I’ve been musing on this lately … it’s part of my job and it’s interesting. What is the “right” price for outsourcing? That is, what is the price where it’s clearly in a company’s best interest to outsource a business function and it’s in a supplier’s best interest to provide the outsourcing?
In principle, it’s simple. If it’s less expensive — all things totted up — for a company to outsource it, then the company should outsource it. If a supplier makes more than their target return (however they calculate their return), then they should supply the outsourcing. This means that the company can put its capital to better use and the supplier is putting its capital to the best use. Such is the kernel of Coates prize winning theory (transaction costs, Ronald Coase). “All things totted up” and “however they calculate their return” is meant to take into account all the very pragmatic considerations a company must consider when investing.
In practice … don’t you sometimes hate the “in practice” sentence opening … it can be damn difficult on both sides to determine if you should do it. It being outsourcing, of course.
There are critical factors that eventually reveal themselves as cost, but masquerade or hide in the beginning. Often, you’ll see contingency reserves on both sides to hedge against these wraiths.
On both sides, there is risk to account for. On both sides, true cost turns out to be more complex and more difficult than those exercises you did in B-school. If you could hold all variables constant but the ones that you want to manipulate, true cost would be easy Usually, you can’t and it isn’t. Both sides end up (in any situation large enough to be interesting) using all sorts of proxies for the truth. Standard costs, plan labor rates, planning figures for time … all turn out in the end to be approximations of the truth. Good approximations mean you make money on the deal. Bad approximations mean … that you may not get to make another deal. On both sides, scope is difficult and critical. What’s in scope, what’s out of scope. What happens if the scope needs to change — like it always does. On both sides, the duration of the contract is important. Too short and it’s not worth it; too long and you’re locked into something that needs to change.
What is the right price for outsourcing? It’s a damn good question.
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