clearly extends to their vendors as well. Sarbanes-Oxley, Basel II-III, and numerous other statutes and regulations in the U.S. and Europe require compliance by financial service and other firms, as well as by their providers. Yet not all outsourcers can assure customers that they are fully compliant. This is another reason for a comprehensive due diligence process.

Operational risks:

Most risks that arise in outsourcing are operational risks. All of the operational challenges related to in-house activities persist when outsourced, but they may be less visible and harder to correct. Operations can go awry in numerous ways:

Poor service performance:

This problem can defeat the most attractive cost advantage. An example in the past has been a well known multinational credit card company who cancelled a contract with one of India's largest call center provider, after instances of workers tempting credit card customers with unauthorized free gifts. Poorly integrated processes, language difficulties, or contextual unfamiliarity also can threaten customer service. To minimize service risks, one major retailer maintains a small team to integrate new service providers into its ongoing operations, viewing the skills for ramping up new vendors as replicable across functions.

Weak governance and poor internal communication by the outsourcing company:

At a leading high-tech company, a major operating function had been outsourced to the same provider independently by four different divisions via seven contracts worth a total of $ 250 million annually. Only when one of the divisions expressed dissatisfaction with the supplier's responsiveness did managers connect the dots. Not surprisingly, the provider then resisted attempts to centralize control over its activities. Success in complex outsourcing relationships demands cross-functional teams, senior management leadership, and metric-driven processes.

Staff resistance and motivational issues:

Outsourcing can profoundly disrupt staff and cause lower morale, lower productivity, higher turnover, and reduced service delivery. Employees should be actively involved in the project, with retention plans, role changes, reassignments, job shadowing, severance programs, and interviews with the provider all part of the plan.

Process fragmentation:

How will the outsourced processes link to other key internal activities? As one bank manager we interviewed put it, "Moving IT across the street was a disaster. How could we ever contemplate offshoring?" The CEO of a software firm that sends development offshore to its India office notes that much of the important knowledge is not committed to paper: "There's so much knowledge sitting in people's heads that even if you sit down to document things, you miss out on quite a few items that you only remember when a problem happens." Joint process analysis prior to launch and continuing close interaction with the provider are critical to ensuring that various processes function well together.