The pros and cons of outsourcing procurement

15 November 2021 Consultancy.uk 8 min. read
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Many companies lack the necessary capabilities to address all of the potential opportunities and capture full value from optimising indirect spend, outsourcing can sound like an appealing option. However, Jamie Loder, a Director at 4C Associates and head of the firm’s private equity practice, warns that outsourcing is not without its own risks – as over time, it can weaken the effectiveness of the procurement function as a whole.

For many organisations, indirect procurement – purchases of services and supplies that support business operations – is a source of tremendous untapped value and savings. But even though indirect spend can represent as much as 20% of revenue in some industries, it typically isn’t fully managed by a single function or business owner, and is frequently overlooked as “noncore” spend.

Because many companies lack the necessary capabilities to address all of the potential opportunities and capture full value from optimising indirect spend, outsourcing can sound like an appealing option. Indeed, outsourcing providers can bring important capabilities and assets to bear, such as functional expertise, knowledge of the market, process discipline, and updated sourcing technology.

Jamie Loder, Director, 4C Associates

But outsourcing can be a risk as well. Over time, it can weaken the effectiveness of the procurement function as a whole, without producing the sustained impact that was hoped for. Instead, companies may find that the value captured in the first few years of outsourcing falls, before plateauing at a relatively low level. Moreover, a lack of strong relationships within the client organisation can impede collaboration, while the transactional focus of many outsourcing relationships tends to inhibit a more strategic approach to optimisation.

A few companies, however, have found that the most effective way to optimise indirect procurement is not simply outsourcing it, but instead transforming the procurement function into a strategic, value-generating arm of the organisation. Such a transformation requires introducing rigorous management practices, changing deep-rooted mind-sets and behaviours, and building new, next-generation capabilities in areas such as digital procurement. Done correctly, it can yield an initial cost reduction of as much as 15%.

Companies can capture most of these gains within 12 to 18 months, and continue to capture annual cost reductions of c.4% after the transformation. Completely outsourcing indirect procurement, on the other hand, captures only about a quarter of the full savings opportunity and can prevent companies from building internal capabilities that can become lasting advantages and sources of resilience.

Benefits of outsourcing indirect procurement 

Extracting the full value from indirect sourcing requires a well thought through, integrated approach.

Some companies realise they lack the talent, expertise, systems, or infrastructure to pursue such an approach, so they must make a critical choice: develop the capabilities internally, or outsource some or all of the indirect-procurement function. Outsourcing may look attractive, given that the benefits indirect-procurement business-process outsourcing (IPBPO) providers can offer include:

  • Category expertise
  • Market intelligence
  • Process discipline
  • The latest sourcing applications and technology
  • Risk mitigation
  • Cost advantages

The expectation is that these value-adds can result in faster time to impact, increased spend visibility and compliance, and reduced operational cost.

Outsourcing’s short-comings

 Relationships with IPBPO providers frequently focus on improving basic sourcing practices, capturing low-hanging fruit such as pursuing volume discounts by consolidating spending. It’s much rarer to attempt more-sophisticated approaches, such as should-cost analysis, highly structured negotiations, or advanced request-for-quotation (RFQ) strategies. Consequently, outsourcing frequently runs up against a series of limitations:

  • Overemphasising commercial levers
  • Barriers to developing strong business relationships
  • Reduced cost and capability advantages
  • Misaligned incentives

Indirect procurement outsourcing in practice

Most companies that decide to outsource indirect procurement achieve moderate initial benefits. Total cost reductions of 4 to 6% in the first couple of years, followed by year-on-year additional cost reductions of a further 1 to 2%. But companies that take back control of indirect procurement and launch full transformations can achieve savings of more than 12%, even after the function has been outsourced for a few years.

The decision to outsource indirect procurement is not all-or-nothing. Indeed, outsourcing nonstrategic procurement can free up stakeholders to focus on systemic improvements that ultimately bring more savings. The key is to understand how to derive the most value from the outsourcing relationship. The considerations may differ depending on whether decision makers are considering outsourcing procurement that creates value, or that preserves value.

Whether to outsource value-creation activities depends on two main factors: the strategic importance of the category, and the depth of internal sourcing capabilities. “Strategic importance” usually is a question of whether the category creates competitive advantage and requires close involvement of the business—or, conversely, whether outsourcing would generate substantial additional risks. Once that determination is made, the organisation can assess its internal sourcing capabilities by analysing the skills, mind-sets, and maturity of the indirect-procurement processes and tools that they have in-house.

Likewise, the decision to outsource value-preservation activities should be based on whether an organisation has internal economies of scale and the capability to effectively run this function. The outcome of these assessments creates four possible approaches to balancing outsourcing with building internal capabilities.

1. Build own capabilities, consider outsourcing temporarily
An organisation can outsource a process to capture short-term benefits while building in-house capabilities. For example, maintenance, repair, and overhaul (MRO) might be managed by an external integrator. This short-term approach can be especially helpful when spend management is not centralised, master data is poor, information on specifications and prices is limited or unpredictable, and suppliers are fragmented.

Integrators can use their tools and knowledge to collect MRO specifications, identify duplicate products, and consolidate the supplier base. Because external aggregators are likely to struggle to unlock the next 5 to 8% of value, organisations can bring indirect outsourcing in-house after building their own capabilities, and use internal relationships to better manage demand.

One method to assess when an organisation is ready to insource is through a structured strategic-sourcing assessment.

2. Keep indirect procurement in-house
Organisations that already act on commercial and demand levers (running frequent RFPs, implementing preferred-supplier models, and managing specifications or implementing catalogues) can handle indirect procurement internally. When meeting certain performance indicators is strategically important—such as on-time delivery—stakeholders may want to keep that category internal as well: for example, choosing the right logistics partner may be too critical to a company’s competitive advantage to leave that decision to a sourcing provider.

Similarly, an organisation can keep activities in-house if it can execute procure-to-pay processes effectively at scale, such as through an internal shared-services organisation, and has established appropriate governance structures to sustain the operation over time.

3. Consider outsourcing nonstrategic indirect procurement
If an organisation lacks the capability, capacity, or scale to invest in sourcing, or if a category is of lower strategic importance, outsourcing the corresponding element of indirect procurement may be the right move. For example, travel and entertainment is not a strategic activity or part of the core capabilities for most organisations. Because many third-party firms specialise in the function, outsourcing this category can be cost effective.

4. Assess in- versus outsourcing cost–benefit trade-off
In some instances, organisations may have internal capabilities even for nonstrategic or subscale indirect-procurement categories or processes. The organisation can then assess the costs and benefits of outsourcing the work or keeping it in-house, often a balance that looks primarily at the relative costs of the internal organisation and the outsourcing contract.

But other factors enter into the equation as well. For example, an organisation might have internal expertise in facilities management. Even if the category doesn’t have immediate strategic value for the organisation, the business might nevertheless determine that retaining the expertise is sufficiently important for future flexibility to opt to retain it. Conversely, it might decide that the expertise would be better deployed elsewhere in the organisation, and opt for outsourcing.