The Case for Procurement Outsourcing
Every year, outsourcing is woven more tightly into the fabric of business. At
last count, more than 40 percent of Fortune 500 companies now outsource all or
part of a business function or process.2 And according
to a leading research firm, nearly all of North America's major companies will
outsource at least some of their IT functions by 2005.3 You could almost say that
promoting IT outsourcing is like "preaching to the converted."
But other business functions — procurement, for example — have not yet achieved such broad outsourcing acceptance. Nevertheless, the benefits associated with outsourcing portions of a company's procurement process are vast, potentially greater than outsourcing IT. This article discusses the big-picture advantages of procurement outsourcing. It also examines the operational characteristics of an outsourced procurement environment and offers guidelines for deciding if procurement outsourcing is right for your organization.
What Is Procurement Outsourcing?
Think of procurement outsourcing as the transfer of specified key activities relating to sourcing and supplier management to a third party — perhaps to reduce overall costs or maybe to tighten the company's focus on its core competencies. Regardless of motivation, procurement outsourcing generally is:
- A multiyear agreement
- More correctly associated with the provision of third-party services than with a complete transfer of control
- Contractually linked to explicit benefit targets, such as cost reduction and service enhancement
- Geared to continuous, step-change improvements in performance
There are several levels of procurement outsourcing. As shown in Figure 1, the most basic involves a migration of infrastructure: people, technology, systems, and supplier management. At the next level, an outsource services provider might also assume responsibility for one or more procurement-related processes, such as requisitioning and procure-to-pay. Higher still are value-added functions, such as strategic sourcing (identifying, selecting, and shaping supplier relationships and value propositions). At the top are broadly strategic responsibilities, such as the formulation of business rules.
Figure 1: A pyramid of increasingly strategic categories, processes, and enablers/assets demonstrates many levels of procurement outsourcing.
Why Procurement Outsourcing?
Companies should consider outsourcing their procurement functions for the same reasons they might outsource other operations, such as payroll or IT. Historically, the top rationale is that the work is not a core competency, and thus should be done by an organization for which the work is a core competency. At most companies, purchasing indirect or non-critical materials — or managing basic processes such as procure-to-pay — are not core competencies.
However, many businesses now see outsourcing as a real opportunity to increase efficiency. This is doubly true in procurement, where significant savings can result from repositioning and centralizing large numbers of people and technologies, and avoiding burdensome investments in upgrades and new systems. Higher-level procurement efficiencies also exist, such as channeling more spend through aggregated corporate contracts (compliance). In this case, raising compliance from 60 percent to 95 percent can cut a company's cost of goods sold by as much as 4 percent. Across the board, it is not uncommon for procurement outsourcing to reduce the cost of materials and services by up to 15 percent.
The travails of driving change through an organization may be another motivator. In most outsource environments, new processes and technologies can be enacted more quickly, more efficiently, and with less resistance. Lastly, companies are ceaselessly challenged to develop and maintain peak personnel skills. With outsourcing, ongoing personnel management is less of an issue.
But beyond the motivations that any company might use to outsource any business function, there are benefits/advantages that speak solely to procurement (see Figure 2). In this context, the common denominator is scale. Assigning procurement responsibility to an organization that works on a larger scale is an opportunity to:
Figure 2: Procurement outsourcing can enhance shareholder value by lowering operating costs, improving capital allocation, and even strengthening the revenue stream.
- Connect with a larger base of suppliers, and thus enjoy more chances to capture lower prices and achieve a better fit with your procurement needs.
- Aggregate spend, since outsource service providers serve multiple organizations. This means more chances to pool purchases and contracts.
- Access higher levels of expertise, such as niche-focused capabilities in technology or process management. Consider that a $2 billion company is unlikely to employ an expert in telecommunications commodity sourcing. However, a qualified outsource services provider probably does employ a telecommunications sourcing specialist, whose expertise can be amortized across multiple clients.
- Tap more economical labor sources, because outsource service providers may be better equipped to leverage offshore labor. Since there is significant wage arbitrage in the transaction-processing of procurement outsourcing, an offshore-labor opportunity may be beneficial.
What's Different About an Outsourced Procurement Environment?
Beyond projected benefits, executives must concern themselves with how their companies will operate following a transition to outsourced procurement. Not surprisingly, the new environment will be automation-intensive. Staff will work largely in a self-service mode, transmitting orders electronically and using Web-based tools to access information about order status, supplier profiles, and contracted terms and conditions. Sourcing and quoting tools will be equally prevalent. Instead of phoning, faxing, or mailing RFQs to suppliers, electronic bidding and quoting will be the order of the day. High levels of automation also are necessary to ensure that up-to-the-minute information reaches online catalogs, inventory management systems, and AR/AP functions.
In addition, a service center approach will pervade, replacing distributed-procurement models that emphasize multiple individuals at multiple locations. In fact, centralization is a procurement-outsourcing staple. Employees interact with a central buying function that, in turn, reaches out to a worldwide range of suppliers. Resources are shared across business units and even across companies. As noted earlier, this is also a compliance-intensive environment: More commodity categories and suppliers are tied to aggregated contracts, so there are fewer tactical decisions for users to make. From the supplier's view, these changes often produce dramatic improvements in order, invoicing, and payment cycles.
Organizations should also expect an intense focus on operating metrics. Outsourcing contracts and fee structures typically are tied to operating metrics, such as cost savings or service improvements. As the outsourcing program is implemented, these metrics become the basis for measuring the performance of individual business units against the broader set of company-wide objectives. Business units that are not performing up to their targeted level are clearly identified and targeted for focused performance-improvement programs.
Lastly, procurement relationships are framed by formal governance structures and service-level agreements (SLAs).
- Governance structures define oversight processes, help evaluate investments, frame risk- and gain-sharing policies, and articulate staffing parameters and operating specifics.
- SLAs delineate operational metrics and help companies measure the success of procurement activities, such as compliance. For example, an SLA might define the expected rate of step-change service improvement, the speed with which service center calls are answered, or even the way those calls are handled and logged.
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A Steady Stream of Procurement Savings for Thames Water |
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With 12 million customers covering 5,000 square miles in and around London, Thames Water is the United Kingdom's largest water utility. To keep its water and wastewater-management systems up and running, the company must have more than 5,000 different items — pipes, valves, pumps, tanks, and so forth — readily available. However, the now-privatized company must also meet tough regulatory mandates to continually improve efficiency and reduce prices. To meet these obligations, Thames Water came up with a unique way to save money and revolutionize the business: outsource its procurement operations. Working with an international outsourcing services provider, Thames Water developed a new outsourcing model called "Connect 2020." Within the scope of that model, the services provider assumed control of all of Thames Water's procurement operations. In the process, Thames' purchasing processes were revamped, and its stable of approved suppliers was downsized, with new, money-saving agreements negotiated with most. The success of Connect 2020 has been unprecedented:
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Is Your Company a Good Candidate for Procurement Outsourcing?
Like most things of value, procurement outsourcing is neither a one-size-fits-all solution nor a program that is right for all organizations. However, there are very few large companies that should perfunctorily dismiss procurement outsourcing as unbeneficial or unworkable.
Manufacturers — process or discrete — may have much to gain from outsourcing their procurement operations, particularly with respect to indirect materials. However, it is neither unfeasible nor unusual for outsourcing programs to include the acquisition of (at least some) direct materials. Consider that many direct materials are commodities, such as resins, grains, petroleum, and electricity. And commodities are leading candidates for the aggregated, contract-based buys that make outsourced procurement beneficial. Opportunities also exist to outsource infrastructure and procure-to-pay processes, regardless of whether materials are direct or indirect.
Within services-focused industries, such as government, financial services, and utilities, virtually all the spend is indirect. Thus procurement is truly a noncore function, and there is less likelihood that a high level of procurement expertise has been cultivated. In most cases, outsourcing procurement makes more sense than developing best-in-class capabilities for a noncore function.
Figure 3: The decision to outsource requires a detailed evaluation of a companys current circumstances.
As shown in Figure 3, procurement outsourcing decisions are not a matter of direct versus indirect, or product versus service. The bigger picture is balancing a host of less tangible, more company-specific issues, and deciding if an alternative solution is worth pursuing. Chances are good that procurement outsourcing will soon be as widespread as the outsourcing of payroll or IT, companies getting in early will enjoy competitive advantages and gains in operating efficiency, revenue generation, and shareholder value.
