Top 10 Hidden Costs of Outsourcing

By David Brown  |  Posted 09-09-2008

Top 10 Hidden Costs of Outsourcing

When it comes to outsourcing, there's more to your business case than the service provider's price. Some outsourcing costs are less visible--or downright hidden. EquaTerra, an outsourcing consultancy, reviews the top 10 hidden costs and how to avoid them.

Hidden Cost No. 1: Currency
Problem: Because of currency fluctuations, last year's invoice of $1 million a month could be $1.4 million today.

Solution: Hedge the currency risk by including caps and collars in the contract. For example, you and your service provider might agree to share responsibility for currency adjustments up to a certain dollar amount, beyond which you'll go back to the table and renegotiate. By hedging the risk in this way, many domestic companies protected themselves against the devaluation of the U.S. dollar.

Hidden Cost No. 2: Hardware/software refresh
Problem: Your contract may include a two-year refresh of hardware like desktops/laptops and software like Microsoft Office. But if your outsourcing deal is five to seven years, you're going to need another refresh--and it's usually not in the contract. Fail to account for it, and the cost can be $500 to $2,000 per employee. One pharmaceutical company, for example, mistakenly assumed its service provider would pay for an unscheduled refresh, and the company had to come up with $20 million.

Solution: Anticipate updates beyond the typical one-year refresh, and put them in the contract. That means carefully evaluating the outsourcing solution, asking service providers the important questions about hardware, and developing contract terms that are clear and precise. To ensure the price includes refreshes throughout the equipment lifecycle, ask your service provider to include a refresh schedule for every piece of hardware.

Retained Organization, Lack of Governance, Internal Transition

Hidden Cost No. 3: Retained organization
Problem: You transferred 50 percent of some employees' jobs to the service provider, but you're still paying them for the full function. This eats into your savings. One retailer, for example, had the work of 1,100 employees in scope, but the company held onto 50 percent of the work for 200 of those employees. As a result, the company overstated its business case by $24 million.

Solution: After the transition, redesign the organization, redefine job functions, and redeploy or sever. Indeed, if the same retailer had realigned its retained organization, it could have regained $12 million of its lost savings.

Hidden Cost  No. 4: Lack of governance
Problem: Companies typically underestimate the people, process and technology required to manage the outputs of an outsourcing contract. In fact, provider invoice errors alone can erode your monthly savings by two to 10 percent. For example, when one global consumer goods company assessed the performance of its governance organization, it discovered overcharges on 5 percent of the provider's invoices, to the tune of $40,000 month.

Solution: Remember, just because you've outsourced a process doesn't mean you've outsourced the need to manage the contract. Invest in governance teams and tools to mitigate risk and achieve the deal's intended value.

Hidden Cost No. 5: Internal transition
Problem: Companies typically overlook the effort required to do things in a new way. In one outsourcing deal for finance and accounting, which included a new e-system for accounts payable, the buyer failed to budget for the interface development required on the client side--an oversight that cost $2.5 million in the original business case.

Solution: Anticipate these costs--including time, external resources, and applications for interfacing with the service provider--and include them in your estimates.

Retirement Costs, Planned Headcount Reduction, Poor Change Communications

Hidden Cost No. 6: Retirement costs
Problem: Many companies continue to pay into retirement plans and pensions even after employees have been terminated--and they never realize the error. This overpayment can cost hundreds of thousands of dollars a year in foregone savings. One company, for example, eventually discovered that it was paying thousands annually into a pension fund for each of about 1,000 displaced employees.

Solution: After the outsourcing transaction, review the list of employees that will be displaced, and work with the HR department to update the database. May seem pretty simple, but this is a common oversight that can add big cost. 

Hidden Cost No. 7: Planned headcount reduction
Problem: Most companies plan to reduce headcount through outsourcing, but they usually end up keeping some employees to help in the transition - and that's a cost they didn't account for. To minimize its risk, for example, one pharmaceutical company kept about 20 percent of its staff for six months after the go-live date, which added $1.5 million in cost. Overambitious headcount estimates can cut projected savings by 10 to 20 percent.

Solution: Don't overstate the savings. Many companies, for example, will anticipate a "ramping down" of employees after the provider takes over the services. This helps ensure a smoother transition and a more realistic business case.

Hidden Cost No. 8: Poor change communications
Problem: Change communication in outsourcing is extremely complex and burdensome. If you do it poorly, some employees may leave before the transition. Or, if you fail to give enough notice, some employees or union workers may stay too long. In this case, you won't be able to reduce your headcount in time, which means you'll end up paying your employees and your service provider for the same work.

Solution: Develop a thorough communication strategy--with external counsel if necessary--and start communicating well in advance of the transition. One company, for example, was outsourcing development and maintenance for a very strategic application, but it wanted to retain about 45 critical staff for their knowledge. Thanks to a "high-touch" communication plan--including frequent communications, an engaging mix of tactics, and strategic messaging--the company kept all of them, including at least 10 at-risk resources. Loss of those resources would have cost the company about $1 million for backfill and knowledge transfer.

Shadow Organizations, Staff Augmentation

Hidden Cost No. 9: Shadow organizations
Problem: Shadow organizations--those employees in the retained organization who continue doing things the old way--almost always exist in an outsourcing relationship. For example, even though a global retailer's service provider was doing operations testing and reporting, a shadow organization continued doing it as well--which eroded savings by $3 million in the first two years of the relationship. Left unchecked, redundancies created by shadow organizations can reduce outsourcing value by 10 to 15 percent.

Solution: As part of change management, educate the organization on why it's important to use the new services. If some departments or executives don't trust the service provider, then the governance team should find out why--and fix it.

Hidden Cost No. 10: Staff augmentation
Problem: If your transition is six- to 12-months long, but employees leave before the transition is complete, then you have to backfill those positions, which adds unanticipated hiring and training costs. One transportation company, for example, failed to keep about 20 employees long enough to do the testing and process-mapping required for the transition. So it paid its service provider an extra $500,000 to do the work. That's a premium of about 20 percent over the salary of each lost employee.

Solution: Most employees are more willing to stay if there's a monetary payout at the end of the road. Hold on to employees by tying their severance to the end date, or give them a retention bonus.

David Brown, a client executive with EquaTerra, leads the firm's financial architecture competency.

See also: Pros and Cons of Offshore Locales

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