What and When You Should Not Outsource

Everyone seems to have an attitude towards outsourcing.    You may like the idea of transferring a “dirty” job to an expert third party so you can focus on your more important “high level” job.   But you might not like the idea of transferring control over how the “dirty” job is done.  And you might feel threatened by the transfer of your job (whether “dirty” or “high level”) to another company that has a different culture, business strategy, management style, incentive plan and personal career path.   So, whether you are:

  • in the trenches doing non-administrative tasks (doing “real work”);
  • in a purchasing department or other administrative department buying services to support your people in the trenches, or
  • a senior executive redefining where the trenches are to be dug, your attitude will be more realistic if you know the types of services that should not be outsourced.

As with every “rule,” there are good reasons not to follow the rule in special situations.  So, with this caveat, we offer a list of “what not to outsource.”

I.          Never Outsource.

“Core business competencies”.
Competitive advantage flows from the superior skill, acumen or execution of the enterprise’s mission.   “Core business competencies” should never be delegated, transferred or compromised by blind dependence on a third party.

Abdication of business judgment, where you cannot delegate authority or discretion over how a function is performed.
The “business judgment” rule reflects the need for retention of “core business competencies.”    [See, e.g., Del. Gen. Corp. Law, Section 141(a) and related case law.]  As a matter of corporate law, a board of directors cannot delegate responsibility for making business judgments.

Conversely, when board members exercise business judgment after suitable due diligence, evaluation of alternatives and good-faith balancing of risks and rewards for the benefit of the enterprise, the “business judgment rule” will normally immunize the board members from claims of breach of fiduciary duty or abdication.

Two exceptions to the “business judgment rule” might apply.  First, in special-purpose entities such as joint ventures, limited partnerships and limited liability companies, the entity’s “constitution” might circumvent this principle using express words of exoneration or limitation.    Second, a member of a Board of Directors may rely upon corporate officers and external advisers “as to matters the member [of the board] reasonably believes are within such other person’s professional or expert competence and who has been selected with reasonable care by or on behalf of the corporation.”  Del. Gen. Corp. Law, Sec. 141(e).   Experienced outsourcing consultants and outsourcing lawyers can help insulate corporate board members from personal liability for failure to exercise business judgment.

Consequently, outsourcing is entirely inappropriate for functions where the outsourcing vendor will have the legal right to exercise discretionary business judgment that cannot lawfully be delegated.   [An LLC may have more flexibility in delegation of management.  See, e.g,. Del. Ltd. Liab. Act, Sec. 18-407.]   Non-delegable corporate functions go to the very heart of the spirit, goals and mission of the enterprise.   No one can give away the steering wheel and expect to remain in the driver’s seat.  The test for this element is whether the company can “afford” to allow the third party to veto a business decision relating to the scope or manner of performance of the function.   (But if the company can afford to delegate the manner of performance, then the job is probably well suited for outsourcing.)

Knowledge-based functions dependent on proprietary company information.
Transferring to a third party keys to the enterprise’s “crown jewels” (intellectual capital) is analogous to ripping the heart out of the enterprise.   In a knowledge-based global economy, competitive advantage depends upon an enterprise’s control of its trade secrets and its ability to build upon skill and experience.   The transfer of such control over intellectual capital may be more appropriate in transactions involving the transfer of the “line of business” (“LOB”) to a purchaser, merged company or a joint venture, and less appropriate in a transaction where the enterprise no longer is an equity owner in the intellectual capital upon which effective performance of a given LOB function depends.

Compliance with legal liabilities.
Should the enterprise rely upon a services provider who assures the enterprise that, by outsourcing a function to them, they will “take care of” your legal liability for compliance with some law, rule or regulation?    What happens if the enterprise accepts their services but have no recourse (other than a refund of some of the service fees) in the event of a mistake that entails legal penalties, interest, legal fees, diversion of senior management’s focus, and public embarrassment?    Ultimately, the enterprise is liable for the mistake, and your “agent” (the service provider) may have a contractual liability to the enterprise.  Unless the enterprise receives some adequate assurance that its losses from a breach of compliance duties will be “taken care of,” the enterprise should not outsource the function.

(As an exception, when the service provider is a licensed professional, the service provider’s standard of care, ethical duties and professional liability are generally well defined under statute and common law.   Accordingly, outsourcing of functions to licensed accountants, attorneys, architects, engineers, physicians other regulated professions occurs normally and fits within the “business judgment” rule where management is lawfully entitled to rely upon the advice of third-party professionals.)  [Del. Gen. Corp. Law, Sec. 141(e); contrast, Del. LLC Act, Sec. 18-406.]

Business functions that are highly volatile or unpredictable in scope or risk structure.
The key to deriving business benefits of outsourced services lies in the service provider’s capacity to deliver predictable service.   Predictability of quality and capacity to perform depends on repeatability (as with the concept of interchangeability of components that sparked the Industrial Revolution in the 1800’s).  Thus, if the customer’s service requirements are highly volatile as to scope or risk structure, the function should be retained “in-house.”

(This does not apply to mere increases or decreases in units of a defined service, or changes in scope within normal evolution of a given field of technology or business maturity, since the scope and risk structure would be predictable, and the volatility in scale would be the subject of normal capacity planning and predictions, based on history, of future technological improvements such as “Moore’s Law”.)

Interdepartmental, or multidisciplinary, functionality.
Outsourcing a function involves retaining responsibility for managing the service provider’s performance.  Prudent enterprises retain the capacity to administer and manage the service provider’s performance under the outsourcing contract.   If the outsourced services cover a range across disciplines and departments within the enterprise, the enterprise will need a multidisciplinary team to manage the outsourced services for success.

This particular dictum applies only to the early stages in an enterprise’s experience with outsourcing.  Enterprises not familiar with the challenges and processes of outsourcing may benefit by avoiding the need for multidisciplinary teams of managers.   More experienced enterprises develop an expertise in managing outsourcing as a generic management tool.   Such advanced outsourcing skills may, with senior executive sponsorship, emerge eventually due to cross-fertilization of internal skillsets in different departments and the synthesis and extension of successful contract administration principles to multi-vendor and multi-disciplinary environments.

Critical Business Functions that are Subject to Unacceptable Levels of Political Risk.
Even domestic outsourcing operations may involve foreign subcontractors whose right to deliver services, or right to receive payment, could be severely impaired for political reasons.  Embargoes, quotas, political restraints, inconvertibility, nationalization, expropriation and similar risks may suggest that special measures be adopted to mitigate any political risk.   Experienced outsourcing attorneys can provide advice on risk mitigation and management.  Such risks are manageable, as evidenced by a 1999 advisory opinion of Swiss governmental regulators relating to foreign transaction processing of Swiss bank information.  [See Transborder Outsourcing of Business Processes for Banks]

II.        Bad Timing for Outsourcing (at least for now).

Similarly, we offer a list of situations when outsourcing would be inappropriate at the moment:

During the period prior to a shift in senior management.
Outsourcing is a process that should not be initiated when the incumbent management will not be present to ensure satisfactory implementation.   Proper outsourcing strategies require substantial time, and cost substantial resources, for planning and implementation.  Every member of the board of directors, and every senior officer, has a fiduciary duty to manage the company assets.   The “new” manager’s hands will be tied by long-term commitments in an outsourcing agreement.   Even contracts that permit a customer to terminate for convenience may cost the company, not only in payment of termination charges, but also in lost momentum and distractions arising from the transitioning to a new vendor or to return to an in-house sourcing strategy (“make,” not “buy”).    (Conversely, new management may take the view that the company can profit from outsourcing, but a “new look” at the “make vs. buy” decision should probably best be made after new management has done an assessment of the suitability of outsourcing for the corporate mission as articulated by the new management.)

During a major restructuring occurring without an outsourcing orientation.
In a weak economy, enterprises may restructure internal operations to reduce costs, eliminate hierarchies, reshuffle teams, divest unprofitable operations, refinance with complex or operationally restrictive covenants, consolidate, recapitalize, transfer to new locations and other strategic initiatives.   In a strong economy, enterprises may launch new initiatives for growth with similar short-term destabilizing effects on “business as usual.”   Where such restructurings are in progress without an outsourcing orientation, the stability needed for analysis, structuring, negotiation and transition towards outsourcing will be lacking.   Under such conditions, any major outsourcing transaction could pose high risks by through complications, distractions to senior executives and possible excessive haste.

Conversely, outsourcing should normally be considered a useful management tool in the tool kit of CEO’s and CFO’s engaged in any restructuring where there is sufficient focus, stability of operations and time to effectively obtain the desired benefits.