Academy o/ Management Executive. 2003, Vol. 17. No.

The seven deadly sins of

outsourcing
Jerome Baitheiemy
Executive Overview

While outsourcing is a powerful tool to cut costs, improve performance, and refocus on
the core business, outsourcing initiatives often fall short of management's
expectations.
Through a survey of nearly a hundred outsourcing efforts in Europe and the United
States, I found that one or more of seven "deadly sins" underlie most failed outsourcing
efforts: (1) outsourcing activities that should not be outsourced; (2) selecting the wrong
vendor: (3) writing a poor contract; (4) overlooking personnel issues; (S) losing control over
(he outsourced activity; (6) overlooking the hidden costs of outsourcing: and (7) failing to
plan an exit strategy (i.e., vendor switch or reintegration of an outsourced activity^.
Outsourcing failures are rarely reported because firms are reluctant to pubJicize them.
However, contrasting them with more successful outsourcing efforts can yield useful "best
practices."

core competencies and serving customer needs is

critical to firm success, anything that detracts from
this focus may be considered for outsourcing.^ Historically, many activities were performed internally because there were no outside suppliers. The
continuing growth of supply markets has provided
the opportunity to reassess which activities should
remain in-house and which should be outsourced.''
While firms may now have the opportunity to
outsource, outsourcing initiatives do not necessarily fulfill all their expectations. For instance, three
quarters of the U.S. managers surveyed by the
American Management Association reported that
outsourcing outcomes had failed to meet expectations.^ While literature on outsourcing has often
sought to draw lessons from highly visible companies that have been successful in outsourcing, this
article sheds light on failed efforts.^ Failed outsourcing endeavors are rarely reported because
firms are reluctant to publicize them. Firms do not
like to report their failures because such information can damage their reputation.' However, valuable "best practices" can be inferred from outsourcing failures, especially when such failures
are compared with successful outsourcing efforts.
My study is based on an in-depth analysis of 91
outsourcing efforts carried out by European and
North American firms. Primary data was collected
through face-to-face interviews and a detailed

Outsourcing can be defined as turning over all or

part of an organizational activity to an outside vendor. In the services industry, outsourcing was traditionally restricted to basic support activities. It was
also primarily used when restructuring firms that
were in bad financial shape. Today, outsourcing pervades the management of most companies. It has
also become increasingly clear that outsourcing is
more than a passing fad. According to a report from
the Economist Intelligence Unit, 34 per cent of firms
outsourced all or part of their information technology
(IT) in 1997. The proportion was expected to reach 58
per cent by 2010. Similar increases are expected for
activities such as telecommunications, accounting,
and human resources.'
Empirical evidence suggests that carefully
crafted outsourcing strategies increase the overall
performance of the firm.^ As the CEO of a mediumsized firm that had outsourced activities as diverse
as IT, logistics, financial services, and facilities
management pointed out: "Outsourcing enabled
us to double our operating income before tax while
our revenues remained stable." Outsourcing is
generally considered as a very powerful tool to cut
costs and improve performance. Through outsourcing, firms can take advantage of the best outside
vendors and restructure entrenched departments
that are reluctant to change. Outsourcing can also
help focus on the core business. Since building
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Academy of Management Execud've

questionnaire with managers in charge of outsourced activities. While most current research on
outsourcing focuses on a single activity (typically
IT), this article simultaneously deals with several
crucial services such as IT, telecommunications,
logistics, and finance (See the Appendix for more
details on the empirical research). Through this
survey, I found that the same mistakes underlie
most failed outsourcing efforts. These mistakes
have been termed the seven deadly sins of outsourcing. It is likely that firms will encounter each
of the deadly sins at some time during the outsourcing process. Though the deadly sins are conceptually distinct, they are not mutually exclusive.
Hence, they must be viewed as interrelated components of a complex system.
First Deadly Sin: Outsourcing Activities That
Should Not Be Outsourced
In the early 1990s, the newly appointed top managers of a car rental company decided to outsource
information technology (IT) to reduce costs. At that
time, IT costs stood at 5 per cent of revenue, which
was higher than the industry average (3 to 4 per
cent). Three years into the outsourcing contract, IT
costs stood at 10 per cent of revenue and the car
rental firm could not get out of the contract. According to the chief information officer: "The entire IT
department has been outsourced, but we should
have kept applications development and maintenance in-house. These activities are too close to
our core business, and it's hard not to have total
control over them . . . If the vendor goes bankrupt,
all I can do is try to hire its former employees."
Insights for Managers
Outsourcing is often associated with automatic cost
reduction and performance improvement. This
overly optimistic view of outsourcing derives from
the fact that most articles about outsourcing are written during the so-called "honeymoon" period (i.e.,
just before or after the contract is signed). At that
time, the reported benefits are not actual but only
projected. This leads to a bandwagon phenomenon,
where firms outsource to mimic competitors they expect will be successful with outsourcing.^
Determining which activities can be best performed by outside vendors requires a good understanding of where the firm's competitive advantage comes from. Resources and capabilities that
are valuable, rare, difficult to imitate, and difficult
to substitute for lead to superior performance.^ Activities that are based on such resources and capabilities (i.e., core activities) should not be out-

May

sourced because firms risk losing competitive

advantage and becoming "hollow corporations.""^
On the other hand, non-core activities may be outsourced for two reasons. First, outsourcing noncore activities allows firms to focus on the activities they do best and improve their overall
performance." Second, transferring non-core activities to specialized vendors can help reduce the
costs and improve the performance of such activities.'^

Determining which activities can be best

performed by outside vendors requires a
good understanding of where the firm's
competitive advantage comes from.
In the middle of the 1990s, for instance, a hightech firm decided to set up a new subsidiary to
enter the Southern European market. This firm defined its core business as designing, manufacturing, and selling high-resolution color screens. All
the activities that didn't belong to any of these
categories (e.g., logistics, after-sales service, and
various types of marketing activities) were outsourced to outside vendors. This strategy enabled
the high-tech firm to enter the new market not only
quickly but also at very low cost. This successful
outsourcing effort can be compared with the case
of the car rental company above. Outsourcing IT
applications development and maintenance was
clearly a mistake. The car rental industry is a
highly IT-intensive industry where a good reservations system is the key to competitive advantage.
Therefore, the IT applications that underpin reservation systems were too close to the core business
to be safely outsourced.
As most activities have parts that belong to the
core business and parts that do not, implementing
a core vs. non-core dichotomy at the firm level
often proves difficult. Hence, the core vs. non-core
dichotomy should rather be implemented at the
activity level.'^ For instance, an oil company decided to outsource IT. Several competitors had already done so, and their endeavors weren't always
successful. As their lack of total success could
largely be attributed to total outsourcing (i.e., outsourcing the entire activity), the oil company carefully separated core from non-core IT activities. As
the IT outsourcing project leader put it: "The recommendation to outsource was drafted by a study
feam who examined the overall effectiveness of IT
service delivery and determined that only nonstrategic commodity services could be outsourced
fo external third parties. This recommendation

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Barth4lemy

was then endorsed by a corporate council consisting of operating company presidents and corporate executives." This company ended up outsourcing mainframe, telecommunications {LANAVAN
voice and data operations, management, and support), cross-functional (help desk, change coordination, service coordination) and carrier services.
Crucial IT activities such as application development and maintenance were kept in-house.
Second Deadly Sin: Selecting the Wrong Vendor
Acting on instructions from its U.S. headquarters, a
European equipment manufacturer outsourced its
entire logistics activity.''* The logic underlying this
decision was the following. While most customers
wanted increasingly small and frequent deliveries, the U.S. top management was not sure that the
internal logistics department of their European
subsidiary had a sufficient level of expertise to
implement a just-in-time organization. They also
knew that a badly implemented just-in-time organization results in tremendous costs. As the headquarters asked for the move to be made very
quickly, the managers of the subsidiary had to find
a third-party logistics provider, sign a contract,
transfer the activity, and hand over the management, all within only six months. Shortly after the
contract was signed, things started going sour as
the third-party provider did not live up to expectations. Goods were either delivered too late or not
delivered at all. There were large shortfalls in inventory. A benchmark study showed that this particular subsidiary had the highest logistics costs of
all European subsidiaries.
Insights for Managers
Selecting a good vendor is crucial for successful
outsourcing. In the case above, for instance, the
third-party logistics provider was selected because it had offered the lowest bid. However, its
main business was transportation. It did not have
the capabilities to manage a full logistics function,
let alone implement a just-in-time organization.
The client's requirements had been made clear
from the outset, and the failure of this outsourcing
effort could essentially be attributed to a lack of
expertise of the third-party logistics provider.
While one important argument for outsourcing is
that specialist vendors have lower costs than their
clients, it is important to note that firms do not
necessarily outsource to cut costs.'^ According to
the VP of supply chain management of a U.S. consumer goods firms, outsourcing logistics to a thirdparty provider is more expensive than keeping lo-

89

gistics in-house. Yet, the cost increase is more than

offset by an increase in revenues and a reduction
in opportunity costs. Revenues increase due to the
ability to implement innovative logistics practices,
and economic value-added (EVA) measures improve because outsourcing avoids keeping fixed
assets,'"''

Firms do not necessarily outsource to cut

costs.
The literature has identified numerous criteria
for successful provider choice.'^ A useful distinction can be made between hard and soft qualifications:
Hard qualifications are tangible and can be easily
verified by due diligence. They refer to the ability
of vendors to provide low-cost and state-of-the-art
solutions. Important criteria also include business
experience and financial strength.
Soft qualifications are attitudinai. They may be
non-verifiable and may change depending on
circumstances. Important soft criteria include a
good cultural fit, a commitment to continuous
improvement, flexibility, and a commitment to
develop long-term relationships. Trustworthiness is an important soft criterion.'^ High levels
of trust are often associated with outsourcing
success.'^ In most cases, the client and the vendor have different business objectives that can
result in conflicts of interest. For instance, the
beginning of the contract is generally more beneficial for the client than for the vendor.^ As
time goes by, the contract becomes subject to
negotiation and misunderstanding. As one of
the interviewees bluntly put it: "Outsourcing is a
profitable operation in the short run. It must
remain profitable in the long run."
The surest way to spot the best providerson both
hard and soft criteriais through first-hand information. A useful technique is to entrust a large
number of vendors with commodity activities before outsourcing more sensitive activities to the
best vendors.^' A manager from a large European
energy firm reported: "We spent approximately
two years with small deals and a large number of
suppliers, followed by one year taking a "strategic
position" and outsourcing to an alliance of a few
key players." Not surprisingly, outsourcing turned
out to be a huge success in this firm.
First-hand experience is both a time-consuming
and costly way to discover whether or not a vendor
is proficient and trustworthy. An alternative and

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Academy ol Management Executive

less costly way is to use second-hand experience

(i.e., to examine the vendor's reputation). A reputation for proficiency and trustworthiness is a useful
asset that vendors care about because it helps
attract new clients.^^ However, issuing a Request
For Proposal is often not enough to determine
whether a vendor has a good reputation. Interviews with clients of potential vendors and industry experts are useful to learn about the technical
skills and the reliability of potential vendors.
Third Deadly Sin: Writing a Poor Contract
A European bank outsourced its entire telecommunications network \o cut costs and refocus on its
core business. This endeavor turned out to be a
complete failure with increasing costs and decreasing service quality. The main reason for the
failure was that the management had rushed to
enter the relationship with the vendor. Too little
time was spent on developing a good contract and
several mistakes were made. The contract, though
very long, was not precise. For instance, the bank
had to pay extra fees even for basic services. There
were no objective performance measurement
clauses either. Fixed fees had been set when the
client's business was booming. As turnover
shrunk, the ratio of telecommunications fixed fees
to total revenue became increasingly large. Moreover, the contract made it impossible to switch
vendors even after the relationship with the incumbent vendor had become increasingly sour.
Insights for Managers
Since the 1980s, vendor partnerships have emerged
as a model of purchasing excellence. Partnerships
replace market competition by close and trust-based
relationships with a few selected vendors.^^ The notion that outsourcing vendors are partners and that
contracts play a minor role was popularized by a
landmark IT outsourcing deal. In 1989, Eastman
Kodak outsourced a large part of its IT operations to
IBM, Digital Equipment, and Businessland. As the
relationships between Eastman Kodak and its vendors were both cooperative and based on loose contracts, it has been wrongly inferred that tight contracts were not necessary to be successful with
outsourcing. However, there are pitfalls in partnership management.^^ A good contract is essential to
outsourcing success because the contract helps establish a balance of power between the client and
the vendor.^^ Spending too little time negotiating the
contract and pretending that the partnership relationship with the vendor will take care of everything
is a mistake.26 Drafting a good contract is always

May

important because it allows partners to set expectations and to commit themselves to short-term goals.
Moreover, it provides a safety net in case the relationship fails.
Regarding the actual content of the contract, I
found that the best contracts are simultaneously:
Piecise. Ill-defined contracts often result in high
costs and poor service levels. Cost and performance requirements should be established from
the outset and clearly specified in the contract.^^
Complete. Writing a contract that is as complete
as possible has two important benefits. First, the
more complete the contract, the smaller the risk
of potential opportunism of the vendor. Second,
the more complete the contract, the smaller the
probability that it will involve costly renegotia Incentive based. The contract should be written
to encourage the right behavior from the vendor.
For instance, the vendor may get a bonus when
its performance boosts indicators of business
value. This incentive could help align the goals
of vendors with the business objectives of their
clients. The contract should also address how
the relationship will change over its life cycle.
For example, unit-based pricing may be used at
the beginning of the relationship. The pricing
could switch to cost-plus as the relationship develops. The contract could eventually call for a
change to a gain-sharing arrangement so that
the client and the vendor have a joint stake in
the outcome.
Balanced. In general, one-sided contracts do not
last long. Even a contract that is weighted
against the vendor is not necessarily beneficial
for the client: service levels quickly drop, and
the vendor tries to win back some value by imposing extra fees.
Flexible. Due to evolving technology and changing business conditions, medium and long-term
outsourcing contracts should not be written in
an inflexible way. Flexibility clauses can help
both parties accommodate to environmental
changes.2^
The failure experienced by the European bank can
essentially be attributed to a badly drafted contract that lacked preciseness (i.e., extra fees had to
be paid even for basic services), flexibility (i.e.,
fixed fees had been set when the business was
booming) and completeness (i.e., it was impossible
to switch vendors because extremely huge penalties would have been incurred). The bank learned
the hard way. As pointed out by a manager:
"Spend as much time as possible developing the
contract. A contract is an investment whose value

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Barthelemy

really becomes apparent if the relationship with

the supplier becomes sour."
Fourth Deadly Sin: Overlooking Personnel Issues
A European department store had to close for two
days because its 70 facilities management personnel went on strike. The shutdown took place during
an important sales promotion and resulted in the
loss of several million Euros. This strike was partly
due to constant rumors that facilities management
would be outsourced. These rumors were essentially fueled by the fact that retiring facilities
management employees were never replaced.
Basically, their colleagues were afraid of being
transferred to the vendor (with lower pay and benefits) or being laid off.
Insights /or Managers
The efficient management of personnel issues is
crucial because employees generally view outsourcing as an underestimation of their skills. This
may result in a massive exodus even before an
actual outsourcing decision has been made. Secrecy in outsourcing feasibility and decisionmaking is very difficult, and open communication
is the key to managing personnel issues in outsourcing. When attempts at secrecy fail, rumors
start spreading. As soon as employees know that
outsourcing is under consideration, counterproductive anxiety arises and employees begin handing in their notice in anticipation of outsourcing.

The efHcient management of personnel

issues is crucial because employees
generally view outsourcing as an
underestimation of their skills.
Firms that contemplate outsourcing must face
two interrelated personnel issues. First, key employees must be retained and motivated. For most
activities, outsourcing does not mean transferring
all the employees to the vendor. When an activity
has been performed in-house for a long period of
time, firm-specific knowledge about how to run the
activity smoothly has accumulated. Employees
who possess this firm-specific knowledge must be
identified. To keep them in-house, the management must be prepared to offer them higher salaries and benefits. Outsourcing has a negative impact on employees' sense of job security and
loyalty even when they keep their positions within
the firm. This may lead to decreased productivity

91

or even dysfunctional actions such as strikes. New

responsibilities may be offered to secure the commitment of retained employees. Generally, their
role tends to shift from service delivery to interface
with the vendor and end users. This important shift
requires new skills that can only be acquired
through considerable training and ongoing support.
A second personnel issue is that the commitment
of employees transferred to the vendor must also
be secured. As a manager in charge of a finance
outsourcing contract put it: "Retention of knowledge and skills is a key issue. Irrespective of the
profile of the service provider, the actual work is
done by individuals harnessing their skills, knowledge, experience, and the technology available to
them. If high staff turnover is experienced, then the
quality of the work will deteriorate noticeably, particularly in specialist technical areas and analytical work." The outcome of an outsourcing effort is
highly dependent on the commitment of employees
who have been transferred to the vendor. Employees working in activities that do not belong to the
firm's core business are often given low-priority.
Once they are transferred to specialist vendors,
they may be offered opportunities for better career
paths in what is regarded as the vendor's core
business. To many employees, vendor employment
is more attractive than continued employment in
an organization where the outsourced activity is
viewed as a mere utility.
Taking ethical considerations into account can
help avoid most personnel issues related to outsourcing.^'^ A utilities firm paid very careful attention to its employees when the decision was made
to outsource 85 per cent of its IT budget to an
outside vendor. The CIO summarized: "We wanted
to find a solution that was not detrimental to the IT
employees." In this deal, the vendor was contractually asked to offer the same pay and benefits to
the 160 employees transferred to the vendor. The
vendor also promised to neither fire outsourced
employees nor to transfer them to other accounts
without their approval. The outsourcing deal was
endorsed by the works council and finally turned
out to be quite successful.
At first glance, it seems surprising that firms
may gain something from outsourcing if they
merely transfer their employees to the third party
and ask that they maintain the same pay and benefits. However, there is more to outsourcing than
transferring people and renegotiating their pay
and benefits. Multiple clients enable specialized
vendors to operate at a scale unattainable by their
individual clients. Because of the variety of their
clients, specialized vendors also have a depth and

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Academy of Management Executive

range of experience that an individual client cannot match.3i

Fifth Deadly Sin: Losing Control Over the
Outsourced Activity
Outsourcing at a specialty retail firm had resulted
in the total dismantling of the internal IT department. Shortly after the outsourcing decision had
been made, the CIO was left alone to manage the
vendor. Outsourcing ended up as a downright failure. IT costs increased by 20 per cent, and IT performance did not improve at all. The five-year contract was cancelled three years after it was signed.
According to the CIO, outsourcing had resulted in
"a total and dangerous loss of control over IT, inability to cope with the changing environment and
command over the future." He also noted that
"while there are important cost decreases at the
beginning of the relationship, extra costs are
quickly incurred."

Insights /or Managers

When the performance quality of an activity is low,
managers are often tempted to outsource it. If poor
performance is attributable to factors such as insufficient scale economies or a lack of expertise,
outsourcing makes sense. If poor performance is
attributable to poor management, outsourcing is
not necessarily the right solution. On the one hand,
it is often easier to manage an outside vendor than
an in-house department.^^ Qn the other hand, outsourcing entails great changes regarding the management of an activity. With outsourcing, control
through direct ownership of assets and employment of staff is replaced by control through a contract. Instead of issuing orders, managers in
charge of outsourced activities must negotiate results with vendors. They must also ensure the effective use of the outsourced service by internal
users who are often reluctant to work with external
vendors.
For an outsourcing client, it is particularly important to avoid losing control over an outsourced
activity. Such a loss of control has two distinct
origins. First, the client may not have the capabilities to manage the vendor. Second, the client may
not actively manage the vendor. In the case of the
specialty retail firm explained above, two mistakes were made simultaneously. The internal IT
department was totally dismantled, and the CIO
was not sufficiently involved in the management
of the vendor. He had very few contacts with the
vendor's management, meeting them formally

May

once a month and informally less than once a

week.
When an activity is outsourced, it is crucial to
retain a small group of managers to handle the
vendor. These managers must be able to develop
the strategy of the outsourced activity and keep it
in alignment with the overall corporate strategy.
While vendor management skills are very important, they must also be complemented with technical skills. If no one in the company is able to assess
technological developments, outsourcing is bound
to fail. New employees may even need to be hired
to manage the outsourcing vendor. Outsourcing
clients should essentially look for managers with
prior experience in outsourcing or joint-venture
management, involvement in an outsourced activity, and experience in leading cross-functional
teams.^^ When a department store outsourced part
of its IT, 85 per cent of the IT employees were
transferred to the vendor. Half of the remaining
personnel were dismissed shortly thereafter. It
turned out they were neither able to manage the
vendor nor handle changes in the scope of the
outsourcing contract. They were replaced by managers with extensive experience in outsourcing.

When an activity is outsourced, it is

crucial to retain a small group of
managers to handle the vendor.
Outsourcing does not mean abdicating! A lack of
active management must be avoided at all cost, as
the following example clarifies. A computer manufacturer outsourced a large part of its after-sales
service activity. Though the rationale for outsourcing was essentially cost reduction, a high standard
of performance from the vendor was also important. In the computer industry, after-sales service
is crucial, and the computer manufacturer did not
want to lose business due to its outsourcing vendor. The first way to deal with this important issue
was to devise a contractual clause stating that the
vendor had to fix 85 per cent of the problems encountered by end-users within a day. However, the
interviewee made clear that such a clause is useless if it is not correctly implemented. As he explained: "Without a constant monitoring of the
vendor, its performance rate would decrease to
around 70 per cent [instead of 85 per cent]). We
cannot accept such a low rate because it would
result in a loss of business for us." While a good
contract is necessary, good enforcement is also
essential.

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Baithelemy

Sixth Deadly Sin: Overlooking the Hidden Costs

oi Outsourcing
Table 1 compares the hidden costs of two logistics
outsourcing contracts. The first case is a manufacturing firm which outsourced a subset of its logistics activity: warehousing. In this firm, warehousing was considered a commodity. The second case
is a manufacturing firm which outsourced its entire logistics function. To take over this activity, the
vendor had to acquire specialized knowledge
about the business of its client and the idiosyncrasies of its logistics activity.
Insights for Managers
Outsourcing clients are generally confident that
they can assess whether or not outsourcing results
in cost savings. However, they olten overlook costs
that can seriously threaten the viability of outsourcing efforts.-^'' Transaction cost economics
(TCE) suggests two main types of outsourcing hidden
Outsourcing vendor search and contracting
costs. Search costs are the costs of gathering
intormation to identify and assess suitable vendors. Contracting costs are the costs of negotiating and writing the outsourcing contract. Both
search and contracting costs are incurred before
the outsourcing operation actually takes place;
Outsourcing vendor management costs. These
costs have three different dimensions: monitoring the agreement to ensure that vendors fulfill
their contractual obligations, bargaining with

93

vendors and sanctioning them when they do not

perform according to the contract, and negotiating changes to the contract when unforeseen
circumstances arise. Outsourcing vendor management costs are incurred while the outsourcing operation actually takes place.^^
TCE suggests that the hidden costs of outsourcing
are essentially influenced by the idiosyncrasy of
the resources underlying outsourced activities.^'^
Specific physical resources refer to specialized
equipment tailored to a single firm's requirements.
Specific human resources refer to expertise that
employees have acquired through years of training and that is useful only in the context of a single
firm. When idiosyncratic resources have been
transferred to an outside vendor, switching vendors or reintegrating the outsourced activity is
quite difficult. As vendors know they cannot easily
be replaced, they may act opportunistically. Opportunistic expropriation occurs when vendors
standardize IT services instead of offering unique
services. While such commoditization enables
vendors to reap greater economies of scale, it also
means that the unique needs of their clients are no
longer met.^^ Firms that select the right vendor and
write up a good contract are less likely to suffer
from the potential opportunism of their vendor. A
good vendor must be proficient and trustworthy
{see second deadly sin). A good contract must
be simultaneously precise, complete, incentive
based, balanced, and flexible (see third deadly
sin).
However, searching for a reliable vendor and

Table 1
The Hidden Costs of Outsourcing in Two Logistics Cases
Low level of
idiosyncrasy (i.e., warehousing)

High level of
idiosyncrasy (i.e..
entire logistics function)

$1.5 million
1 year

$4 million
3 years

4
0
$10,000
0.7%

5
4
$250,000
6.2%

2
1
4
$100,000
6.7%

2
12
12
$200,000
15%

Contract amount
Contract duration
Search and contracting costs
Number of internal employees
Outside consultants and lawyers
Total search and contracting cost
Fiatio of total search and contiacting cost to to(a] con(rac( amount
Vendor management costs
Number of employees
Number of formal meetings per year
Number of informal meetings per year
Annual vendor management costs
Ratio of annual vendor management costs to total contract amount

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Academy of Management Executive

draiting a good contract is expensive. In the two

cases stated above, search and contracting costs
were nearly ten times higher for the entire logistics
activity than for the warehousing outsourcing contract (6.2 per cent vs. 0.7 per cent). Vendor management costs were more than twice as high for the
entire logistics activity as for warehousing (15 per
cent vs. 6.7 per cent).^^ The figures for the second
case were high enough to nullify the cost savings
from outsourcing.
The hidden costs ol outsourcing are an important
topic for managers because they can challenge the
rationale for outsourcing. It is also paradoxical
that these costs are both necessary and detrimental to the outcome of outsourcing efforts. While
successful outsourcing requires substantial spending on vendor searching, contracting, and management costs, these costs can also turn potentially
successful outsourcing efforts into a complete failure. While carefully selecting the vendor and crafting contracts with well-articulated expectations
and clearly set performance measures is expensive, such expenses are necessary to keep vendor
management cost at a decent level. Considering
the potential impact of the hidden costs of outsourcing, it may be worth the additional cost of
hiring outside experts. Such experts are familiar
with outsourcing and know how certain pitfalls
can be avoided. Legal experts are useful when it
comes to writing the outsourcing contract and negotiating with the vendor. Technical experts can
help develop precise measures such as serviceperformance level.

The hidden costs of outsourcing are an

important topic for managers because
they can challenge the rationale for
outsourcing.
Seventh Deadly Sin: Failing to Plan an
Exit Strategy
One retail company outsourced several IT activities
that senior management considered to be commodities (data centers, applications maintenance, and
user support). However, outsourcing failed due to
high costs and low performance. Though the vice
president of information services wanted to get out of
the contract, he was reluctant to cancel it. Indeed, he
knew that a vendor switch would take over six
months while reintegrating the activities would require as much as ten months. All he could do was to

May

renegotiate the contract, implementing a 15 per cent

reduction in services due to poor performance.

Insights for Managers

Many managers are reluctant to anticipate the end
of an outsourcing contract. Therefore, they often
fail to plan an exit strategy (i.e., vendor switch or
reintegration oi an outsourced activity). For instance, the manager in charge of a facilities management outsourcing contract stressed that "this
outsourcing deal is based on a long-term relationship. A vendor switch is altogether out of the question." This attitude is a mistake because switching
vendors does not necessarily mean that outsourcing didn't work. Shrinking the vendor base and
establishing long-term relationships with a few
selected vendors is not always the best solution.
Actually, outsourcing relationships can be viewed
on a continuum. At one end are long-term relationships where investments specific to the relationship
have been made by one or both partners. There is a
considerable advantage in recontracting with the
same vendor because switching vendors or reintegrating the outsourced activity is very difficult.^^ At
the other end are market relationships where the
client has a choice of many vendors and the ability to
switch vendors with little cost and inconvenience. In
this case, there is no real advantage in recontracting
with the same vendor. For instance, a firm in the
computer industry successfully outsourced telemarketing. The duration of the contract was only one
year. Every year, the incumbent vendor's price and
performance were benchmarked against other vendors. If the incumbent vendor had not made the best
offer, its contract would never have been renewed.
Managers who do not want to anticipate the end
of an outsourcing relationship also have a tendency not to include material reversibility clauses
(i.e., option to buy back premises and equipment
from the vendor) and human reversibility clauses
(i.e., option to hire back employees from the vendor) in the contract. The absence of such clauses
leads to weak power bases for any negotiation
with the vendor and makes it very difficult to back
out of an outsourcing agreement.'" This is exactly
what happened in the case of the retail firm described above. Even when an outsourced activity is
not very idiosyncratic, it is important to plan an
exit strategy. Switching vendors or reintegrating
the outsourced activity was hardly feasible because it had not been anticipated in the contract.
Table 2 summarizes the seven deadly sins of
outsourcing and the lessons to be learned.

Baithelemy

2003

95

Table 2
The Seven Deadly Sins of Outsourcing and Lessons Learned
Timetable
Original idea to outsoutce

Deadly sin

Lesson learned

Outsourcing activities that should

not be outsourced

Only activities that do not belong to the core business can

be safely outsourced. The core vs. non-core approach
can be implemented both at the lirm and activity level.
Outsourcing clients should look for vendors that are able
to provide state-of-lhe-art solutions and are trustworthy.
The contract is the main tool to establish a balance oi
power in outsourcing relationships. Good contracts have
four characteristics. They must be precise, complete,
balanced, and flexible.
Loss of key employees and lack of commitment can
seriously threaten the viability of outsourcing efforts.
However, good communication and ethical behavior
towards employees can help avoid such problems.
In order to keep control over outsourced activities, clients
must retain a small group of qualified managers. An
active management of the vendor is also crucial.
The hidden costs (i.e., search, contracting, and managing
costs) can threaten the viability of outsourcing efforts.
Hidden costs are likely lo be lower when commodities
are outsourced.
The end of the outsourcing contract musi be planned from
the outset. Building reversibility clauses into the
contract is crucial.

Selecting the wrong vendor

Writing a poor confract

Beginning ol the relationship

Overlooking personnel issues

Losing control over the outsourced

activity
Overlooking the hidden costs of
outsourcing
Vendor switch or reintegration of
the outsourced activity

Tailing to plan an exit strategy

Outsourcing: Dangers and Opportunities

Historically, outsourcing was restricted to basic
support activities such as janitorial services. Today, outsourcing has extended to more crucial activities such as IT, telecommunications, finance,
and logistics. Increasingly complex types oi outsourcing have developed. For instance, the emergence of fourth-party logistics providers is a major
trend with U.S. auto manufacturers. General Motors has a joint-venture with Menlo Logistics,
called Vector. Vector is responsible for all outbound logistics for General Motors. It operates as a
fourth-party provider that manages multiple thirdparty providers for GM.'*^
Based on a survey of 91 outsourcing efforts, I
uncovered seven major pitfalls that can threaten
the viability of outsourcing efforts. As shown in the
Appendix, statistical results confirm that the seven
deadly sins are good differentiators between outsourcing success and failure. Several important
implications can be drawn from the statistical results:
Some sins were "deadlier" than others. "Writing
a poor contract" and "losing control over the
outsourced activity" had the largest impact on
the outcome of outsourcing efforts. On the other
hand, "failing to plan an exit strategy" was not a
good differentiator between success and failure.

perhaps because planning an exit strategy only

becomes necessary in the case of vendor switch
or reintegration of an outsourced activity;
Mistakes were made even in successful outsourcing efforts. Mistakes such as "outsourcing
activities that should not be outsourced," "writing a poor contract," and "failing to plan an exit
strategy" were the most frequent. However, making only one or two mistakes does not necessarily lead to failure.

"Writing a poor contract" and "losing

control over the outsourced activity" had
the largest impact on the outcome of
outsourcing efforts.
By contrasting successful and failed outsourcing
efforts, I provided advice on how to avoid the seven
deadly sins of outsourcing. An important message
of this article is that some outsourcing efforts are
doomed to fail even before the relationship with
the vendor has actually started. When a firm has
outsourced activities that should not be outsourced, selected the wrong vendor, and written a
poor contract, the likelihood of success is close to
zero.

96

Academy of Management

To be successful with outsourcing, iirms need to

accumulate the expertise required to avoid the
seven deadly sins of outsourcing. Such a process is
unfortunate both time consuming and costly.
Throughout this research, I noticed that this expertise was rarely capitalized at the company level.
This is unfortunate as my research suggests that
the seven deadly sins are very similar from one
outsourced activity to the other. Hence, I strongly
believe that firms using substantial outsourcing
could gain a lot from setting up a department devoted to capitalizing outsourcing management expertise.'*^ Such a department may be charged with
sharing and leveraging prior outsourcing experience and knowledge throughout the company. Setting up a dedicated outsourcing function may be a
luxury for small firms or firms that do little outsourcing. In that case, outsourcing-related information
may be collected at the purchasing department level.
Outsourcing is a way for firms to cut costs, improve performance, and focus their limited resources on their core business. However, outsourcing can also be dangerous when it is not properly
implemented. Firms must think seriously about
how they will manage the deadly sins before making their actual outsourcing decisions.

Executive

May

cesses when managers were "very satisfied" or "totally satisfied." They were considered failures when managers were "not
satisfied at all," "not satisfied," or "moderately satisfied." Using
this methodology, 63 per cent of the outsourcing efforts were
considered successes and 37 per cent were considered failures.
To check the reliability of my measure, I developed an objective
indicator oi outsourcing success using nine binary items: (1)
cost reduction. (2) ability to turn ilxed costs into variable ones,
(3) control of expenses, (4) personnel management, (5) overall
performance, (6) access to better competencies, (7) access to
better skilled personnel, (8) improved service quality, and (9)
reallocation of resources to the core business. The average
number of objectives met was respectively 3.2 for outsourcing
failures and 6.8 for outsourcing successes. Results from an
ANOVA analysis suggests that this difference is statistically
significant (F - 16.1; p < 0.01).
The table below lists each sin in the first column, the number
(and percentage) of failed efforts that committed the sin in the
second column, and the number (and percentage) of successful
efforts that committed the sin in the third column.
Company profiles

Percentage of sample

Geographical origin

Europe
North America
Industries
Raw materials and utilities
Manufacturing
Services
Finance and banking

76
24
22
41
24
13

Number of employees

Appendix: Information on Companies and

Outsourcing Operations Profiles
My findings are based on an extensive analysis of the academic literature and an in-depth study of 91 outsourcing cases
with various characteristics (see "Company profiles" and "Outsourcing operations profiles"). Primary data were collected
through detailed questionnaires and interviews. There are two
broad types of outsourcing; (1) outsourcing as an alternative to
vertical integration and (2) outsourcing as a means to vertically
disintegrate {i.e., outsourcing activities that were performed
in-house). In this article, I focus on the second type of outsourcing. To detect announcements for outsourcing contracts, I conducted an exhaustive electronic search of two major databases:
ABI/INFORM-GLOBAL and REUTERS. I was able to compile an
initial sample of 816 "vertical disintegration" outsourcing
cases. Questionnaires were then obtained for 91 cases (yielding
an 11 percent response rate). Each questionnaire came irom a
different iirm. The respondents were senior executives responsible for outsourced activities. Due to financial constraints, I
could only conduct interviews for approximately half the cases.
Unless otherwise noted, all presented data and illustrations are
irom this research project.
To assess whether outsourcing efforts were successes or failures, I used a five-point Likert scale (Irom "not satisfied at all"
to "totally satisfied"). Outsourcing efforts were considered suc-

< 1,000
1,000-10,000
> 10,000
Outsourcing operations profiles

24
38
38
Percentage of sample

Type of activity oufsourceci

Information Technology
Telecommunications
Logistics
Finance
Others

54
7
17
7
15

Contract amount

<S10 million
$10-100 million
>$100 million

38
30
24

Percenfage o/ budget outsourced

0-20%
21%-40%
41%-60%
61%-80%
81%-100%

11
12
11
23
43

BarthSlemy

2003

87

Deadly sin

Number (and percentage)

of failed efforts that
committed the sin

Number (and percentage)

of successful efforts that
committed the sin

Outsourcing activities thai should not be outsourced

Selecting the wrong vendor
Writing a poor contract
Overlooking personnel issues
Losing control over the outsourced activity
Overlooking the hidden costs of outsourcing
Failing to plan an exit strategy

50 (55%)
27 (30%)
63 (69%)
35 (38%)
34 (37%)
13 (14%)
41 (46%)

26 (28%)
8 (9%)
21 (23%)
19 (20%)
5 (6%)

4 (4%)
33 (36%)

Results of
chi-square
test
/
)^
)^
i^
)^
)^

=
=
=
=
=
=

5.46"
5.58"
16.40"
2.99*
12.82"
2.60'

y" = 0.70

' p < 0.10, " p < 0.05, ' " p < 0.01.

Endnotes
' The Economist Intelligence Unit. 1999. Designing fomorrow's oiganisation. London.
^- Gilley. K., & Rasheed, A. 2000. Making more by doing less;
An analysis oi outsourcing and iis effects on firm performance.
Jouinai oi Management, 26(4): 736-790.
^ Quinn, J. B., & Hilmer, F. 1994. Strategic outsourcing. SJoan
Management Review, Summer: 43-55.
^ Jennings, D, 1996. Outsourcing opportunities for financial
services. Long flange Pianning. 29(3): 393-404.
^ Bryce. D., & Useem, M. 1998. The impact of corporate outsourcing on company value. European Management Joutnal,
16(6): 635-643.
^ See for instance Huber, R. 1993. How Continental Bank outsourced its "crown jewels." Harvard Business Reviuw, JanuaryFebruary: 121-129; Cross, J. 1995. IT outsourcing: British Petroleum's competitive approach. Harvard Business Review, MayJune: 94-102; and McFarlan, F.. & Nolan, R. 1995. How io manage
an IT outsourcing alliance. Sloan Management Review. Winter:
9-23. However, there are exceptions such as Ang, S., & Toh, S.
1998. Failure in software outsourcing: A case analysis. In Willcocks, L., & Lacity, M. (Eds.), S(ralegic sourcing of in/ormalion
systems.' Perspectives and practices. Chlchester: John Wiley.
351-368.
' Sitkin, S. 1992. Learning through failure: Tbe strategy oi
small losses. In Cummings, L., & Staw, B. (Ekls.), Research in
organizational behavior. Greenwich: JAI Press,
Lacity. M.. & Hlrschheim, R. 1993. Thj information systems
outsourcing bandwagon. Shan Management Review, Fall: 7386; Loh, L., & Venkatraman, N. 1992, Diffusion of information
technology outsourcing: Influence sources and the Kodak effeci.
/nformafion Systems Research, 3(4): 334-358; and Ang, S., 8f
Cummings, L. 1997. Sirateglc response to institutional influences on information systems outsourcing. Organizafion Science, 8(3): 235-255.
^Barney, J. 1991, Firm resources and sustained competitive
advantage, journal ol Management, 17(1): 99-120. Classic references regarding the resource-based view of ihe firm include
Amit, R., & Schoemaker, P. 1993. Strategic assets and organizational rent. Strategic Management Journal, 14(1): 33-46;
Dierickx, I., & Cool, K. 1989. Asset siock accumulation and sustainability of competitive advantage. Management Science,
35(12): 1504-1511; and Teece, D., Pisano, G., & Shuen, A. 1997.
Dynamic capabilities and strategic management. Strategic
Management JournaJ, 18(7): 509-533.
'" The case of the U.S. consumer electronics industry is a
classic one. Poorly performing business units started outsourcing components manufacturing to Asian suppliers. Ai that time,
mosi of them even had to teach their suppliers how to build the
components. As outsourcing resulted in lower cosis, it quickly

spread through the entire U.S. consumer electronics industry.

Later, some U.S. manufacturers found out that their suppliers
were unable or unwilling io supply them as requested. However, ihe U.S. firms had losi their manufacturing skills and
could noi preveni the suppliers from entering downstream markets on their own. See Beitis, R., Bradley, S., & Hamel, G., 1992.
Outsourcing and industrial decline. The Academy oi Management Executive. 6(1): 7-22.
" Dess, G., et al. 1995. The new corporate archiieciure. The
Academy oi Management Executive. 5(3): 7-20; Markides, C.
1992. Consequences of corporaie refocusing: Ex anie evidence.
Academy oi Management Journal. 35: 398-412; and D'Aveni, R.,
& Ravenscraft, D. 1994. Economies of integration versus bureaucracy costs: Does vertical integration improve performance?
Academy of Management Jouinal, 37(5); 1167-1206.
'^ Leiblein, M., Reuer, J., & Dalsace, F. 2002. Do make or buy
decisions matter? The influence of organizational governance
on technological performance. Strategic Management Journal,
23(9): 817-833; Poppo, L., & Zenger, T. 1998. Testing alternative
theories oi the firm: Transaction cost, knowledge-based and
measurement explanations for make-or-buy in information services. Strategic Management Journal. 19(9): 853-877; and Silverman, B., Nickerson, J., & Freeman, J. 1997, Profitability, transactional alignment and organizational mortality in ihe U.S.
trucking industry. Strategic Management Journal, Summer Special Issue: 31-52.
'^Lacity, M., Willcocks, L., & Feeny, D. 1996. The value of
selective IT outsourcing. Sioan Management Review. Spring:
13-25.
'* Though transporiaiion had been ouisourced for a long
time, logistics was largely iniernalized in this firm.
'^ For a thorough review, see Razzaque, M., & Sheng, C. 1998.
Outsourcing the logistics function: A literature review. International Journal oi Physical Distribution and Logistics Management. 28(2): 89-107.
'^ Rabinovitch, E., ei al. 1999. Outsourcing of integrated logistics functions: An examination of industry practices. International Journal of Physical Distribution & Logistics Management,
29(6): 353-373.
" I am grateful to an anonymous reviewer for suggesting this
example.
'^ Trusiworihiness can be defined as the expectation ihat the
vendor will not take advantage of ihe clieni even when the
opportunity is available. See Zaheer. A., McEvily, B., 8E Perrone,
V. 1998. Does trusi maiter? Exploring ihe effects of interorganizaiional and interpersonal trust on performance. Organization
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'^ Mohr, J., & Spekman, R. 1994. Characteristics of partnership
success: Partnership attributes, communication behavior and
conflict resolution techniques, Strategic Management Journal,
15(2): I3&-152.

98

Academy of Management Executive

At the beginning of the contract, the client receives a onetime capital payment and shifts the problems to the vendor.
^'Ring, P., & Van de Ven, A. 1992. Structuring cooperative
relationships between organizations. Strategic Management
Journal, 13(7): 483-498.
^^ Barney, J.. & Hansen, M. 1994. Trustworthiness as a source
of competitive advantage. Sirafegic Management jouinal. 15(2):
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^^ Lambert, D., Emmelhainz, M.. & Gardner. J. 1999. Building
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20(1): 165-181; and Anderson, J.. & Narus, J. 1990. A model of
distributor firm and manufacturer firm working partnerships.
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^* Ackerman, K. 1996. Pitfalls in logistics partnerships. Inteinational Journal of Physical Distribution and Logistics Management, 26(3): 35-37; and Lambert, Emmelhainz, & Gardner, op. cit.
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^^ Willcocks, L., & Choi, C. 1995. Co-operative partnership and
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" Realistic measurement af outsourcing success is never
easy. Indeed, the most Important measures of outsourcing success are often intangible.
^^ Parkhe, A. 1993. Strategic alliances structuring: A game
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^^ Harris, A., Giunipero, L., & Hult, G. 1998. Impact of organizational and contract flexibility on outsourcing contracts. Industrial Marketing Management, 27{5): 373-384.
^ See Henderson, M. 1997. Ethical outsourcing in the UK
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to be fired, and right not to be discriminated against.
^' Alexander, M., & Young, D. 1996. Outsourcing: Where's the
value? Long flange Planning, 29(5): 728-730.
^^ Poppo, L. 1995. Influence activities and strategic coordination: Two distinctions oi internal and external markets, Management Science, 41(12): 1845-1859.
^ Useem, M., & Harder, I. 2000. Leading laterally in company
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^* Maltz, A., & Ellram, L. 1997. Total cost of relationship: An
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^Williamson, O. E. 1985. The economic institutions of capitalism. New York: Free Press; Williamson, O. E. 1975. MarJtef and
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22(4): 535-548; and Barthelemy. J. 2001. The hidden costs of IT
outsourcing. Sloan Management fleview. Spring: 60-69.

May

^^ In the transaction cost economics (TCE) literature, vendor

search and contracting costs are termed ex ante transaction
costs, and vendor management costs are termed ex post transaction costs.
^^ Williamson, O. E. 1991. Comparative economic organization: The analysis of discrete structural alternatives. Administrative Science Quarterly, 36(2): 269-296; and loskow, P. 1988.
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^^ Klein, B., Crawford, R., & Alchian. A. 1978. Vertical integration, appropriable rents and the competitive contracting process. Journal of Law and Economics, 21(2): 297-326.
^^This difference is all the more significant as the hidden
costs of outsourcing are largely fixed. In other words, they are
very sensitive to scale economies. See Dyer, J. 1996. Specialized
supplier networks as a source of competitive advantage: Evidence from the auto industry. Strategic Management Journal,
17(4): 271-291.
'^''Dyer, J., Cho. D., & Chu, W. 1998. Strategic supplier segmentation: The next "best practice" in supply chain management. California Management Review, 40(2): 57-77; Weiss, A., &
Anderson, E. 1992. Converting from independent to employee
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Marketing Research, 29(1): 101-115; Klemperer, P. The competitiveness of markets with switching costs, fland 7ournai of Economics, 18(1): 138-150; and Porter, M. 1980. Competitive strategy:
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"' Greer, C, Youngblood. S.. & Gray. D. 1999. Human resource
management outsourcing: The make or buy decision. The Academy of Management Executive, 13(3): 85-96.
"^ I am grateful to an anonymous reviewer for pointing to this
important trend. A discussion of the relationship between
Menlo Logistics and General Motors can be iound on www.
vectors CM. com.
^^ On a related topic, it has been recently shown that firms
having a dedicated alliance function generate more alliance
value than others. See Kale, P., Dyer, I., & Singh, H. 2002. Capability, stock market response, and long term alliance success:
The role of the alliance function. Strategic Management Journal, 23(8): 747-768.
lerome Barthelemy is assistant
professor of strategic management at ESSEC Business School
(France). He holds a Ph.D from
HEC (France) and has been
a visiting research scholar at
the University of California of
Berkeley. His research on outsourcing has appeared in journals such as MIT Sloan Management fleview and European
Management Journal. Contact: