Offshoring and outsourcing practices remind us that organizations often make “sourcing” decisions – where to do what work – that help to define their supply chain. These decisions raise concerns about reliability (will they deliver) and responsiveness (can they meet changing needs). Those risks, in turn, require risk management approaches.
Data reported by the Human Resources Outsourcing Association (HROA) suggests that outsourcing of HR tasks grew by over 20 percentage points from 2007 to 2009 alone and now exists in about 90 percent of organizations. Manufacturing firms have long had to decide in which of their locations to produce the various components of their final products or to buy them from vendors. Better information technology has expanded the range of businesses where sourcing choices are possible, especially in white collar jobs.
Operating costs should not be the only or arguably even the most important factor behind these decisions, though. Bank of America kicked off the outsourcing trend in 2000 in a partnership that transferred most all of its HR tasks for 144,000 employees to the new Exult venture but struggle to see the expected benefits. Some Professional Employer Organizations (PEOs), which take over the employment functions for organizations, created different problems when some owners absconded with their client’s cash. Nor does the decision to keep the work in house necessarily eliminate risks. Smaller companies in particular frequently found that their own competencies in key areas such as IT resided in a few key employees. When those individuals left, or worse, if “lift-outs” took away an entire team, the company was devastated. Labor disputes in other countries disrupt production in complex supply chains. Consumer backlash in the U.S. from outsourcing call center operations to India forced some business to backtrack on that decision.
The Sourcing Challenge
Beyond cost, there are two main issues that should drive how we see sourcing choices. The first and perhaps easiest to see is reliability. Will the products get produced on time? Will they maintain a standard level of quality? Not surprisingly, reliability usually costs more. To some extent that is because investments are required to ensure reliable operations: modern equipment is less likely to fail than old equipment, backup systems are needed to guard against breakdowns, etc. Quality, especially consistent quality, also requires investments in systems like TQM and monitoring technology. At the very least, reliable suppliers can charge more because of the value they provide, which raises the costs to their clients. Strikes and employee turnover are classic problems that affect reliability.
The other major concern is responsiveness, or the extent to which it is possible to adapt output or performance standards to changes in demand. Employment relationships are the most responsive arrangement for getting work done as employees can be directed to change activities and goals at a moment’s notice. Independent contractors, in contrast, cannot be redirected when needs change without altering their contracts. While it is possible to change out contractors to bring in new skills, that process does take time and requires recontracting, which raises new uncertainties.
There is typically a trade-off between cost and responsiveness as well because it is easiest to sustain lower costs if volume and standards remain constant. When we outsource tasks, they are governed by contracts that tend to lock-in performance specifications and output levels. To get vendors to respond to changing demands from clients, we either have to renegotiate the contracts, a potentially time-consuming and expensive process, or we have to build flexibility into the original contracts. We pay a premium for contractual flexibility, and we have to know in advance what aspects of flexibility will be needed in order to do so.
In industries like manufacturing, location and transportation, costs affect responsiveness as well. Suppliers who are farther away cannot respond as quickly because delivery takes more time. Capabilities, which relate especially to labor, affect responsiveness across the board: Does a vendor have enough employees to meet our needs if demand rises, do its employees have the capabilities to deliver different services or products if our business changes? Yet responsiveness is not always better inside one’s own organization, and again often the reason centers on labor issues. Using temp services to meet a client’s seasonal demand (e.g., retail stores around the holidays) without having to build in more permanent capacity is a classic example.
A recent trend in supplier relationships, led most famously by GM and Wal-Mart, of putting suppliers in competition with each other to win bids based on price increases, causes concerns about reliability and responsiveness to changes in demand as vendors skimp on investments that may affect prices.
HR’s role in business sourcing decisions is to advise about the risk that employee-related issues could cause for reliability and responsiveness in providers.
Risk Management Strategies
Problems of reliability and responsiveness are much more like risk, which can be estimated with some precision, than true uncertainty in that we can anticipate their boundaries (e.g., the probability of a fire in our location) because they occur often enough. Operations research scholar Brian Tomlin categorizes possible solutions to the risks of sourcing problems as falling into two camps. The first are mitigation tactics that take place in advance of the problems. A human resource example of a mitigation tactic might be to maintain a staff of “relief workers” who step in to replace absent workers in assembly lines or other lower-skilled jobs.
The second set is contingency tactics that go into place only when the problems occur. A standard contingency solution to the HR reliability problem of absent workers is to call in a temp agency to provide substitutes when workers are absent.
Mitigation and contingency strategies differ in important ways. Mitigation arguably handles the problems better but involves more upfront costs. One might think of mitigation tactics as being the equivalent of preventative medicine. Contingency has the reverse attributes, only being used if the problems arise but in most contexts not dealing with them as well when they do occur. This is the equivalent of emergency room medicine.
If we carry the medicine analogy through, we see that sensible strategies for risk management rely on a mix of the two approaches depending on the problem. We might change our diet to reduce the risk of heart attacks – a mitigation strategy – even though it is a long-term and (to many) irritating solution. The reason we make that choice is because the damage of a heart attack is huge and emergency-style treatment once the problem occurs is not very effective. On the other hand, we don’t bother wearing football pads around the house, even though it might well prevent broken bones from falls, because the damage from broken bones for most people is not nearly as great as from incidents like heart attacks and because emergency care after the fact works reasonably well. Preventing problems obviously is better than dealing with them after the fact but often is not worth the cost. In human resources, we make similar risk management choices routinely, although we rarely think about them explicitly. Nor do we typically assess the options objectively.
Consider, for example, the growing concern about succession management. In practice, this issue is really a concern about the reliability of our internal source: What if we lose our current CFO? Growing an internal replacement and having them serve as back-up – sitting on the bench ready to go in – is a common solution to that reliability concern. This is a mitigation strategy and is the equivalent of carrying inventory. Another alternative, a contingency strategy, is to outsource the problem when it pops up by retaining an executive search firm to find a replacement only when we lose our CEO.
It isn’t enough just to have a strategy for managing sourcing risk, however. It is important to have the most effective strategy. One place effective risk management strategies is explicitly calculated in human resources is in sports, where individual employees are both incredibly expensive and crucial to the “product” outcome. Consider, for example, U.S. football where losing a quarterback, arguably the most central player, is a huge reliability problem as it threatens in a powerful way the overall team’s performance. Teams always have backup quarterbacks who can step in when the starter is out of the game, an inventory-based mitigation strategy. But they almost never have a backup who is anywhere near as good as a starting quarterback because any quarterback good enough to be a starter will want to be a starter somewhere else, and it may not be possible to pay a good one enough to sit on a bench waiting for an opportunity.
What most teams do, therefore, is have a backup only good enough to be a temporary replacement until the starter recovers – a mitigation strategy – or until another starter can be hired on the open market – a contingency strategy. For less expensive players who can fill multiple positions (e.g., linemen), teams are more likely to hold some starter-level players in inventory for those positions, the mitigation strategy, as it costs less and is more likely to be needed. In the executive world, the notion of “bench strength” borrowed from the sports context, is a mitigation strategy and an expensive one for top talent.
Assessing the Value of Risk Management Strategies.
Understanding which risk management strategies begins with assessing the losses each prevent. We adjust those losses by their probability of occurring: If we think it will cost us $3 million if our key sales manager leaves, but the odds of that happening this year are one-in-three, then the value of a strategy that eliminates that risk is $1 million this year. We then assess that value against the costs of executing the risk management strategy. The costs of mitigation tactics are paid up front. For example, a mitigation strategy for managing the risk that our key strategy executive might leave could involve locking her in with stock options or employing an assistant sales manager who is ready to step into the manager role, someone who is overqualified – and overpaid – for their current role. Mitigation strategies are the equivalent of buying insurance. The process of deciding whether mitigation tactics are worthwhile is the same as deciding whether insurance is worth the cost.
The costs of contingency tactics, in contrast, are only incurred when they are used. A contingency solution to counter the risk that the key executive will leave might be to engage a strategy consulting firm to handle the tasks in the short-term. This strategy is likely to be less effective than the mitigation strategies above because the vendor will not know the company’s context as well as an insider would. But the main costs are not incurred unless and until the risky event occurs. A $200,000 cost of finding an outside replacement if a key sales manager leaves turns out to be more cost efficient than paying $80,000 in stock options to hold the key sales manager if we only have a one-in-three chance of needing that outside replacement. Holding an overqualified assistant manager as a backup may be the most expensive strategy because those associated costs have to be paid every year.
The Options for Risk Minimization
Voltaire’s adage that “The perfect should not be the enemy of the good” applies in contexts like these where we can improve decision making greatly just by identifying the risks and the options. There are a variety of options for managing reliability and responsiveness risks associated with the mitigation/contingency dichotomy above. They are described in the Figure 1:
Reliability and Inventory Responses: Reliability is arguably the most common risk issue, and inventory responses are the most common strategy for addressing it, such as maintaining some internal capacity to backup a vendor if that vendor fails to deliver. A mitigation strategy against social unrest in foreign-based operations might be to maintain multiple locations. The biggest reliability risk management challenge most HR departments are likely to have addressed is the possibility of a disease epidemic like Asian flu, where being able to maintain operations is the challenge. Mitigation strategies here include putting in place IT support systems in the homes of employees to allow them to work from home before illness strikes. A very different inventory response is to purchase insurance against the costs of a reliability problem. A potential downside to these mitigation solutions, noted by operations research experts, is that some are the equivalent of supply “buffers” that may make it easier to ignore the underlying issues that cause reliability problems. If we have lots of spare capability for addressing turnover, for example, will that make us less interested in solving turnover problems?
Just-in-time Back-up: A contingency solution to vendor problems might be to have another supplier arranged to fill in the gap (at a premium price, of course) until either the problem is rectified or a new vendor can be found. For talent management shortfalls, a contingency strategy might be a just-in-time development and coaching program to get an internal candidate up to speed quickly in the job. The most common contingency strategy, though, is to use outside searches to fill vacancies in the long run or consulting and contract firms to make up for shortfalls in capabilities, at least on a temporary basis.
Contingency solutions to the risk of epidemics might be using short-term vendors in other locations.
Responsiveness and Internal Capacity: A typical responsiveness problem occurs when business strategies change and the company needs new employee competencies to enter a new market. Mitigation strategies include having centers of excellence or internal consultants in larger organizations, which have competencies that can be redirected, at least in the short-run, to new and pressing demands.
If mitigation approaches for reliability issues are the equivalent of inventory, then mitigation approaches for responsiveness concerns can be thought of as the equivalent of holding a financial option or precisely a “real” option: We hold assets in reserve in case a business opportunity or need arises that we would not otherwise be able to accommodate.
Outsourcing: Contingency options for responsiveness problems might also include acquisitions or “lift outs” – hiring a team from outside – to get them into the organization when needed.
Senthil Veeraraghavan and Alan Scheller-Wolf describe a classic contingency solution where low-cost providers tend to require long lead times for contracts during which demand can change. So clients hedge their bets on changing demand by placing only the minimum order that they are reasonably sure they can sell with the lowest-cost provider. Then they engage other providers that are higher cost but can take last minute orders to meet any demand above that minimum volume.
Choosing Among the Options
Some risks are not worth the cost of offsetting them, and our own tolerance for risk matters as well, as does our preference for fixed costs (mitigation strategies) versus variable costs (contingent strategies).
Contingent strategies tend to be better when disruptions are less frequent because they are used less often while mitigation strategies work better when problems are more frequent and shorter because they are used more.
Contracts with vendors and outsourcers that specify reliability standards in the form of performance contracts may be comforting, but remember that contracts have to be enforced, a costly and time-consuming process. And contracts do not prevent a vendor from simply going out of business.
Contracting against infrequent but catastrophic events, such as natural disasters, may not be reasonable or even possible as they may well take small vendors down with them. It may be simpler to buy insurance. When incentives and penalties for reliability are imposed in contracts, they should be expressed in terms of “average downtime per disruption” for events that vendors are unlikely to be able to control, such as acts of God, as these create incentives to get back online quickly. Standards based on “cumulative downtime” should be used for events that they can control, such as equipment failure, because they create incentives to stop the problems in the first place.
Advising on Business Sourcing Decisions
The same processes outlined above can be used to advise the business on the human capital sourcing risks of supply chain decisions. Consider, for example, a business deciding whether to outsource its call center operations to a vendor in India. Assessing reliability risk should be central to the decision, and at least some of those risks turn on the stability of their workforce. What does the organizational culture and climate look like in this facility? Are there risks of strikes or simply mass walkouts? What is the turnover rate, and what ability does the facility have to hire and train new recruits? Questions like these get to the heart of the reliability risk at this vendor, and they are best assessed by human resource experts.
Common responsiveness risks typically center on the ability of a supplier to expand operations for the client should needs increase. Beyond simply assessing spare capacity, the ability to ramp up turns on human resource capacity. Could they manage a bigger and more complex operation, do they have a broad portfolio of competencies to handle different demands if the business broadens its approach, and so forth.
The idea that there are risks besides financial ones that should be assessed and then managed is gradually gaining attention in business. Sourcing decisions are now among the most fundamental decisions that organizations make. Each option comes with significant risks that are rarely analyzed and even less typically managed. Understanding how they should be assessed, compared, and then mitigated requires a different set of competencies than one typically sees in human resources. But fortunately, they exist elsewhere, and the arguments above suggest how to apply them to this new context.
*A longer version of the ideas in this article appeared in the journal Organizational Dynamics 2012 and contains appropriate references.
About the author
Peter Cappelli is the George W. Taylor Professor of Management and Director of the Center for Human Resources at the Wharton School. His book, Talent on Demand: Managing Talent in an Uncertain Age(Harvard Business 2010) discusses some of the risk management challenges associated with talent management issues.