Turner Nicole

Note: Final Paper is attached under "Files"

Outsourcing Financial Risk Management

Bradley University

FIN 627

Nicole Turner

October 7, 2009

In today’s business world it is inevitable that companies will want to make a profit on all aspects of their operations. As competition has increased and the cost of keeping up has increased as well, companies have found numerous ways to save money. As we look into the various cost saving methods we find a familiar process known as outsourcing. The idea of outsourcing has been around for many, many years but has developed and changed in the way people and companies utilize it. Although there has been substantial exploration and discussion on outsourcing, the idea of outsourcing financial risk management of a firm has not been closely studied. The financial risk management sector of a firm has the capabilities of not only hedging risks, but also generating great profit for a company. The question arises, therefore, that if a company can greatly benefit from proper financial risk management, why isn’t every firm doing this? The answer to this question is the massive amount of knowledge and resources needed to accomplish successful risk management. This is where the idea of outsourcing such tasks comes into play. Throughout the research, there will be discussion on both the positive and negative aspects of outsourcing such tasks to an external work site.
What is outsourcing and what types of outsourcing are available? According to Webster dictionary, outsourcing is the action of “procuring (as some goods or services needed by a business or organization) under contract with an outside supplier.” Outsourcing is the reassignment of a business function to an outside company or organization. Outsourcing does contain a contractual agreement between the two parties that illustrates the specified tasks or services being provided. Some of the most popular business aspects that are outsourced today include information technology, human resources, call centers, and accounting. Many people use outsourcing and offshoring as if they have the same meaning. Offshoring differs from outsourcing in that offshoring is transferring that specific task to another country, where outsourcing would remain in the native country. There are not only different business components that can be outsourced, but also different types of outsourcing itself.
There are multiple types of outsourcing, but for the most part outsourcing can be broken out into two categories. Those two main categories include Business Process Outsourcing (BPO) and Technology Services Outsourcing (TSO). Business Process Outsourcing is used so that companies can focus on their niche or core competencies, yet outsource those components they are not efficient at to a supplier who can efficiently complete those tasks. With using BPO, companies can focus their resources and time on areas where they can profit the most, instead of using those resources on areas that can easily be outsourced for lower cost. The most common forms of BPO include accounting and finance, human resources, customer relations, supply chain, security, equipment management, and logistics. Technology Services Outsourcing (TSO) is used mainly because of the fast pace of the technology in the business world. TSO allows companies to use more refined and faster technology then they would if they were responsible for the technology in-house. Since technology needs to adapt as the business changes, it is imperative to have the capabilities to make the technology processes keep up with the competition. The most common forms of TSO include web development, software application, eCommerce, and network/infrastructure.
Even though we are all aware that outsourcing is occurring in almost all aspects of the business world today, many people do not know where it began. The progression of outsourcing has been most substantial in the past twenty years, but has been evident for many years dating all the way back to the 20th century. During the late 20th century, companies began contracting out certain, smaller components of their business activities to other companies who specialized in those areas. Before outsourcing became evident in the business world, companies would handle every aspect of their business, from the obtaining the raw materials to getting the product or service into the hands of the end consumers. A majority of the companies who did not conform to this new outsourcing idea could not keep up with the companies who were taking advantage of it, and eventually conformed or failed. During the seventies and eighties, companies began outsourcing payroll, accounting, and human resources tasks and this began outsourcing as we know it today. Outsourcing began with local companies, but once globalization started to become more common, outsourcing began to spread overseas to developing countries as well. What began as mostly manufacturing outsourcing has transformed to make the greatest market share for outsourcing to be in information technology. Out of the top five-thousand United States companies, half of them outsource some function of their business. Since companies can outsource functions to foreign countries such as China, India, and The Philippines for lower costs with higher skilled laborers, the amount of outsourcing has been increasing. Not only has it been increasing in the past, but the number of companies outsourcing is growing at a continual rate and shows no sign of disappearing in the near future as illustrated in the following two charts. (Figure 1 and Figure 2)

Figures 1 and 2
Although outsourcing seems to be the best situation for any company to get involved in, there are also some consequences or negative aspects to outsourcing. The most important aspect to deciding if outsourcing is the best solution to a specific business function is to understand the basic pros and cons of outsourcing. After an understanding of the pros and cons is obtained, it is easier to determine which of those apply to the specific form of outsourcing a company is thinking about imposing and determine if it will be beneficial to implement. Many people only recognize the benefits of outsourcing because these are most obvious when we think about why so many companies are outsourcing. The most apparent benefit of outsourcing is lowering costs, in which most people associate with cheaper labor. Since many times outsourcing ends up in developing countries, the wages are much lower due to the lower cost of living. Along with cheaper labor, there are also lower operating costs. Since the work will be done outside of the company, outsourcing cuts the costs entailed to set up “workstations” for each worker that would be a part of your organization without outsourcing. One of the most expensive expenses a company can endure is training costs. Although many people do not recognize this as being a substantial cash outflow, training new employees and existing employees can be a large financial burden. With outsourcing, the supplier is responsible not only for the task at hand, but also the training of its employees to perform those functions. Many companies looking to outsource are small in size; therefore technology can be hard to stay up with. When this is the case, outsourcing technology services can help a smaller company to obtain better technology for a relatively lower cost. As far as productivity goes, it is hard to find qualified employees to work all shifts within a company. When outsourcing, there is the capability of having workers on shift twenty-four hours a day because of it most likely being a developing country. Core competencies are what make companies so successful. More than likely a company is very successful and knowledgeable at one or a few specific tasks, therefore they should focus as much of their resources and time on those competencies instead of other areas they are not as competent in. Outsourcing allows companies to give the functions they are not as strong in to a supplier who specializes in that area, which saves money and also frees up other resources and of course time. Although all of these reasons seem like outsourcing should be a “no-brainer”, there can also be negative results.
The negative aspects of outsourcing can affect your employees, customers, investors, and of course your company as a whole. The first thing most employees think of when they hear the word outsourcing is job cuts. Sometimes this can cause current employees to feel the threat of losing their jobs and begin searching for a position elsewhere, which can result in a company losing valuable employees. The most prominent negative aspect of outsourcing is loss of control. Once a function is handed over to the supplier, all control over managerial decisions and methods of accomplishing the task at hand is also handed over. This can be very scary for companies, especially ones that are skeptical about giving up control. Some companies have experienced a loss of customers due to outsourcing. Especially when it comes to outsourcing customer relation functions, some consumers will decide to change companies to deal with a company who holds their customer relation functions in house. Another negative aspect is the lack of security. When outsourcing certain functions there is a lot of information being transferred to the supplying company and the loss of security can happen. The security of customer and company data is no longer in the security of the company and therefore can become an issue. Finally, outsourcing can bring about lower quality of work. Outsourcing can mean that the employees of the supplying company are competent and educated, but not in every case. Sometimes it would be more beneficial to keep the tasks in-house to have the greatest return.
The second component of the research was introducing financial risk management and outsourcing together. “Financial risk management is the measurement and the attempt to control trade-offs between risks and rewards in both profit-motivated enterprises and non-profit organizations. The vocabulary of financial risk management is the heart of the language of finance.” Financial risk management has the intent of adding economic value by managing risk and using financial instruments to do so. Most commonly financial risk management is focused on credit risk and market risk, but can include volatility, foreign exchange risk, and inflation risks to name a few. When a company is using financial risk management it focuses on hedging risk and exposure to risk. Financial risk management should add value to the firm and shareholders, but in a way in which the shareholders can not do so for themselves. Therefore the cost and time involved with hedging risks should be applied to aspects in which shareholders cannot accomplish in their position.
Financial risk management can be a very difficult task to be assigned to. It takes a great amount of understanding and knowledge in the field to successfully hedge risk and a company must make sure they give the responsibility to competent employees or outsourced companies. Every company would like to be able to estimate the likelihood of losses in the financial sector, but the truth is it can be very difficult to estimate. There are a few basic steps when a company is managing financial risk which includes identifying financial risks, determining risk tolerance, applying a risk management strategy, and finally measuring, examining, and improving the process after it has been implemented. Financial risk management should grow along with a company, therefore as a company grows so should the financial risk management sector. The financial risk management process should not only focus on external risk, but also internal risks. Factors that affect such things as interest rates, exchange rates, and commodity prices are all important to understanding financial risks.
The three main factors that affect financial risks are interest rates, exchange rates, and commodity prices, are all important to understand. Interest rates are important in financial risk management because they influence the cost of capital. Interest rates can also include a risk premium which can affect the credit merit of a borrower. Foreign exchange rates are affected by the supply and demand for a specific currency. The economy, foreign trade and investing in foreign countries can all affect the supply and demand. Commodity prices are affected by supply and demand, quality, and location. Other components that can affect commodity prices include inflation, interest rates, availability of substitutes, economic conditions, and cost of production. Financial risk management is not only about understanding these factors that bring about risk, but also hedging those risks. Hedging is about offsetting one’s position with the opposite position. With an understanding of financial risk management and outsourcing as two separate items, it is understandable why combining these two can be difficult and also should be given a lot of thought before combining.
The final portion of this research will be in determining if financial risk management should be outsourced. First, a look at successes and failures in outsourcing will be taken to determine the odds of successful outsourcing situation for such a function as financial risk management. Finally, a recommendation will be made on whether or not a company should outsource their risk management task.
Outsourcing, like any other business decision, can be a great success or failure for a company. As suggested throughout this research, the key to obtaining the best results from an outsourcing would be to have distinct guidelines set up in advance to ensure the tasks are being completed in the desired manner. The following three stories are successful outsourcing experiences provided by CIO.com.
“A few years back, a business unit of Cinergy Corp. outsourced database administration services. A couple of years down the line, the outsourcer was asked to handle database administration enterprisewide. With this move, the outsourcer has enabled a major technology shift from data marts to an enterprise warehouse.”
“Summit Information Systems, a software developer, outsourced disaster recovery services for its data center in Florida. When Florida met with the worst hurricane conditions in 2004, the outsourcer was committed to keeping the company's systems in working condition.”
“When JM Family Enterprises outsourced all mainframe hardware, software and operations, the outsource partner optimized business processes, leading to timely financial reports.”
For every success story, there is also an instance of failure. Although outsourcing has been a part of our business world for many years now, the instances of failure have yet to weaken. So what causes failure in outsourcing?

Figure 3

As you can see in Figure 3 above, the most prevalent in outsourcing failures is that the buyers are unclear in the expectations upfront. Second in line to attribute the blame for outsourcing failure is that interests had become misaligned over time and in third poor governance for the ongoing relationship. We can eliminate over 50% of the failures by eradicating these three main problems.
With this in mind, we can finally discuss the main purpose of this research and that is to decide if it is beneficial to outsource financial risk management. My suggestion is that if a company does not have the capabilities and resources to effectively manage their own risk, it can be a great profit potential to outsource this to a company who specializes in financial risk management. This can be exceptionally beneficial for smaller companies who cannot afford to hire personnel equipped with the knowledge and expertise to effectively hedge risk, nor do they have the time and resources to do so. I think it could be beneficial for larger companies to keep financial risk management in-house, because it can utilize personnel that have been with the company for many years and know the company inside and out, whereas an outsourced company may be missing some of that crucial information. Overall, the most important aspect of outsourcing financial risk management would be to forth set specific guidelines and expectations upfront and then follow-up with the outsourcing company on those guidelines on a regular basis to ensure both companies are still on the same track. If the company interested in outsourcing can make sure all aspects of the deal are being met and the services being provided will be effective, outsourcing this type of function can return great profits for a company.

Bibliography

CIO Magazine May 2002

Computer Economics 2006

Fulks, Rick Pros and Cons of Outsourcing. “Love to Know” September 21, 2009

Gastineau, Gary L. & Kritzman, Mark P. Dictionary of Financial Risk Management. 1996

Goolsby, Kathleen, Whitlow, F. Kheaton Business Writer What Causes Outsourcing Failures? August 2004.

Hardigree, Debbie Advantages of Outsourcing: When and What to Outsource? August 20, 2009.
Hunton & Williams, Risk Management in Next Generation Outsourcing. 2008
“Outsourcing Times” Outsourcing Success Stories. October 1, 2005
Sourcingmag.com A Great Guide to Outsourcing Risk Management, Part I. January 20, 2009.
Thomas, Mary Why Outsourcing Risk Management Can Save You Money. July 19, 2009
Thomas, Mary The History of Outsourcing – What You Can Learn From the Past. July 16, 2009.

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