Think value, not dollars: what the growth of outsourcing means to CPAs.

EXECUTIVE SUMMARY

* OUTSOURCING IS REVOLUTIONIZING the way business is being conducted around the world, and that means CPAs will have to rethink how they establish the value of a business and the metrics they traditionally monitor. If they fail to do this, they will be left in a place equivalent to the days of green eyeshades and columnar pads.

* A GROWING NUMBER OF MANUFACTURERS no longer operate factories. Instead, their products are produced and distributed by specialized contractors.

* AS A RESULT MANY FINANCIAL MANAGERS are expected to answer questions they never had to address before: Which business capabilities should our company own? Which should it contract for?

* IN THE PAST THE GOAL OF FINANCIAL MANAGERS was to optimize internal business-process costs, focusing on price rather than on total cost. But the emphasis now is on cost--not price.

* ACCOUNTANTS MUST NOW DETERMINE the true cost to a company of its various business activities by establishing the value of a specific business capability.

* COMPARING THE CURRENT DOLLAR COST of performing an activity internally vs. externally is only the start. The CPA must take the next step: to determine and quantify how important that activity is to the company's strategic objectives.

Outsourcing--the management strategy for contracting out a company's manufacturing and services operations to specialized contractors--is not only revolutionizing the way business is being conducted around the world, it's requiring CPAs to rethink how they value a business and the metrics they traditionally monitor. If they fail to change with it, they will be left in a place that is equivalent to the days of green eyeshades and columnar pads.

Until recently, outsourcing was a strategy applied by just a handful of forward-thinking companies. Today, it's the way to go for many businesses. Look down the list of the Fortune 500 and you'll see that a growing number of major manufacturers no longer operate factories or even assembly plants. Instead, all their products are produced, and even distributed, by specialized contractors.

What does that mean to the accounting profession? It means many financial managers are being expected to answer questions they never had to address before. For example: Which business capabilities should our company own? Which should it contract for? And what information do we need to make those decisions?

For the past 1 O0 years the goal of financial managers was to optimize internal business-process costs. Contact with the external world was limited to purchasing and sales, both of which traditionally focused on price rather than on total cost to the organization. But for the company that outsources not only production but its distribution, as well, accountants must now compare internal business-process cost with the cost of outsourcing those processes; the emphasis now is on cost--not price.

Accountants must now determine the true cost of a company's various business activities by establishing the value of a specific business capability--and that includes such things as quantifying the value of contracting out supply chain logistics or human resources management.

Comparing the current dollar cost of performing an activity internally vs. externally is only the start. The CPA must take the next step: to determine, and even quantify, how important that activity is to the company's strategic objectives. For example, how much could current costs be reduced if an outside company's price for performing that activity was lower? If a reengineering plan could reduce costs to the best outside price, or even beat that price, would it still be worth the company's while to use internal resources to perform that function? And since outsourcing gives a company the opportunity to change its product line swiftly, how valuable is that flexibility to change the company's market position or to exploit new customer opportunities? What business strategies would become available if time-to-market could be reduced drastically through outsourcing? How could the real cost of product development--including the higher profit from getting products into the marketplace faster--be reduced by partnering, even if that incurred higher development costs?

And, as if the aforementioned questions weren't hard enough, consider this one: How do you quantify the value of internal cooperation? For example, how do you assess the value of quality as an integral part of operations, product development and strategic planning rather than as an outside function? Or how valuable would it be if engineers could be transferred freely within a company as their skills were needed across lines of managerial authority at a lower cost than hiring that expertise from a contract engineering firm?

Clearly, these questions present a unique challenge and opportunity to the accounting profession. However, what makes the challenge more thorny is that there are no textbook processes for examining these questions or even existing metrics for quantifying them. The processes and the metrics must be developed. "Where to Find the Answers" on page 55, suggests books that begin to explore ways to address these questions.

GO BACK IN TIME

If we examine how business got to this stage, where outsourcing has become so prevalent, we may be able to begin to see how such processes can be formulated. To do that we must go back nearly two centuries--to 1814. At that time Francis Cabot Lowell, who owned a textile mill in Waltham, Massachusetts, took a revolutionary step. Up until then textile manufacturing was done by outside contractors--work was put out to independent crafts people, so the system was called "putting out." Each step in the manufacturing process was moved from one home or small workshop to another--a slow and expensive operation.

Lowell decided to junk the putting-out process and, instead, brought all the operations under one roof, with the work performed by his own employees--a management concept later called integration. Lowell was 100 years ahead of even Henry Ford, who applied the same principle at his River Rouge car assembly plant in Michigan.

It took many years for Lowell's idea to catch on--not just because it was revolutionary, but because switching to integration from the putting-out system required both hefty capital costs and the hiring of a large number of full-time employees at a time when U.S. labor costs were relatively high compared with those of Great Britain, the major competitor in the textile trade. But Lowell saw integration overcoming those obstacles because it was able to process converted raw material into final products more quickly.

It wasn't until later, in the 19th century, that economic changes began to support integration: Improvements in mass production, communication and transportation technologies made the value of time more precious; in addition, managers acquired new skills that improved the running of complex integrated enterprises. And then, when U.S. labor costs declined as immigrants flooded the country, the advantages of integration became so overwhelming that the vertically integrated, hierarchically organized, centrally managed industrial corporation became the model for 20th century manufacturing.

But in the 1990s two of the integrated enterprises' most prized advantages began to slip. Internet-based business collaboration software was introduced and that almost immediately weakened integration by making real-time coordination of business capabilities among a group of collaborating companies a cost-effective option. At the same time, technological innovations were changing the marketplace. The market lifetimes of even highly successful products and services started to decrease--narrowing profit windows. To remain competitive, companies were forced to offer a wider range of continually changing models or services. They even found they had to abandon still-profitable products because fast-moving new competitors threatened to chip away at their market share.

This inevitably led to the growth of manufacturing outlets that could produce special-purpose products and services aimed at niche markets--perfect candidates for outsourcing--quickly, cheaply and in high volume.

Finally, the market change that, for many companies, sounded the death knell for integration was the switch from selling individual products and services to producing solutions: customer-specific combinations of physical products, information and services. General Electric and IBM are outstanding examples of traditional manufacturing companies that in the 1990s successfully made the transition from sellers of products to marketers of solutions.

AND THEN DISINTEGRATION

If the gathering of production under one roof was called integration, its demise is nothing short of disintegration. Once suppliers have been integrated into production operations, why not have a key supplier manage the entire supply chain? Can a specialized logistics company take over that function at a lower cost than an internal operation?

Given the value of flexibility in the face of rapidly changing demand and constantly changing products, why not form an alliance with a company whose sole competence is highly flexible manufacturing? Given the extremely short market lifetimes of information and knowledge, why attempt to "own" information and knowledge personnel, as opposed to acquiring information and knowledge opportunistically, as new solution opportunities arise?

How far can disintegration be pushed? General Motors and Volkswagen are building auto assembly plants whose workers are employed and supervised by a few key suppliers. Suddenly, an auto company doesn't even assemble cars let alone manufacture them. GM is moving toward becoming a vehicle design and marketing company--in effect, the customer interface. Boeing is moving in this same direction: Partners and contractors do all the manufacturing and assembly.

The message is clear: A high-tech version of the old putting-out system is back, and that means the role of the accountant must change apace. That opens an extraordinary opportunity for the profession to exercise creativity--but CPAs will have to be proactive. In short, financial professionals can either count dollars or they can measure value.

RELATED ARTICLE: Where to find the answers.

Identifying metrics for valuing business capabilities draws on a wide assortment of management fundamentals including knowledge of Economic Value Added, activity-based costing, time-based costing and the balanced scorecard. In addition, the following books will provide guidance:

* Real Options, by Martha Amram and Navil Kulatikala (Harvard Business School Press, Boston, 1998).

* The Real Options Solution, by F. Peter Boer (John Wiley, Hoboken, New Jersey, 2002).

* Innovation Explosion, by J. Brian Quinn (Simon & Schuster, New York City, 1997).

* Knowledge Assets, by Mark Clare and Arthur Detore (Harcourt Brace, Orlando, Florida, 2000).

* The Strategy-Focused Organization, by Robert S. Kaplan and David Norton (Harvard Business School Press, Boston, 2000).

* Digital Capital, by Don Tapscott (Harvard Business School Press, Boston, 2000).

* Value Migration, by Adrian Slywotzky (Harvard Business School Press, Boston, 1995).

* Cooperate to Compete, by Kenneth Preiss, Steven L. Goldman and Roger N. Nagel (John Wiley, Hoboken, New Jersey, 1997).

STEVEN L. GOLDMAN, PhD, is the Andrew W. Mellon Distinguished Professor in the Humanities at Lehigh University, Bethlehem, Pennsylvania. His e-mail address is [e-mail].