Outsourcing Suppliers Act Like Insurance Companies
Last month Bill Gates, the chairman of Microsoft, was giving a presentation to stock analysts when the ground shook. No, it wasn't the power of the newest version of Microsoft Office he was displaying. At that moment Seattle, Washington was hit by a massive earthquake which caused billions of dollars in property damage.
Property owners prescient enough to have purchased earthquake insurance are now rebuilding with the funds they received from their insurance policies. The insurance companies have enough cash on hand to pay off their policy holders because they know how to underwrite risk.
First, property and casualty insurance companies diversify their risk. In addition to earthquake insurance, they sell fire, flood, and hurricane coverage. They pool the funds of their policyholders, knowing it's unlikely that the insurer will suffer multiple disasters at the same time.
Second, they have experts who know how to calculate risks. These gurus understand how to project the probability of the losses they could face. They know the odds and the pay offs. Then they structure their portfolios and their premiums to reduce their overall risk. Part of every policyholder's premium goes to pay for this knowledge.
Finally, they are able to charge affordable premiums to each customer because all the customers are paying for the service, not just one.
"This is how insurance companies handle risk in everyday life. And that's exactly how outsourcing mitigates capital risk: Outsourcing buyers rely on people with better knowledge than they have to manage their situation in a pooling arrangement," explains Robert Klepper, professor of management information systems at Southern Illinois University at Edwardsville. Klepper and Wendell Jones are the authors of "Outsourcing Information Technology, Systems and Services" (Prentice Hall, 1998).
The Three Types of Capital Risk
Klepper says outsourcing can involve three types of capital risks. The first is asset risk. These are long-lived physical assets that produce a stream of income. Companies have to invest to acquire these assets.
Klepper says owning assets includes a risk. Rapid technological change can render them obsolete. Or, "if the equipment represents bleeding edge technology, there's the risk you can't get it to work," adds the professor.
The second capital risk involves a company's human capital. Companies hire people with skill sets they need. Then they train them. Like physical assets, their knowledge becomes capital that can become obsolete as technology or business needs change, Klepper explains. And people can leave the firm, taking their knowledge with them. Turnover is a human capital risk.
The third capital risk involves knowledge capital. Klepper defines knowledge capital as the information the organization uses to make good business decisions. "Knowledge capital is not inherent in one person. It's a group phenomenon," he notes. Knowledge capital becomes obsolete when economic conditions change or key people leave.
Klepper says buyers who outsource shift much of these risks to the vendor. "It's like buying insurance," he says. In this analogy, the outsourcing vendor is akin to the insurance company.
Scale Mitigates Risk
The larger outsourcing vendors have tremendous scale. Their scale mitigates the human capital risk by "fitting people into a much larger puzzle than exists in the buyer's company." The vendor has many ongoing projects and can reassign people depending upon the need. Because their customers operate in a wide variety of industries, they may not feel the sting of economic ups and downs as sharply as their individual buyers do.
"This wide range allows a vendor to diversify risks that you can't," says the professor.
The same applies to technology assets. The vendor's "bigger picture" helps it deal with obsolescence in a more effective way. "Outsourcing vendors have more options and greater flexibility," he observes. For example, they may have preferred relationships with equipment manufacturers which entitle them to better prices than an individual company could negotiate on its own and preferred relationships with equipment resellers.
Outsourcing Vendors Can Afford the Gurus
Some outsourcing vendors specialize in a small but important area of expertise. These suppliers can hire experts a buyer could never afford. They can spend the big bucks because they spread the cost of this high priced knowledge over many buyers. Their knowledge and expertise mitigate some of the risk of working with new technologies, markets or products.
Knowledge capital, however, is risky for any company to outsource, in Klepper's view. "This is the knowledge that differentiates your company from every other company," he explains.
However, companies may discover they are lacking in knowledge capital. The professor says one of the ways to gain it is through partnerships and alliances with companies that have complimentary but different knowledge capital. "By sharing complementary knowledge capital with each other, both parties can perform in ways they could never do alone," says Klepper.
The best way to make this work is to act as co-equals and share both the risks and the gains. These partnerships also mitigate risk because they allow companies to tap into knowledge capital they don't have. A good example of this kind of partnership is the Exult/Deloitte & Touche story in our BPO Journal.
Lessons from the Outsourcing Primer:
- Insurance companies provide a good paradigm for mitigating risk: They diversify their risk, employ experts and pool capital by having a large number of policy holders pay small premiums. Large outsourcing vendors mitigate risk in much the same way.
- Companies face three kinds of capital risk: asset, human and knowledge. Outsourcing mitigates the asset and human capital risks.
- Companies should not outsource their knowledge capital. Instead, they should form strategic alliances if they need to acquire knowledge capital.