Outsourcing: seizing the new markets in corporate functions.

Is overhead a thing of the past? Not yet. But as markets develop for mission-critical services, providers can sometimes do it better, faster, and more cost-effectively. CEOs must know how to rate themselves against the new competition.

What have we done for our shareholders lately? In recent years, most of us have restructured and downsized; we've instituted activity-based costing, trimmed product lines, qualified suppliers; we've invested in distributed information networks and training; we've re-engineered order fulfillment and design processes - the list goes on.

The good news is that our businesses have all improved. The bad news is that our businesses have all improved. There is little we've done that our competitors haven't - and unfortunately, we're competing against who they are now rather than who we were five years ago.

One area that bears scrutiny but often is ignored by CEOs is how corporate "staff" departments - accounting, strategy development, information technology, and legal counsel, among them - contribute value to the company. While a company may expect improvement in logistics or food services (and will outsource to get it), it may routinely accept significant annual growth in head-office "overhead." In fact, no company should accept this today.

The expansion of corporate staff functions was not unreasonable in the 1970s and '80s, when it was necessary to integrate vertically to achieve corporate growth. But growth can have a logic of its own. For example, when IBM was expanding rapidly and needed many sensitive contracts drawn up, it made sense to create a legal department. Today, IBM employs 500 lawyers. Other companies built up huge internal audit staffs and strategic-planning departments. More recently, companies have bulked up inhouse departments to handle telecommunications, distributed data processing, and systems integration and maintenance.

There were advantages to maintaining these functions in-house. A company didn't have to contribute to someone else's profit margin, and management didn't have to listen to the sales pitches of service vendors. Most notable, however, was the fact that the markets for large-scale or mission-critical services were underdeveloped. It was probably safer - if not cheaper - to do it in-house.

SOPHISTICATED SERVICES

Today, however, it's a different story. The markets in critical corporate services are vastly more sophisticated than they were 10 years ago. For nearly every support function, there are expert firms that can customize their work and have advantages of scale, method, data management, and global reach - and they compete intensely with one another to get business.

Many of these firms are bigger than their clients, recruiting from the best schools, and training relentlessly. They are making markets in core business strategy functions that their clients once thought were necessary to "own."

Does it make sense for a retailer or manufacturer to do its accounting inhouse when the company could outsource to one of the Big Six more cost-effectively? Should these businesses maintain their own strategy or IT departments?

Not all think so: Despite Motorola's decision to use in-house systems integrators in the late 1980s to link the information systems in its semiconductor plants with Hewlett-Packard's computer factories, the company has changed its tune. Motorola Semiconductor managers now say they are looking to link 'customers' information systems with a "hybrid" of software services, some internally developed, some purchased from outside providers.

They are not alone. Recently, Eastman Kodak signed a five-year agreement with Northern Telecom and Integrated System Solutions Corp., a subsidiary of IBM, for management of Kodak's data, voice, and video telecommunications networks in the U.S. The contract was brokered by Kodak's chief information officer, who took bids from several vendors. One global metals company we know has taken its strategy consulting vendor in-house to oversee data collection, problem structuring, and new business development - in effect, becoming the company's strategy department. Today, CEOs have the option of making outsourcing decisions, make-or-buy decisions, about highly sensitive activities, which have themselves become strategically distinct businesses developed by global companies. At the least, we should expect our staff people to learn from them and compete against them.

THE "NEW" COMPETITION

Pacific Telesis has instituted a new policy whereby its own legal department will have to bid for business along with outside law firms. The business units will be free to set their own legal budgets and choose the in-house team or an outside firm; the legal department will have to prepare hourly billings and if it cannot beat the outsiders' prices, it will be closed. One senior PacTel executive put it this way: "It will be survival of the fittest. We will have an exact measure of what every lawyer and paralegal will be producing."

It may sound a bit draconian, but the logic for PacTel's approach is clear - and it is not only about saving money. In most corporations, people who work in corporate functions too often are protected from competition, and they become mere overhead. The managers of the business units tend to think of staff functions as an overhead tax on the value they create.

It's up to CEOs to create a process by which functional managers can prove the value they create for the company. Among the first questions to ask are: Is a particular function critical to the strategic success of the business? Does it contribute to competitive advantage? If the answer is no, then the decision to outsource is obvious. Senior management time is too valuable for companies to do things that are peripheral to their competitiveness, especially if they do not excel at them, and there are reliable companies that can do the job for them.

But if an activity does contribute to competitive advantage, then the next question is, how good is the corporate department vis a vis the competition? How good are the company's financial people lined up against Morgan Stanley or Goldman Sachs? How good are the product designers as compared with Stone & Webster or Design Continuum? It's up to functional managers to prove they meet the highest standards. Service firms have to do it every day. Besides, the IRS and Labor Department have never made it easy to keep more personnel on the books.

A SMARTER INTERNAL INVESTOR

CEOs can help by learning to be smarter investors in internal services. That is a skill in itself. There are usually eight practical demands CEOs can make of functional managers.

* Unbundle activities. Break them down into types of service provided for particular internal clients. Providers should make it easy to determine the contribution a service makes to each line or staff operation.

* Apply activity-based costing methods. What are these activities' operating expenses and use of fixed assets as applied to the value they create? Costs (including opportunity costs) should be broken out for the life cycle of each unbundled activity.

* Benchmark the competition. (Competition in this case means vendors who can provide these activities, not competitors in the company's core business.) It is easy to get salient information on vendors' expertise and performance. But benchmarks also can be drawn from the performance of other service businesses in analogous situations.

* Determine relative cost. What is the "all-in" cost of functional activities versus outside service companies? Margin becomes irrelevant if a function's cost structure is more than 20 percent higher than that of a service company.

* Determine execution time. Another key measure is mean time to execution for any specific task; time is more valuable than money these days. Gauge internal delivery against the competition, from the time of the first call for help, to the time the job is done.

* Demand continuous learning. Each department should benchmark the knowledge assets embodied in its staff and the quality of training. It should also maintain a knowledge "inventory" - an archive, technology data base, and a developing description of proprietary intellectual property.

* Determine transaction costs. These are the actual costs of working with internal staff as compared with the costs of working with outsiders.

* Offer the equivalent of a service guarantee. What guaranteed targets for quality and performance can be set in collaboration with internal customers? How will meeting them impinge on shareholder value?

All these metrics assume that functional managers are, in effect, running their own service businesses whose primary customer is the corporation. After doing this groundwork, functional managers may decide they want to start their own company that can market its services to other customers, raise its own capital for expansion, or become a profit center within the corporation.

A few years ago, DEC spun off its inhouse publishing services. The result was Butterworth-Heinemann, which is now a division of a larger publishing company, employing 100 people.

Coopers & Lybrand LLP recently contracted to buy a Web-based knowledge networking platform for its U.S. professionals from a group of former employees, who in 1994 left the firm to start a software design house called The Agency. "We would not likely have done this in-house," says John Clippinger, head of The Agency. "The committee meetings would have drained us." And yet, he concludes, "it is almost inconceivable that a group that was unfamiliar with the personalities and culture of C&L could do what we're doing."

There is a huge upside here, and functional managers should be encouraged to appreciate it - learning to play offense. Functional departments have one advantage over an outside firm. They know the company: its strategy, capabilities, and dark corners. At the same time, there are no magic metrics with which to guarantee that corporate functions will be valuable. There is only what some would call selling.

This example at General Motors illustrates this point: A generation ago, GM picked its plant sites largely on the basis of favorable railroad freight rates. The personnel department was never consulted. But one year, that department got a new head, and he wanted to be noticed. He took the initiative and studied areas being considered for GM plants: demographic studies and analyses of the available labor pool. Top management found these so helpful that it began to include personnel in site-location decisions. No one had asked the head of personnel to do this; rather, he and his department had become valuable to corporate deliberations in the way good consultants become valuable.

What functional managers most need now is a new attitude, governed by this old, tested, and more entrepreneurial business model. Companies now can look at corporate functions much like a venture capital firm looks at businesses it has already put money into. Even in a more patient world, this model would require gumption from both sides to work. In today's world, gumption just means survival.

Victor Millar is president and chief executive of AT&T Solutions, a global consulting and systems integration unit of AT&T, based in Washington, DC.

Joseph B. Fuller is a founding director of Monitor Co., a Boston-based consulting company.