Diminishing Returns for Outsourcing?

The benefits may be harder to come by than is widely assumed, and they could become even more elusive if a new international rule is embraced by th...
Ronald FinkJanuary 30, 2006

Outsourcing has become so common among U.S. companies that the question no longer seems to be whether to engage in the practice but how far to extend it. The answer, according to the conventional wisdom, is the farther the better.

The benefits seem obvious indeed. To the extent a company can cut its costs by turning over non-core services to an outside firm, its earnings and stock price may increase. And consultants contend the impact can be transformational. The trick is to identify costly but ancillary functions that can be outsourced without sacrificing the quality of the support.

But there’s the rub. In fact, outsourcing’s benefits may be harder to come by than is widely assumed, according to recent studies. And they could become more elusive still, if a new international accounting rule is embraced by the Financial Accounting Standards Board.

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At least two new studies call into question the widely held assumption that outsourcing creates shareholder value or at least higher profits. One, conducted last year by the London-based Center for Economic and Business Research (CEBR), found that the stocks of companies announcing outsourcing deals outperformed those of other companies by less than 2 percent during the following month — hardly an eye-popping difference. And even that was called into doubt after the study was released last July, when a managing director of CEBR confessed to the trade publication Business System News for Finance and IT Professionals that it was “impossible to demonstrate conclusively a direct link between share price and outsourcing arrangements.” (An earlier study, conducted in 2000 by the consulting firm Stern Stewart & Co., found a more pronounced correlation between outsourcing deals and higher stock prices.)

The other recent study of outsourcing, by Paul A. Strassmann, a professor of information sciences at George Mason University and outspoken critic of the practice, examined the performance during 2003 of 1,100 diversified companies in Standard & Poor’s Compustat database. Strassmann found that those companies in the top half of the top quartile in return on equity (ROE) outsourced work representing less than half of their sales, compared with two-thirds for their counterparts at the bottom. And the gap in ROE was substantial: The top 277 companies generated a median return of 18 percent, while the bottom 277 companies absorbed a loss of 55 percent. Separately, Strassmann has calculated that General Motors’ ROE dropped from 39 percent in 1997 to 10 percent in 2004, even as its outsourcing increased from 68 percent to 75 percent.

To be sure, Strassmann defines outsourcing in a purely economic sense, that is, as purchases of goods and services from a supplier, ideally for less than what the company would spend on identical work from its own employees. Under that definition, however, a company’s ROE should automatically increase with outsourcing. So why did the reverse occur for the heaviest outsourcers in the sample he studied? As Strassmann put it in an article in the March 2005 issue of Baseline magazine, “Either the costs of purchasing outside work are too high, or their businesses have inherent flaws.” Indeed, in a recent interview with CFO, Strassmann insisted that many if not most companies inadvertently transfer knowledge capital to outsourcing companies along with tangible assets, if only because research and development costs are included in sales, general, and administrative expense for accounting purposes, and SG&A is where the bulk of cost savings from outsourcing are derived.

Under an accounting rule enacted in January 2004 by the International Accounting Standards Board, moreover, much of any cost savings could disappear, since companies would no longer be able to transfer any of their outsourced assets from their balance sheets to that of the service provider. That’s because the contract would be considered a form of leasing, and the IASB rule won’t allow assets financed by leases to be transferred for purposes of financial reporting. While the international rule won’t automatically become part of U.S. GAAP, standards-setters in the United States and are bent on aligning their regimes as closely as possible (see “The Narrowing GAAP,” CFO, December).

Experts say the change could have a sizable effect on a company’s reported results. “Outsourcing customers are likely to find that these new rulings have a significant impact on their balance sheets, depreciation schedules, and potentially even their earnings,” Julie Giera, an analyst for Forrester Research, noted in a research report last June.

All this will put more pressure on companies to realize less tangible, but perhaps less illusory, benefits from outsourcing. Companies might, for example, glean additional expertise from their outside firms or take advantage of an enhanced ability to focus on core activities. Yet that could require a shift in priorities, according to a survey of 224 companies in 2004 by the Institute of Management and Administration. More than 61 percent of respondents said their main reason for outsourcing was to reduce costs. Only 48 percent said their prime motivation was to focus on their core business; 35 percent said it was to improve service; and 11 percent said it was to maintain a competitive edge.