The hidden cost of outsourcing

Outsourcing customer service may seem like a bargain, but it can cost you some of your most valuable clients.

(Business 2.0) - Dell (Research) tried it, then reversed course. Capital One (Research) gave up as well, and so did JPMorgan Chase (Research). All came to the same conclusion about their attempts to farm out front-line customer-service jobs to outside contractors: The hidden costs far outweighed the potential savings in labor expenses.

Waning enthusiasm

With consumers enjoying more choice than ever before, evidence is growing that great service is essential for long-term customer retention. To cite just one example, a recent survey of pension policyholders in the United Kingdom found that 75 percent would leave their current provider if they experienced bad customer service.

Meanwhile, the current enthusiasm for outsourcing call centers, IT support, and other "noncore" service functions isn't delighting anyone. Two-thirds of the companies that responded to a survey by InformationWeek reported either no change or a worsening in customer satisfaction as a result of business-process outsourcing.

A 2005 Gartner study predicts that 60 percent of organizations that outsource customer-facing processes will see significant numbers of frustrated customers switching to competitors. The costs associated with these defections add up quickly, which helps explain why the same study found that 80 percent of companies that outsource customer-service functions fail to meet their cost-savings targets. No wonder all three of the companies cited above recently brought some of their customer-support operations back in-house after contracting them out to companies that weren't very good at providing help.

There are practical reasons why an outsourcer's service level is seldom as high as what you'll get from your own people. If outside contractors cut costs, it might be because they're more efficient. But it's far more likely that the savings occur because contractors pay their people less, spend less on training, or both. In the petrochemical and mining industries, for example, research shows that a disproportionate number of accidents involve contractors. Just as there's no such thing as a free lunch, there's no such thing as a free worker who's been properly trained to do a great job.

Likewise, when people don't identify with the organization on whose behalf they're working, their performance typically suffers. That's because in-house employees tend to be far more interested in nurturing a good reputation among clients and customers. It's human nature: Since the name of their organization isn't directly associated with the service that contractors provide, there's less motivation to make sure it's done right.

Real competitive advantage

Which is why the backlash against customer-service outsourcing is upon us, and why it's gathering steam. Sure, outsourcing offers short-term cost savings. But contracting out critical functions can never deliver sustainable competitive advantage, because competitors can always hire the same contractors to do the same thing (equally poorly). Real competitive advantage stems from strategies that aren't easily imitated--and, sorry, buying services on the open market isn't one of them.

Unless you work for Wal-Mart (Research) or you sell a commoditized product like petroleum, you'll soon figure out that competing solely on price is a fool's game. Even in retail: Tiffany is having a stunning year, andWhole Foods Market's (Research) profits and stock price are way up--5 and 70 percent, respectively--in 2005. Neither of those companies seeks to compete on price. Their edge stems from perceived value--what consumers think they'll get for their money. If you're prepared to dash those expectations just to save a few pennies per customer, perhaps it's time to rethink your strategy.

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Business 2.0 columnist Jeffrey Pfeffer is the Thomas D. Dee II Professor of Organizational Behavior at Stanford University's Graduate School of Business.