Co-sourcing: what's in it for me?

A partnership between internal audit staff and professional service firms is a cost-effective way to fill even the most specialized needs.

EXECUTIVE SUMMARY

* CO-SOURCING OF SOME INTERNAL FUNCTIONS is a way for a company to maintain control while cutting costs and maximizing internal audit capabilities. Co-sourcing arrangements with outside vendors allow the in-house auditors to retain responsibility for the internal audit process while relying on the outside entity for specialized technical skills and personnel. By contrast, a company that outsources loses day-to-day control over its activities to the vendor--usually a professional service firm.

* INTERNAL AUDIT IS A LOGICAL CANDIDATE for co-sourcing. It is well suited to companies experiencing rapid strategic expansion into global markets and diversifying into a variety of business lines, each focused on a niche market requiring specialized expertise.

* CO-SOURCING HAS HELPED MANY companies that don't have the staff capability to deploy new systems. For example, co-sourcing has been successful for information services projects ranging from consolidation of e-mail to establishing electronic data interchange systems.

* CO-SOURCING ALLOWS A COMPANY to obtain maximum value from the internal audit function while saving on long-term investment in staff. It also provides in-house flexibility and control, because projects can be planned and executed without adding staff.

* CO-SOURCING PITFALLS INCLUDE possible turf battles between staff and outside partners, and the development of a "silo mentality," where internal audit staff focuses so much on the department's functional core it fails to oversee global monitoring and profitability issues.

Many companies have gone on "crash diets," using outsourcing to shed noncore tasks such as internal audit to outside vendors. In the process they've lost day-to-day control over a department to a professional service firm and often gained new problems. Proposed solutions from outside consultants--strangers to the organization--don't always work. As a result, quality, profitability, and employee morale can suffer. Co-sourcing is another way to get a company into shape, trimming costs while maximizing internal audit capabilities and still retaining control.

The case study in this article (page 87) shows how co-sourcing can work. Arrangements with outside vendors allowed the in-house auditors to preserve responsibility for the internal audit process while relying on the vendor

* For specialized technical skills and personnel to implement risk-based internal audit methodology, such as diagnostic reviews of regulatory compliance issues in the home equity lending industry.

* To supplement key technical and consulting skills, such as evaluation and recommendations on hedging practices, derivatives coverage, insurance and other risk-sharing methodologies.

WHAT IS CO-SOURCING?

Co-sourcing is a partnership between a customer and an outside vendor, a professional service provider. A company chooses the vendor, which works with and often alongside--but doesn't replace--the existing staff based on specific skills needed to get the job done. When the project is finished, the professional service firm's job is over, too.

Although it may seem similar to consulting, co-sourcing is different because the company's personnel play an ongoing role in the project. In a typical consulting project, a consultant comes into a company, plans and performs a specific task and then presents a report, working independently most of the time. In a co-sourcing arrangement, the company staff takes an active part in project planning and decision making and may participate in preparing the final report. Instead of relinquishing control over an activity, as is the case with outsourcing and hired consultants, company managers involved in co-sourcing actively manage and work alongside the specially skilled outsiders.

Co-sourcing has helped many companies that don't have the staff capability to deploy new systems. For example, co-sourcing has been successful for information services projects ranging from consolidation of electronic mail to establishing electronic data interchange systems. Companies can also use co-sourcing arrangements to bring in needed expertise in fields such as engineering and architecture--or even foreign language skills to be used for a temporary assignment in an overseas location. Although initially only small to midsize professional service firms offered co-sourcing, larger firms now offer a wide range of co-sourcing services to partnering companies of all types and sizes. Examples of the diversity of services now offered are:

* Internal audit support, such as reconciliation of specialized accounts; valuation, disclosure and Environmental Protection Agency compliance issues for certain types of inventory; and reconciliation of foreign accounts where business customs pose review problems.

* Diagnostic review of specialized areas, such as secondary marketing in the mortgage industry; hedging practices and valuation methods for mortgage servicing rights; and valuation and accounting for securitizations, residuals or other hard-to-value assets.

* Evaluation of personnel, training or development of training programs; or development of specific reporting, systems that use standard business software and database programs.

AN INTERNAL AUDIT CASE STUDY

Because it is relatively autonomous, the internal audit function is a logical choice for co-sourcing. An ideal candidate is a company expanding rapidly into global markets that needs to diversify into a variety of business lines, each focused on a niche market requiring specialized expertise.

A good example is J-Hawk Corp., which was founded in the late 1980s on the heels of the banking crisis in the U.S. Southwest. Its initial core businesses were

* Identifying, evaluating and acquiring pools of distressed assets, loans and real estate.

* Servicing and managing their disposition.

* Performing the accounting, debt administration and treasury functions associated with maximizing returns on distressed asset pools.

In 1995, J-Hawk acquired First City Bancorporation of Texas, a holding company in bankruptcy, after regulatory agencies closed First City's banks. The final entity (FirstCity Financial Corp.) was a publicly traded company with $40 million in equity and a net operating loss carry-forward in excess of $595 million. In 1996, FirstCity introduced the consumer finance segment of the business, derived from a subprime auto finance business. The company acquired a mortgage banking company in 1997 that specializes in originating, purchasing, selling and servicing mortgage loans. The FirstCity capital markets division, started in 1997, focuses on subprime home equity lending and capital market transaction support. In addition, in 1996, with the help of several multinational equity investing strategic partners, FirstCity broadened into international markets, acquiring asset pools in France, Mexico and Japan. In two years, FirstCity had expanded to five operating units, each with different complex business problems. Today, the company has 2,000 employees. In a typical recent month it handled more than $900 million in loans.

Given this growth, the company realized it needed to expand its risk-monitoring and control activities, as well as develop and maintain profitable business synergies between divisions that complemented each other. However, creating an internal audit function to fit the greatly expanded and diversified entity posed a dilemma. To build a staff with all the knowledge and skills necessary to address this wide array of increasingly complex problems would have cost far too much. Additionally, even if the internal audit staff grew, there was no guarantee it could maintain its technological edge as the company expanded into more diverse business lines. On the other hand, complete outsourcing of internal audit meant loss of control, an alternative that FirstCity's audit committee considered unacceptable.

Using the Internet, the company's director of internal audit (one of the authors of this article) found professional service firms with expertise in the specific financial services conducted by FirstCity. As a result, as many as 25 outside professionals from three different professional service firms and specific independent consultants have worked in internal audit co-sourcing arrangements with the company on eight distinctly different projects. The engagements have lasted from four days to three months--averaging about two weeks--depending entirely on the company's immediate needs. Compensating full-time staff for this work would have cost the company approximately $750,000, or about 63% more than the co-sourcing arrangements. Following are some of the co-sourcing projects the FirstCity internal audit department has commissioned or is planning to commission:

* Researching information on industry best practices and receiving input on the overall control framework for mortgage servicing rights, including initial capitalization, valuation and hedging strategies.

* Diagnostic reviews of asset management, default and foreclosure practices, secondary marketing, cost evaluation of servicing, collateral handling and warehousing of mortgage loans.

* Analysis and review of securitization of various types of financial instruments executed by the company, valuation of resulting residuals, determination of reserves and development of pricing models.

* Risk analysis and development of evaluation models for pools of subprime consumer lending.

* Assistance with review of systems and controls used in international distressed asset pool acquisition and servicing platforms and growth.

* Documentation of best practices and peer company accounting procedures, controls and reporting procedures for the mortgage and consumer lending and servicing segments of the business.

* Review, evaluation and design testing for the hedging and interest rate-monitoring methodology for the capital assets division.

When examining proposals, the company asks for very specific credentials based on the project and looks at vendor team members' job experiences with similar engagements. As a result, no matter how specialized the undertaking, the company has been able to find short-term assistance from teams that have previously performed identical projects. When it comes to bidding, vendors are told that their people's experience is the most important factor in the decision.

PROFITS AND PITFALLS

Co-sourcing allows a company to obtain maximum value-added from the internal audit function while saving on long-term investment in staff. Co-sourcing projects generally take a short time, and a company has no long-term obligation to the service provider.

Another advantage is that co-sourcing provides maximum in-house flexibility and control in strategic planning for internal audit because projects can be planned and executed quickly and without the addition of new staff. In a rapidly expanding and changing business environment, adaptability can help maximize profits. Because co-sourcing is performed on a case-by-case basis, the company pays only for the most important projects.

Still another advantage is the opportunity to shop for the strongest skills for specific projects rather than accepting a package of services from a single provider. While a vendor may have a great deal of outsourcing experience in a particular industry, it is unlikely to have people with expertise in all of a company's specialty businesses. Co-sourcing allows the company to select partners for each of its functional areas from among the best in the field.

There are also potential pitfalls to co-sourcing. Internal audit managers and their staffs who enter into initially amiable co-sourcing arrangements eventually may find themselves in turf battles with their outside partners. One worry from staff members is that if co-sourcing is successful, it may turn into an outsourcing arrangement, and the professional services firm may eventually take over the entire internal audit function. However, while a fully outsourced internal audit operation initially might cost less than an organization's budget for an in-house staff, in the long run it may not be the best choice. A cost-conscious, proactive internal audit group with custom-designed co-sourcing programs retains the advantages of outsourcing along with the benefits of having an in-house internal audit staff, such as knowledge of management methods, accessibility, responsiveness, loyalty and a shared vision for the organization's strategic business goals.

It is also possible to lose coherence with co-sourcing. The company's internal audit staff may develop a "silo mentality," focusing on the department's core functions and failing to oversee important global monitoring and profitability issues. To combat this problem, the prudent internal audit manager should evaluate each co-sourced project carefully in terms of its contribution to the organization's goals. It may help to include the vendor team partner or senior manager as an ad hoc member of a company management committee during the project.

INVESTIGATE THE OPPORTUNITY

FirstCity's experience demonstrates the many potential benefits of co-sourcing. As one important example, the internal audit director remains the department's sole employee despite the company's expansion. When interviewing potential co-sourcing partners, internal audit directors should ask questions that confirm the specific expertise needed and probe for similar projects the team has accomplished. This will make it possible to find a cost-effective solution to even the most specialized problems. Internal audit directors who manage co-sourcing opportunities well should be able to cut costs and enhance their departments' quality and productivity.

Tips for Evaluating Co-Sourcing Providers

PHASE 1: Before starting a project

* Know your own business. Use your company's mission statement to perform a thorough analysis of your business processes. Carefully evaluate them and differentiate the core processes from those that are ancillary.

PHASE 2: Begin the process

* Determine the co-sourcing processes for which you need help, as well as the degree of control you wish to retain over the processes.

* Evaluate resources. Clearly identify your talent pool and their abilities, as well as budgetary and other constraints.

* Identify potential providers, using the communications network outlined above. Perform an Internet search for additional providers if necessary.

PHASE 3: Evaluate vendors

* Contact the potential providers. Submit a request for a proposal and ask for a conference to discuss your needs and the project. If the initial contact is made through a "cold" source (someone you don't know personally), note the length of time that it takes the consulting firm to respond. Firms that have both the motivation and the ability to serve you should get back to you within 3 to 10 business days.

* Be specific. Be prepared to explain your precise needs, time frame, budget constraints and the degree of control you wish to maintain over the process.

* Observe and listen carefully. From the earliest stages of discussion, you should have access to the most competent professionals the firm has to offer. When going over the project with the provider, try to determine the provider's familiarity with your process and the degree of success the firm has experienced in dealing with similar issues.

* Ask for references. The provider should be willing to supply a list of satisfied clients and a detailed executive summary of previous projects that closely resemble yours.

C. WILLIAM THOMAS, CPA, PhD, is J. E. Bush Professor of Accounting at Baylor University, Waco, Texas. JOHN T. PARISH, CPA, is director of internal audit at FirstCity Financial Corp., a publicly traded company in Waco.