Finance & Accounting Outsourcing: Does Outsourcing Reduce Risk?

October 9, 2009 by

When enterprises look to outsource in-house responsibilities, finance and accounting functions are usually not the first ones farmed out. Executives might expect to read headlines like, “Aon Negotiating to Outsource Most of its U.S. IT Infrastructure to Computer Sciences Corporation,” a development Aon and CSC touted in a 2004 press release. Sophisticated business process outsourcing (“BPO”) such as finance and accounting is not as widespread as IT outsourcing.

As enterprise firms seek to enhance their competitive advantage and minimize risks in the Sarbanes-Oxley environment, more and more businesses are looking to outsource parts of their finance and accounting functions. Determination of the right fit with a service provider and the right mix of services is essential.

This article addresses some key business and legal issues in whether F&A outsourcing reduces risks.

What F&A functions are candidates to be outsourced?

Not all F&A functions are created equal. Each F&A function has its own risk profile and potential suitability for outsourcing. Risk profiles reflect the nature of the business functions, size and character of the enterprise, since publicly trade companies must deal with the vagaries and criminalization of accounting practices under Sarbanes-Oxley, and other considerations.

Transactional vs. Judgmental Operations.
Transactional functions, especially payroll and accounts payable and receivable, are the most commonly outsourced functions. Financial reporting and more advanced functions can also be outsourced, though the more interaction required for a function—say, for instance, budgeting—the less likely it is to be outsourced. But today, F&A outsourcers are taking on responsibilities once executed by entire in-house F&A departments.

Enterprise Maturity.
F&A outsourcing depends on enterprise maturity.

Public Companies and “Wannabe’s.”
Mature enterprises — public companies and those considering going public — must, or will have to, establish and certify, on a quarterly basis, the adequacy of their accounting reporting and control systems. Compliance with the Sarbanes-Oxley Act has generated new software and service offerings by information technology service providers and consultants. Such technology might be maintained in-house, a hosting service provider or by a managing service provider.

For public companies, the challenge is to identify those F&A functions that can be “safely” outsourced with minimal risk that a failure will result in civil or criminal liability for the CEO and the CFO. Once such “safe” functions have been identified, the lawyers can deal with “reasonable” allocations of risk between the service provider and the enterprise.

Startups and Emerging Companies.
Startups may outsource more of a function. Outsourcing helps startups avoid misestimating their own needs. Two scenarios are common among startups: they underestimate their F&A needs, or they overestimate them.

Startups will often hire a bookkeeper, for instance, and may get the basic transactional aspects of the business right. But without an accountant, they can’t optimize their F&A strategy. This mistake can often require a startup to sink far more capital in F&A and litigation down the road than they would have had to invest up front.

Alternatively, some firms will bring on a CFO or Comptroller when their F&A needs do not demand that those positions be filled by a full-time employee.

Governance Considerations.
Entire F&A departments can be outsourced, all the way up to the CFO level. We interviewed two F&A outsourcing firms on the desirability of outsourcing CFO and Comptroller functions. Ephinay will take over all F&A responsibilities from a customer except CFO and Comptroller, which Ephinay believes must be retained by the customer for governance purposes. Other outsourcers, like Geller & Co., are more willing to absorb even the responsibilities of CFO and Comptroller, eliminating the need for any F&A functions to be retained by the customer. In contrast, Ephinay believes that is rarely optimal except when the customer’s business is highly specialized. Perhaps the distinction is not so important for small business, but for larger and growing businesses, retention of key internal executives helps ensure controls are retained as well.

When is F&A outsourcing a better solution than in-sourcing?

Business Process Analysis.
As in all other types of outsourcing, F&A outsourcing starts with an analysis of the business processes of an enterprise. This analysis must cover virtually all essential elements of the business processes under consideration. Thus, an “end-to-end” approach will identify functionality, interaction with third parties (such as suppliers, customers and regulators), the degree of human expertise required for each process and the degree to which human expertise can be captured in a scalable information technology solution that includes hardware, software, telecommunications and technology managers.

Business Processes Considered for F&A Outsourcing.
Having dissected the business processes from end-to-end, the enterprise then considers how the classic types of rationales for outsourcing might fit into each F&A process. Many firms find outsourcing F&A business process functions preferable to retaining them. Here are some common reasons why.

Shifting functions plays to core competencies.
F&A outsourcers exist for one reason and one reason alone: to take over the F&A functions of other businesses. If F&A outsourcers fail to do a good job of F&A in a competitive marketplace, they will fail entirely. F&A is an F&A outsourcing firm’s core competency, by definition. Of course, this is an agreement to “trust me.”)

In-house functions are always secondary to the fundamental premise of the company.
In a semiconductor business, for example, making and selling semiconductors is the lifeblood of the business; F&A functions are necessarily secondary because they do not create business. This is no less true of large corporations than it is of startups or enterprise businesses. Top talent is routed to revenue-generating departments; being an accounting whiz, for example, is unlikely to take you to the top of GM. F&A outsourcers, unlike their customers and prospective customers, are structured to reward those who perform F&A functions well.

F&A outsourcing optimizes functions of non-F&A businesses.
F&A outsourcers allow businesses to focus on revenue generation instead of worrying about F&A matters, which are integral to their operations but do not actually create revenue for their business.

Outsourcing optimizes the function of the CFO and other senior-level employees.
When transactional functions are outsourced, the CFO can focus on F&A strategy rather than minutiae. The CFO can be a CFO, the Comptroller can be a Comptroller.

Cost Substitution.
Outsourcing enables businesses to implement more advanced technology solutions more cheaply. Take, for example, a firm with an antiquated IT system that costs them $10 million dollars a year to run. They want to upgrade, but the upgrade will require a capital investment of $15 million; the outsourcer, on the other hand, can provide the service for $8 million. The customer may prefer to go with the outsourcer, who can provide the improved technology for less than the cost of the customer’s obsolete technology and for substantially less than the cost of an in-house upgrade.

Economies of scale.
F&A service providers such as Ephinay and Geller claim they can give the customer “more F&A bang for the buck.” An outsourcing provider (or a CPA firm) could enable a company outsource its needs to F&A experts who work part-time for the company. When ’re hiring a part-time F&A provider, the enterprise can afford to tap a deeper bench for the same money. For the same costs as for a CFO, the enterprise might get a CFO, a Comptroller, and a bookkeeper. The customer can take advantage of the fact that the outsourcer likely has a much larger and more specialized staff than the customer’s in-house F&A department. A customer could afford to have a small army of outsourced accountants, for example, working on its projects at crucial times, which it could never do in-house.

Peaks and Valleys.
Outsourcing may also help smooth peaks and valleys in the monthly, quarterly and annual financial and accounting cycles. Variability in service volumes enables companies to budget for their in-house baselines and manage the pricing and costs — on a variable pricing method — of outsourced staffing for peak loads. In contrast to staff augmentation as a business model, though, outsourcing involves minimum purchase commitments by the enterprise customer, thereby allowing an efficient outsourcer to engage in resource management planning and delivery of lower per-unit resource costs.

Process Complexity.
Certain F&A processes are so inherently complex, or judgmental, that the entire process is outsourced before the enterprise even considers hiring and supporting its own staff. Such areas include employee retirement planning, ERISA fund investment and pension administration. (These processes overlap with HR functions, making them even more complex.)

Why F&A outsourcing minimizes risk

Outsourcing in F&A is often a way to increase competitiveness and minimize a firm’s risk. Outsourcing can improve competitiveness by cutting costs, but it can also improve the capabilities of the customer’s firm beyond freeing up intellectual and financial capital. Here’s what the sales pitch sounds like:

  • Shifting functions is shifting risks.
    Shifting functions to an outsourcer can be a way of shifting risk to that provider. When a customer contracts with an outsourcer to execute a function, the customer then looks to the outsourcer for results; it becomes the responsibility of the outsourcer rather than the customer to deliver. This improves efficiency for the customer; if an employee calls in sick and can’t deliver before an important deadline, for instance, that now becomes the outsourcer’s problem rather than the customer’s.
  • F&A outsourcers are better structured to catch many kinds of errors.
    Many outsourcers have multiple levels of review built into the F&A process and are therefore more likely to catch errors before they become catastrophes. These errors could range from the occasional arithmetic mistake to faulty accounting and the attendant potential for civil liability. Many customers cannot afford to hire in-house the quantity or quality of people required to match an F&A outsourcer’s product. F&A outsourcers also often have more detailed or more up-to-date knowledge of arcane tax regulations that can be leveraged to the customer’s advantage. This is, of course, more important in the Sarbanes-Oxley world, where accounting errors can embroil firms in heftier fines and more serious litigation than before. In addition, unauthorized expenditures by outsourcers are impossible—whether the result of a mistake by the outsourcer or criminal embezzlement—when the contract between the customer and the outsourcer spells out precisely what expenditures are authorized and what responsibilities will be retained by the customer.
  • F&A outsourcers are less likely to make mistakes because it undermines their entire business.
    F&A outsourcers’ livelihood comes from their contractual work. At a minimum, outsourcing in general does not increase risk. Problems presented by the risks of mathematical errors, incompleteness of records, lost records, and inappropriate classification of transactions for accounting purposes, for example, are at least as likely to occur among F&A departments of businesses that retain F&A functions as they are among F&A outsourcers. But in general, F&A outsourcers minimize these risks because F&A is their exclusive function; if they make these kinds of mistakes routinely, their business stands to pay a substantial material price. (In response, the enterprise needs to consider who is better at assuming the risk of making and making good on the typical types of errors associated with a particular business process.)

Questions that enterprise customers want answered

The prospective customer is considering handing over his business’ finances to another business. That is an inherently delicate process, especially if the prospective customer is not already acquainted with the outsourcer. Customers expect answers to the following questions:

  • Why should I outsource when I can retain control by insourcing?
  • for what functions is the outsourcer responsible?
  • Is the outsourcer reachable, or do I have to call between 9 a.m. and 5 p.m. to get in touch with a responsible person?
  • What attitudes and cultures should I look for in a “good” service provider?
  • How will outsourcing my F&A functions increase my firm’s competitiveness?
  • Will outsourcing allow the CFO to be more effective and act more strategically?
  • Will outsourcing increase our risk? Even if outsourcing can increase quality and reduce cost, the customer wants to know what the risks of outsourcing are, and whether and how they can be managed, before he closes a deal.
  • How do I assure that the outsourcer will track what we need to track, including possible fraud in its own operations?
  • What alternatives exist to outsourcing this function? Would an investment in software “solve the problem” of managing the particular F&A function?

Friction points

In outsourcing arrangements as in any transaction, friction points arise particularly when responsibilities are poorly defined. As in other types of outsourcing, F&A outsourcing involves classic issues that need resolution in planning and contracting.

  • Scope of services must be defined. If the scope of services to be performed by the outsourcer is left vague by the parties in their contract, serious problems can arise. The customer must know what responsibilities he is contracting to the outsourcer and what functions he retains. Likewise, if the number of hours or amount to be billed by the outsourcer is left open-ended, opportunity for customer-outsourcer friction increases.
  • Due dates for projects must be spelled out in advance by contract where appropriate. Outsourcers cannot be expected to respect informal internal agreements customers may have been accustomed to when F&A functions were in-house (“Frank always got me the numbers on Fridays—I don’t see what the problem is”) unless they are specified up front. But this is a problem inherent in any transaction, in outsourcing and insourcing.
  • Software compatibility is generally not an issue.
    This is a major concern for customers—how much of my standard operating procedure will I have to change to accommodate the outsourcer?, they frequently ask. The answer can be “none.” Generally F&A outsourcing firms do not impose tech solutions on their clients when transactions are light. Platform compatibility can become an issue, however, as the complexity of the mathematics increases. Some outsourcers are “platform agnostic” regardless of the volume of transactions involved, while others may require their high-volume customers to use Solomon or SAP.

Transitional Issues

A business’ decision about whether to outsource any function, F&A or otherwise, often hinges on the cost of transitioning responsibilities to the outsourcer. The slope of the customer’s learning curve and the amount of time required to make the transition depends on the number and importance of the outsourced functions. It also depends on the particular outsourcing firm.

Timing.
Some firms require four to six weeks to take over bookkeeping responsibilities from their customers; others do it in as little as two weeks. Outsourcing a whole F&A department could take as long as a year, or as little as a month

Transition Planning Toolkit.
Firms will often require their customers to fill out a questionnaire detailing business expenses to help acquaint the outsourcer with the customer’s regular expenses. This helps accelerate the transition. However, some pain occurs when the enterprise of the customer has to modify its process to accommodate the new outsourced business process.

Comparison with In-sourcing.
Some F&A outsourcers assert that transition costs entailed in a switch to outsourcing are not necessarily higher than those of hiring a new person in-house, and can often be recouped much more quickly. However, in a larger organization, the degree of change management is much greater when transitioning to an outsourced process.

Conclusion.

F&A outsourcing contracts may still represent a small minority of total outsourcing arrangements. Yet businesses are increasingly looking to F&A outsourcers to take over certain high volume, low risk, F&A functions with a modest degree of discretion or judgment. The trend in outsourcing towards allowing smaller and smaller businesses to outsource has taken hold in the F&A area as well. Small and mid-sized businesses (“SMB’s”) and startups can often find it profitable to outsource a variety of different F&A functions that would only have been profitable for major corporations to do just a few years ago. F&A outsourcing is becoming increasingly common among businesses that want to reduce risk and optimize their competitiveness and are willing to invest in strategic sourcing plans and skilled contract lawyers.

Effective risk management requires effective legal contracting. Given to complexity of F&A outsourcing, careful contracting is required.

Strategies for OEM Manufacturing – Contract Manufacturing

October 9, 2009 by

Instead of exiting a losing line of business, companies can retain customer relationships and full product lines by creative outsourcing of manufacturing capacity. A contract manufacturer could rescue the customer.

Computer Manufacturing.

Nowhere do we see this more than in the personal computer business. Economic recession, sharp declines in unit prices and direct-to-customer customized mail order manufacturing have forced PC manufacturers to either exit the business (as did Unisys), reduce internal capacity (as did Gateway) or outsource the manufacturing process (as Apple Computer, Hewlett-Packard and now IBM have done). In this case, after continuing losses totaling about $2.8 billion since the beginning of 1998, IBM saw outsourcing as a defensive tool to maintain market share, a full range of products for varying types of customer needs, a “one-stop” shop, and control over design and integration among a product line. As of January 2002, IBM agreed to outsource the manufacture of all its PC’s (“Netvistas”) and transfer manufacturing facilities to the contract manufacturer. When the PC industry produced greater competition, IBM exited the business by its sale of the PC division to Lenovo, a Chinese manufacturer.

Rationale for Contract Manufacturing.

Outsourcing of “original equipment manufacturing” enables the customer to private-label the OEM products. For technology leaders, OEM manufacturing also gives the customer access to skills of specialists in manufacturing efficiency, flexibility in volumes of OEM products that can be made and sold, and control over research and design. Where the customer earns significant revenues from sources other than manufactured products, an asset sale and outsourcing of manufacturing can redirect revenues to higher-profit operations such as operations management services, licensing of generic and custom software, security design, management for the manufactured products, and lease financing. OEM manufacturing allows the customer to convert investments in property, plant and equipment into cash for infusion into R&D and marketing, for example.

Control without Ownership.

Customers like IBM maintain control contractually through choices of components, configurations and design. They lose control, however, over the processes of managing raw materials, assembly operations, the manufacturing employees and the real estate and manufacturing equipment.

Pre-Contract Planning.

Prior to such an outsourcing, the vertically integrated manufacturer should strip out the non-manufacturing functions so that the shell can be transferred. For example, before choosing to sell its PC manufacturing plants to Sanmina SCI, Inc. in January 2002, IBM re-integrated PC sales functions into the IBM corporate sales department, leaving the PC sales unit dependent on salesmen who promote a variety of products, not merely the PC.

Flexibility in the Business Model.

Contract manufacturing can promote flexibility in business strategy and risk-shifting shock absorption in business cycles. As demand for the manufactured goods declines, the enterprise customer can reduce its variable costs and does not need to carry fixed costs (except to the extent of minimum purchase commitments, such as under a “take-or-pay” pricing model with the contract manufacturer). As demand grows, the enterprise customer can pay only variable increases of the costs in excess of its baseline of purchase commitments.

Outsourcing Tools for Insourcing

October 9, 2009 by

Outsourcing Tools for Insourcing.

The typical outsourcer also provides a spectrum of support and consulting services compatible with a totally insourced environment. Thus, outsourcing is only one of the core service offerings. Enterprise customers now ask the question: why outsource when I can insource using the right tools? While there may be many reasons to outsource, there are equally many reasons not to outsource. The reasons relate to ERP, SCM, CRM and DRM solutions that can be used to keep customers loyal and flexibly prepared for a future outsourcing. Emerging BPM / business process management tools and software as a “service,” can likewise create opportunities for retention of functions in house.

Does your “outsourcer” also sell tools that facilitate insourcing? In this article, we take a quick look at one particular tool offered by the king of outsourcers for its enterprise customers’ data centers.

Panoply of Insourcing Tools.

Insourcing tools help a customer manage its technology and service delivery to its internal customers without dependence on a third party for design, maintenance and support. Let’s consider a few:

  • Web-Enabled Self Service and the ASP Model.
    Under the “Applications Service Provider” model, the external services provider hosts its own proprietary software solution. The customer enters data into the provider’s software by remote control, either using web-enabled services or high-speed link.
  • Web-Enablement of Customer’s Proprietary Software.
    Companies such as Citrix have developed tools to allow a customer to place its own proprietary software on a secure Intranet, thereby reducing access costs, particularly for end-users who are traveling, home-based employees, or in a large complex organization with multiple offices worldwide.
  • Software Licensing Model.
    Software that helps customers perform their own “managed services” has developed over time. In the “early days,” data base software such as Oracle and DB2 organized data. More recently, enterprise resource planning software (“ERP”), supply-chain management (“SCM”), customer relationship (“CRM”) and device-relationship management (“DRM”) software have enabled enterprise customers to harness a uniform set of business process tools across large organizations. Such more robust software serve as tools for reducing complexity, enforcing business process rules and showing transparency of data. Such software also can plan, identify and manage for business continuity in case of disasters. As an emerging insourcing or outsourcing tool, new software tools facilitate provisioning of resources.
  • External Benchmarking and Performance Metering Tools.
    Service level agreements (“SLA’s”) define the various performance parameters that define the essential services under any outsourcing agreement. Enterprise customers have tools that measure the same operational data that the external service providers see at the service provider’s facilities. Customers now are demanding access to benchmarking and performance metering tools.

Why Outsourcers Might Offer Insourcing Tools.

There are many reasons why outsourcing might not be a proper solution for a client. Currently, IBM, Hewlett-Packard and Sun Microsystems all offer some form of tool to enable an enterprise customer to automatically provision server workloads based on supply and demand and network traffic. The same “silicon switch” that enables a customer to manage insourced IT resources could thus be used to transform to a hybrid insourced-outsourced combination or externalize the business process virtually.

Transitional Tools for Eventual Outsourcing of Process or Infrastructure, or for Provisioning of Services “On Demand.”

In such cases, the outsourcer should consider providing tools that retain customer loyalty and, like a Trojan horse, enable the customer to become an outsourcing customer “on demand.” The customer becomes trained in the service provider’s software, and such training might inspire confidence that, by using such tools, the customer can place more trust in an outsourced solution, either temporarily or on a continuous outsourced basis. These tools face the challenge of maintaining user control and limiting access to software applications while demand surges or subsides across a network of servers and data centers.

Infrastructure Support.

In fact, among others, IBM has adopted this strategy to service customers who might need hosted infrastructure and rapidly deployable additional server capacity. Its Tivoli “Intelligent Orchestrator” software will allow customers to convert a data center into an IT utility, where provisioning of network capacity (bandwidth), server processing capacity, storage and other computing resources are allocated dynamically in response to defined parameters of supply and demand. This resembles a “utility” because the “grid” operator may now anticipate demand and plan for allocation and reallocation of resources. In emergencies, the “grid” (data center with Intelligent Orchestrator (or competitive equivalent) could redistribute computing resources globally. But the challenge of dynamic global provisioning will remain daunting.

Pricing Challenges.

Tools for insourcing present challenges for the vendor. If the price of the tool is too attractive, the tool will sell and the services will not. If the tool is too expensive, outsourced services might be preferred, but only where the customer has no alternative. And by promoting tools, the vendor might cannibalize revenue from services, and vice versa. Pricing could be in the form of per-seat, per user, global site license, or site license by some other “line of business” demarcation.

Legal Issues in Dynamic Provisioning of Computing and Telecom Resources.
When we look at dynamic, rules-based provisioning of resources across international boundaries, we must remember that data transfers across borders remain subject to local legal controls. These include:

  • data protection laws.
  • privacy laws.
  • export controls on military data or “dual use” civilian-military processes.
  • license restrictions on authorized use.
  • infringement indemnifications that may be territorially restricted.
  • force majeure risks.

Transitioning from Software Licensing to Outsourcing.

Generally, a contract for a software license does not change when the parties enter into an outsourcing relationship. But customers should consider what changes should be made when this occurs, and what risks and assumptions have changed by virtue of the transition. By gaining the customer’s trust through a software tool, the vendor can thereby convert the customer to an outsourcing customer quickly, almost immediately. “Just sign here.”

We believe, in such cases, there could be significant business issues that need to be reflected in an appropriate contractual document. We recommend that an outsourcing lawyer be consulted in such circumstances.

More Information.

Bierce & Kenerson, P.C. does not provide any of the tools described above. However, we may be able to identify or comment on legal and practical issues of tools that may be of interest to the IT and technology-enabled services community. Please let us know if you have any questions about our experiences with particular vendors.

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