7 Must-know Principles of Cost Saving When Outsourcing (Part-2)

In Part 1 of this 3-part series, we talked about the first 2 principles of cost savings while outsourcing. In Part 2, we will talk about the next three principles: Barking up the wrong tree: What everyone has got wrong about outsourcing; Penny Wise, Pound Foolish: Why narrow vs. broad framing changes everything?; and Goodhart’s Law: When a measure becomes a target, it ceases to be a good measure. Read on.

The fundamental premise of outsourcing is centered on leveraging purchasing power. Due to the strength of the dollar, it stretches further overseas than domestically. For instance, a professional migrating from the US to India may earn less for the same job, reflecting different socio-economic conditions. Conversely, moving from India to the US could result in higher pay for identical skills and qualifications. Essentially, outsourcing is about achieving cost savings because the dollar goes further in other markets.

However, a critical error occurs when decision-makers conflate and confuse this principle with the ‘cheapest quote’ approach. Overseas costs are substantially lower from a US perspective, which can misleadingly appear as a competition for the lowest quotes. But effective outsourcing involves working with reputable companies charging market-standard rates in their countries, which, due to currency differences, appear more affordable to us. Outsourcing was never meant to be about engaging companies that are below par even by local standards.

The problem with the ‘cheapest quote’ strategy is that outside of commodities it is not only largely discredited (see Goodhart’s Law) but also largely obsolete in many areas of business and society. We rarely base decisions on the cheapest options in personal or professional spheres as time and experience has proven this to be a poor strategy. Quality, reliability, and value are typically weighed alongside cost.

This is why the ‘cheapest quote’ approach has largely fallen out of favor in the US and Europe. Its propensity to trigger a race to the bottom often leads to compromised quality and unsustainable services. Additionally, from a vendor’s perspective, few service providers position themselves solely on the basis of offering the lowest prices. Even those who do use competitive pricing typically offer only modest cost differences, avoiding drastic undercuts that could undermine the quality of their services.

The principle of leveraging purchasing power is not unique to offshoring. Companies in high-cost areas, such as New York, often establish back offices in lower-cost regions like Kansas, Iowa and Ohio to reduce expenses. However, if these New York companies were to adopt a policy of hiring only the ‘cheapest’ personnel in Kansas, the flaws in such a strategy would be apparent. Surprisingly, this is exactly the approach that many decision-makers adopt when outsourcing internationally.

We are now facing a paradox in the outsourcing industry: many US clients are so focused on securing the lowest possible rates that Indian companies, like VE, are often willing to pay more for top talent than what their US clients are prepared to spend.

Outsourcing falters when decision-makers abandon the sound business practices they adhere to locally. Ideally, outsourcing should mirror the approach of medical tourism, where enhanced purchasing power enables the selection of premium options with ease and confidence. However, what many clients end up doing is akin to haggling in a foreign bazaar, driven by the suspicion of overpaying. This approach is a departure from the true essence of outsourcing, which was never intended to be about ruthless cost undercutting. Understanding outsourcing as such is a fundamental misinterpretation of its concept and overlooks the substantial advantages it can offer.

Life is too complicated for us to take all considerations and the relevant parameters into consideration—moreover if we tried the time taken to make a decision would making living unpragmatic and unsustainable.

Accordingly, our brains use reliable rules of thumbs or heuristics and models to simplify the complexities of life that make decision making faster and yet still empower us to make a pretty good decision.

Another technique our brains rely on is frames—once more because there is too much information for us to process in a given decision—we are only able to focus and take into consideration certain aspects and factors. However, depending on the information we focus on and the way it is presented to us, (or we present it to ourselves) can massively impact the way we perceive a situation and the judgement we ultimately make.

For instance, studies have shown that you’re more likely to switch energy providers if a salesperson tells you, ‘You are currently losing $300/month on your energy bill,’ rather than ‘I can save you $300/month on your energy bill,’ even though both statements offer the same end result.

In ‘Decisive’ by Chip and Dan Heath, the concept of ‘narrow framing’ is explored as the tendency to define our choices too restrictively, often in binary terms. Rather than asking, ‘Should I break up with my partner or not?’ a broader perspective would have us consider, ‘What are the ways I could make this relationship better?’ Instead of a simple ‘Should I buy a new car or not?’ we might ask, ‘What’s the best way I could spend money to improve my family’s quality of life?’ The Heaths argue that by being willing to look beyond the immediate, binary choices, we typically find a wealth of alternatives that we might not have initially seen.

Consider the decision to buy a pen listed at $15. If you discovered the same pen on sale for $8 just a fifteen-minute walk away, would you make the effort to get it? Now, imagine you’re in the market for a suit priced at $600, and a store a fifteen-minute walk away offers the same suit for $590. Would the $10 savings motivate you to walk?

Far more people would trek to save on the pen but not the suit, despite a larger absolute saving on the latter. This illustrates how narrow versus broad framing affects our decision-making.

In the first scenario, we engage in narrow framing, focusing on the substantial nearly 50% discount on the pen, which appears significant enough to warrant the extra effort. Conversely, in the second scenario, a $10 discount on a $600 suit—a mere 1.6% saving—prompts us to think about the bigger picture, whether the modest savings are worth fifteen minutes of our time, which often, they are not.

How does this relate to outsourcing? Many clients weigh the options between established outsourcing vendors and less reputable ones. Distance can obscure the stark contrasts in reliability, infrastructure, and competence between a proven provider and a ‘mom-and-pop shop.’ With just a website for comparison, which can be imitated,(if reviewed thoroughly in the first place, which typically is not the case) it’s easy to overlook the absence of a solid foundation and expertise—especially if the evaluation is based solely on cost.

Less established vendors may offer lower quotes to make up for their lack of resources and experience. For instance, if a reputable vendor offers services at $1,500 per month and a less reputable one undercuts this by quoting $1,150, the immediate saving of $350 per month, or $4,200 annually, seems significant. The allure of saving money is the very essence of outsourcing, making it challenging to ignore such apparent upfront savings.

How does our perspective shift with broad framing?

By considering the entire scope of potential annual savings from effective outsourcing, which could range from $40,000 to $80,000, the immediate appeal of saving an additional $4,000 diminishes. It becomes apparent that fixating on this smaller figure risks the larger sum that could be saved.

Many small business owners are initially sceptical about outsourcing. If presented with a guaranteed annual saving of $50,000, they’d be overwhelmingly enthusiastic. Yet, paradoxically, these same clients might jeopardize substantial savings by overemphasizing minor cost differences, essentially sacrificing dollars for dimes.

The consequence of a poor outsourcing decision can be severe. Once a business owner experiences a setback due to choosing a low-cost provider over quality service, they may become disillusioned with outsourcing entirely, missing out on its substantial benefits and incurring significant opportunity cost.

While the drive to maximize cost savings is a universal goal in business functions, we typically temper this objective with considerations of a vendor’s capability and track record. Intuitively, we recognize that real cost savings are contingent upon achieving certain results or benchmarks. In essence, quotes are not absolute and should be qualified accordingly.

Regrettably, this prudent approach is often neglected in the context of outsourcing and there are three primary reasons why clients fail to quality quotes:

The perception of outsourcing is largely negative, characterized by scepticism and apprehensions. Such a generalized view at the industry level often results in homogenization, where all entities are bucketed as a single monolithic group with little attention or consideration given to individual differences. This pattern is not unique to outsourcing; it manifests similarly in industries like Big Pharma, tech and social media, oil and gas, and fast food.

If you’re sceptical of outsourcing across the board, then investigating the unique characteristics of each company, (and the merits of their quote) seems like a pointless exercise.

Few clients view outsourcing as a value-adding operation; therefore, much like when purchasing a commodity, focusing solely on cost seems justified.

This cost-centric attitude oddly persists even when outsourcing complex, technical, and mission-critical functions. Furthermore, even for basic back-office tasks, the intricacies of operations and the demands of the broader ecosystem require a competent partner. Consequently, treating any professional services as mere commodities invites problems. This approach is not typically adopted for local services and is even less justified when applied to outsourcing.

The focusing illusion is a cognitive bias that leads people to overemphasize one aspect of an event while neglecting other relevant factors. This bias implies that the aspect one concentrates on is given disproportionate weight, skewing one’s overall judgment. Essentially, the focusing illusion is why we often assign greater importance to things than they warrant.

In the realm of outsourcing, cost has become so closely intertwined with the concept that the two are practically seen as equivalent.

This fixation on cost, as explained by the focusing illusion, causes us to overlook other crucial factors, leading us to assess the value and credibility of an outsourcing proposal based on cost alone, even when it might not be the most significant aspect.

In summary, the strong association of outsourcing with cost directs our attention to quotes. When this happens, the focusing illusion amplifies its significance, leading us to attribute more importance to a quote than may be justified.

In local settings, a clear distinction is appreciated between the promise of a quote and the realization of cost savings. Yet, when it comes to outsourcing, this discernment due to the aforementioned reasons tends to fade, and the lines become blurred.

This single-minded pursuit leads clients to erroneously assume that a lower quote will automatically lead to greater cost savings. In turn, obtaining the lowest quote becomes an obsession, with clients wrongly equating it with success in their outsourcing endeavours. Consequently, clients often avoiding meaningful dialogue, withholding project details, or neglecting to evaluate a vendor’s full capabilities. If the lowest quote is believed to equate to the best cost savings, then all efforts inevitably become concentrated on ‘fishing for quotes,’ turning a single indicator into the sole determinant of the outsourcing strategy.

Indeed, some even see obtaining the lowest quote as a point of professional pride, a marker of diligence and negotiation skill. Yet, they miss a crucial fact: a quote can be pulled from thin air.

Such a singular focus is naive and overly simplistic, a concept encapsulated by Goodhart’s Law, which states: “When a measure becomes a target, it ceases to be a good measure.”

Goodhart’s Law warns us that when a measure, such as cost, becomes the sole target, its ability to accurately reflect value diminishes. This is because the pursuit of the target can lead to gaming the system and prioritizing the metric over more substantial outcomes.

Take, for example, a company that uses the number of software bugs fixed as an indicator of developer productivity. Developers might shift their efforts to resolving only simple bugs quickly, ignoring complex but significant issues, thus undermining the measure’s validity.

A similar phenomenon of gaming the system is observed in the outsourcing industry with rogue vendors. These vendors often lure clients with deceptively low quotes, drawing attention away from their inadequate value propositions. Rogue vendors have become adept at this practice: over-promising, under-delivering, and cutting corners has become a common strategy for winning clients.

By chasing the ‘cheapest quote,’ clients inadvertently create a race to the bottom. Ultimately, they become the biggest losers in this scenario, as the cost savings they seek are seldom realized. This system has indeed been ‘gamed,’ and it’s crucial to recognize that decision-makers are equally complicit through their sheer negligence.

In the final part of this 3-part blog, we will talk about the last two principles: Contradictory behaviour: Why our actions and attitudes don’t align and Comparing Apples to Oranges: Are you looking for the best talent locally but the cheapest ‘quote’ offshore?