Outsourcing and out of control

BA must be reflecting that there's no such thing as a cheap lunch. When it sold off its in-flight catering arm to Swissair in 1997, it only seemed to be doing what everyone else was. Outsourcing, together with its sibling, offshoring, has become a seemingly unstoppable management bandwagon.

Outsourcing adviser TPI estimated that major outsourcing deals - those worth more than $40 million (£22m) - totalled $58 billion last year, while adding in smaller deals and related consultancy would multiply that figure several times. The UK spent £2.5bn on outsourcing advice alone in 2004, much of it in the public sector. BA itself has more than 2,000 outsourcing relationships in place.

For BA, as for other companies, there is a management rationale for outsourcing a function previously done in-house. The doctrine of 'core competencies' suggests that an organisation is better off cultivating the few things it is distinctively good at and farming out the rest. This is not new: companies have always had to make trade-offs between making or buying.

However, what made outsourcing a hot ticket was its application in the 1990s to IT, which not only lent itself to outsourcing as a function; by the same token, other functions based on it, such as HR and administration of all kinds, could also be hived off to third parties. Services as well as manufacturing could be taken apart, farmed out, then reassembled seamlessly at the point of delivery.

As a result, a growing army of eager vendors queued up to offer an increasing range of processes that went deeper and deeper into the heart of the firm. At the height of the internet boom, excitable observers were suggesting that conventional companies would eventually disappear, being replaced by fluid networks that constantly reconfigured themselves. 'Outsource everything except your soul!' exhorted arch-guru Tom Peters.

As with much in management, however, outsourcing has a less obvious agenda. To find out what is really driving its exponential increase you have to look at the incentives. The major impetus is not what it does to operational but to financial performance.

Taking assets off the balance sheet increases reported return on assets at a stroke, just as the reduction in headcount boosts revenues per employee. Moreover, it is far easier for the firm that is outsourcing to use market pressure to cut costs - by threatening to switch suppliers - than it would be to do so internally. In effect, it offloads the difficult task of operational improvement to the supplier.

Lower costs drop straight to the bottom line; higher earnings leveraged by high price-earnings ratios boost the share price; rising shareholder value increases executive pay - at least in the short term.

The financial engineering angle explains why outsourcing is so much more important in the Anglo-Saxon economies, with their emphasis on shareholder value, than in continental Europe. By the end of the 1990s, US manufacturing firms were outsourcing between 50 and 70 per cent of the value they added. But in the long run operational considerations have a nasty habit of reasserting themselves - as is happening with BA.

Suppliers' margins cannot be squeezed ad infinitum, particularly when there are only two of them, as in the case of global airline caterers, and both are in financial trouble. BA has already had to improve the terms of its contract with Gate Gourmet to allow it to survive, thus negating part of the point of the deal.

As many companies are finding, outsourcing has hidden costs that over time diminish its apparent advantages or even wipe them out. These are simply not captured in the economic model. The most obvious is control when things go wrong, as at Heathrow.

But basic operational knowledge is also a casualty. When Gate Gourmet's new owner, Swissair, collapsed, the caterer was bought by Texas Pacific, a private-equity group. Private equity, too, is all about finance: companies are loaded with debt and sweated mercilessly with a view to being sold on as soon as possible. So Gate Gourmet was under huge pressure to drive down costs (mostly labour) from both its customers and its owners.

If the airline had still been in charge, it would have known the strain and risk to which it was submitting its supply chain. It would have also known that its baggage handlers and support staff were not only members of the same trade union as the catering workers - they were their husbands and brothers. Whatever they say in public, companies typically outsource to cut costs. But because they fail to look at the process as a whole, they often end up increasing them.

In BA's case, the airline estimates that the summer chaos has cost it at least £30m, but who knows the real total in terms of damaged reputation and lost custom in the future?

Conventional wisdom says that companies should never attempt to outsource problems or risk, and for once it is right. The only way to make outsourcing work is to know as much about the function and to put as much work into managing it as the company you have handed the job to. In which case, of course, you might equally well do it yourself.