Outsourcing

MTSU Accounting Alumni DayMay 13, 2004

Jeannie Johnson Harrington

Introduction Outsourcing is the transfer or delegation of a

part of the business activity that was previously performed by internal staff to an external service provider with the overall goal of improving a company’s competitive advantage.

Two types Traditional – employees of an enterprise cease to

perform the same jobs for the enterprise Greenfield – the enterprise changes its business

processes without the service provider having to hire any outside personnel; for example, a new service is provided by the outsource firm.

History of Outsourcing Losing skilled jobs to low-wage foreign

competition is as old as the Industrial Revolution in the 1830s Originally unskilled or semiskilled labor-

intensive jobs were outsourced British Textile Industry outplaced the Indian Cloth

Makers Skilled weavers in Britain were replaced by more

efficient machines Low-cost labor came to the U.S. in the form of

immigration Prices overall became lower raising the standard

of living for everyone

History of Outsourcing (cont.)

Now skilled service work like information technology and customer call centers are being moved overseas Wages in India cost about 1/4 to 1/3 of

the wages in the U.S. for comparable quality

The number of U.S. programming jobs declined about 14% between 2000 and 2002.

Theory of Outsourcing Law of Comparative Advantage –

Countries will specialize in activities that they excel in and trade for the activities or goods that are scarce.

Ex: a country with an abundance of cheap labor is usually better off producing labor-intensive products.

Economists rationalize that old-economy jobs that move abroad are replaced by better, higher-value jobs

Anything that increases efficiency is good for the economy over the long run, lowering costs and creating new opportunities that eventually lead to an improved standard of living.

Cost/Managerial AccountingTextbook Example Carlsen Company manufactured 6,000 units of a

component part that is used in its product and incurred the following costs per unit:

Direct materials $ 10.00 Direct labor 5.00 Variable manufacturing overhead 3.00 Fixed manufacturing overhead 8.00 $ 26.00

Another company has offered to sell the same component part to the company for $24.00 per unit. The fixed manufacturing overhead consists mainly of depreciation on the equipment used to manufacture the part that would not be reduced if the component part was purchased from the outside firm.

Cost/Managerial AccountingTextbook Example (cont.) Solution: Make Buy

Difference Direct materials $ 60,000 $ -0- $ 60,000 Direct labor 30,000 -0- 30,000 Variable OH 18,000 -0- 18,000 Fixed OH 48,000 48,000 -0- Purchase price (6,000 × $24.00) -0- 1 44,000

(144,000) Total annual cost 156,000 192,000

(36,000)

Income is expected to decrease by $36,000 if the component part is purchased from the outside firm. Therefore, quantitatively it looks best to make the part in house.

Cost/Managerial AccountingTextbook Example (cont.) Make or buy decision

Additional Considerations: Consider opportunity costs

Suppose you could use that space to manufacture another part with a contribution margin of $50,000, numbers would say to purchase part from outside.

Nonfinancial considerations Effects on employment Quality of products made elsewhere Supply of additional units Reliable delivery of units

Cost/Managerial AccountingTextbook Example (cont.)

In short, textbook examples are somewhat cut and dry until we consider the opportunity costs and the nonfinancial considerations.

Updating the textbook example, we add many additional reasons to consider outsourcing.

Reasons for Outsourcing Staff utilization is spent on core

activities. (55% of Outsourcing Institute’s 2002 survey respondents)

Lower costs (54% of respondents) Access to specialized, “best practices”

skills Reduced recruitment and training Proliferation of information services and

the internet have made it possible May be easier to comply with Sarbanes

Oxley by outsourcing to a professional

Benefits of Outsourcing Besides allowing a company to focus on

strategic, core competencies and having access to limited availability highly skilled workers, these additional benefits are cited:

Cost savings or cost avoidance Through productivity improvements Through economies of scale with outsource provider Labor arbitrage (lower labor cost area) Commercial nature of outsourcing contract brings

efficiency to the relationship Flexibility for using services as needed Changes fixed costs into variable costs

Types of Business Activities Outsourced

Information Technology (IT) Human Resources (HR) Learning Function (Corporate

Training) Customer Service (Call centers) Business Process Outsourcing (BPO) Finance and Accounting

Finance and Accounting Outsourcing Payroll (Ranks second overall to

benefits administration) Accounts Payable and Accounts

Receivable General Ledger Preparation Financial Reporting Internal Auditing Tax Return Preparation

When to Outsource

Rapid sales growth Mergers and acquisitions When entering new markets Staff are strained Rapid employee turnover

When Not to Outsource During a shift in senior management

No one will be onboard throughout the entire outsourcing process

During a major restructuring (without an outsourcing orientation)

Business climate is very stable with little year over year sales growth

Controlling or reducing expenses is not a concern

Your current accounting systems are sufficient for your long term needs

Activities That Should Not Be Outsourced

Core business competencies Knowledge-based functions dependent

on proprietary company information Critical Business Functions that are

subject to unacceptable levels of political risk

Finance and accounting: Budgeting and forecasting are the least likely functions to be outsourced.

Activities That Should Not Be Outsourced (cont.)

Activities that involve conflicts of interest (Internal auditing and external auditing by same provider)

Corporate law prohibits the Board of Directors from delegating the responsibility for making business judgments

Large Outsourcing Firms for Finance & Accounting Bermuda-based Accenture (formerly

Andersen Consulting) “Accenture can help clients reduce finance

operating costs by as much as 30 to 50 percent in the finance and accounting area through outsourcing.” – Accenture website

Cap Gemini Ernst & Young (CGE&Y) IBM Global Services (acquired

PricewaterhouseCoopers consulting division)

Regional Outsourcing Firms for Finance & Accounting Many local and regional firms

AuditForce (Milwaukee, WI) Supports internal auditing departments and serves as internal

auditing function 99% of work done on client’s business site

Norrell Financial Staffing (Atlanta, GA) Prepares A/R, A/P, and payroll applications

Lang Group (Washington, DC) 110-person CPA firm Has 28-member outsource division Realization rate is around 93%. Generated $1 million in its first full year of operation

Business Technology Solutions (Raleigh, NC) 12 people CPA/IT firm Provides services to CPA firm’s clients

International Outsourcing Asian outsourced market is not as well

developed due to cultural issues impeding outsourcing.

Europe is not as further along as U.S. European Data Protection Directive prohibits

data on individual Europeans from leaving the EU unless it goes to countries where the laws are as strict as Europe’s or where there has been a safe harbor agreement negotiated to protect that data. (India does not comply).

Canada seems to have a strong acceptance of outsourcing.

Building an Outsourcing Niche Get it right from the start

Determine if clients are the right cultural match

“It is better to forgo an opportunity than pursue the wrong one.” Lang CPA Group

Use a checklist for helping clients analyze the degree to which functions are core or noncore

Also allow clients to use a vendor criteria checklist

Building an Outsourcing Niche Ask yourselves these questions:

Is our firm more focused? Can we do the work faster than our client’s staff? Will efficiencies result from delegating tasks? Will our services lower the client’s operating

costs? If clients wish to use their own computer

systems, can our staff work with them? Can the work be done in our office or must it be

in theirs?

Building an Outsourcing Niche

Hire the right staff Appoint a champion to develop and

lead the new outsourcing niche Identify needs of specific

engagements and hire accordingly Consider part-time professionals Different people can do the parts that

they do best

Building an Outsourcing Niche Administer the Engagement

Prepare a formal, legally enforceable contract Establish due dates Identify specific staff with outsource firm and

client who will be responsible for what items Be clear and consistent as to what

responsibilities are going to be covered in the agreement.

Give time frame for the agreement Consider a termination clause Have staff members read contracts for

boundaries

Building an Outsourcing Niche

Find your market Client may mention that something in

their accounting department is not working well for them

Read newspaper want ads to determine potential outsourcing activities

Be involved in non-profit agencies

Examples BP (outsourced its entire accounting function under a

$1.1 billion, 10-year contract in 1991. They transferred 320 BP employees to Accenture and saved more than 50% from this business deal.)

Bank of America (outsourced human resources and accounts payable)

British Telecom (transferred more than 500 accounting and finance staff to their outsourcing firm)

J.P. Morgan (outsourced $5B in IT to IBM) Citigroup (uses 20 offshore Indian vendors, mostly for

IT) Motorola (10 year, $650 million contract to ACS

Outsourcer. Motorola transferred 650 key HR and learning employees to the ACS payroll for a joint venture).

Tax Return Preparation Tax experts say Indian chartered accountants

will prepare 150,000 to 200,000 U.S. tax returns in 2004, up from about 20,000 in 2003 and only 1,000 in 2002.

Average accountant in India makes $250-$300 per month

California-based SurePrep, a software and consulting service with 300 Indian accountants, says “it’s going to change the paradigm in which professionals prepare taxes, maybe even more than the way TurboTax changed the way individuals did their taxes.”

Tax Return Preparation Problems:

Security problems with sending private information including names, addresses, and social security numbers overseas.

Traditional training ground for CPAs is causing “brain drain” in our industry.

A 1040 costs about $50 - 150 to prepare in India; U.S. CPA firm still bills regular fee of hundreds to thousands of dollars, not passing on savings.

Tax Return Preparation

Disclosure of the outsourcing is not required.

Ernst & Young has customers sign a document acknowledging that a foreign accountant may work on their return.

Most firms do not make such disclosures.

Tax Return Preparation Procedure:

Clients’ W-2s, 1099s, K-1s and other records are scanned and sent to Indian workers through strongly encrypted e-mail or private networks at the end of the U.S. day.

Indian workers complete forms obtained from IRS web sites during the U.S. night (Indian day).

Completed returns are transmitted to American accountants who review, print, and sign the documents the next morning, assuming legal liability.

Quality is considered high because they are prepared by knowledgeable, degreed accountants.

Tax Return Preparation Procedure (continued):

Indian firms have armed guards outside offices

Entry is restricted by microchip embedded swipe cards

Bags and briefcases are prohibited Computers have no printers or devices for

removable storage like floppy disks. U.S. Firms do not have to hire a lot of

temporary accountants for tax season or lay off a lot of workers after tax season is over.

Tax Return Preparation Ernst & Young employs more than 1,000

workers in India which prepares 15,000 tax returns (4,000 individual)

KPMG has an Indian subsidiary and is exploring whether to use offshore accountants for preparation of U.S. returns.

PriceWaterhouseCoopers & H&R Block have no immediate outsourcing plans but will consider it.

SurePrep represents over 300 accounting firms nationwide, up from 70 last year. This number includes 1/3 of the nation’s top 100 firms.

Vendor Selection Appoint an outsourcing manager

Responsible for planning, facilitating, and coordinating all the project activities

Appoint an outsourcing committee Comprised of business experts They must determine the processes needed and

establish quality standards Interview clients and employees Choose vendor

Critical not to rush selection process Many outsourcing projects fail because of poor

vendor selection and inadequate quality checks

Alternatives to Outsourcing

Shared Services Subsidiaries Joint Ventures with Services Providers Cosourcing – relies on strong in-

house departments as the primary resource and uses an external service provider for nonroutine services when special capabilities are needed

Legal Considerations Ultimately the enterprise is liable for the

outsourced function Example: Wal-Mart hire of illegal immigrants

was an outsourced contract Gramm-Leach Bliley Act (GLBA)

Administered by the Federal Trade Commission Require persons or businesses offering financial

services for personal, family or household purposes to provide notices regarding their information-sharing policies and practices.

Notices must be given at the beginning of the engagement and each year thereafter.

Legal Considerations GLBA

Notices generally require disclosure to the client of categories of nonaffiliated third parties to whom there is disclosure of nonpublic information.

Does not require that a practitioner specifically disclose to a client the fact that independent third-party providers are used in performing services for clients.

Section 313.14 provides an exception to the notice and opt-out requirements for “processing and servicing transactions.”

Legal Considerations GLBA

If the third-party provider is connected to or involved in the processing of the services offered by the practitioner, there is no requirement to disclose to the client the fact that information is shared with that third party.

Following language must be included: “We do not disclose any nonpublic personal information about our customers or former customers to anyone, except as permitted by law.”

Legal Considerations IRS

IRC Section 7216 prohibits anyone who is involved in the preparation of tax returns from knowingly or recklessly disclosing or using the tax-related information provided other than in connection with the preparation of such returns.

Exemption is provided for third party preparers There is no requirement for informing the client

that a third-party provider is being used. IRC Section 7525 provides client confidentiality.

The CPA must make sure the outsourcer does not violate this.

Sarbanes-Oxley Act Expressly prohibits all internal audit

outsourcing related to internal accounting controls and financial systems

Applies to all publicly held companies Outsourcing the internal audit

function to an accounting firm that is not its external auditor is permitted, however.

Ethical Considerations AICPA Code of Ethics

Addressed in 1973 in Ethics Ruling No. 1, Rule 301 – Computer Processing of Client Returns (applies to outsourcing)

Advises that members “must take all necessary precautions to be sure the use of outside services does not result in the release of confidential information.”

Special task force was appointed on January 22, 2004 to determine if additional rulings should be made.

Ethical Considerations AICPA Code of Ethics

Member remains responsible for ensuring the accuracy and completeness of the services provided by the third-party provider.

All services must be performed with “professional competence” and “due professional care.” (Rule 201)

Using third-party providers to assist in performing services for clients does not in any way excuse practitioners from these or other responsibilities under the code.

Ethical Considerations CPAs should satisfy themselves

regarding the competence, practices, and procedures of any third-party provider. Inquire as to encryption techniques use of networking connections availability and processing integrity of the

information whether an independent security attestation

regarding their systems has been done.

Ethical Considerations CPAs should satisfy themselves that

controls are in place to ensure the information remains confidential. Use nondisclosure agreements with their

employees Implement certain computer protections that

prohibit downloading, printing, scanning, or copying a client’s financial information

Incorporate firewall security to prevent outsiders from hacking into the system.

Periodic testing of the these security measures

Limitations of Outsourcing Loss of Control Fear of the unknown Dependency on the vendor Reluctance to share information worldwide Loss of proprietary and strategic information Vendor may have competitors as clients (Risk of valuable data falling into competitors’

hands) Loss of expertise Lack of knowledge to monitor vendor Risk of vendor going out of business

Limitations of Outsourcing Internationally:

Cultural barriers Language barriers Time zone differences Currency differences Date formats Local rules and regulations must be followed Economic and political issues Lack of advanced low cost communication

infrastructure

Legislation States

41 states are contracting with companies that use workers in India to answer questions from U.S. welfare recipients.

At least 31 states have proposed banning contracts with companies that hire overseas workers.

Of $3.8 billion spent on technology by states, 5% is outsourced overseas.

Federal An amendment to the budget signed into law in January

prevents U.S. companies that win new federal contracts from offshoring the work.

This expires September 30 but has been proposed to be permanent.

Another proposal would prohibit states from using federal money on contracts that employ overseas workers.

Services Outsourcing “About 90% of the value of services output is now produced within the

providing firm, but they expect this share to drop to 60% in 10 years.” McKinsey in Wall Street Journal,1/28/04

A 2002 report by Forrester Research estimates that 3.3 million U.S. service sector jobs could be moved overseas by 2015. Some estimate more than 14 million jobs over that same time period.

However, manufacturing has lost more jobs. And not just in the U.S. Between 1995 and 2002, China, Japan, Brazil and other countries lost more manufacturing jobs than did the U.S., according to an Alliance Capital Management Study.

The manufacturing outsourcing frenzy has caused elaborate quality movements. These movements have not shown up yet in the service sector.

In order to compete, it is expected that service providers will become more specialized and seek new ways to improve their efficiency and productivity.

Conclusion “There is no job that is America’s God-given right

anymore”, Carly Fiorina, Hewlett-Packard CEO, “We have to compete, over time, for jobs as a nation.”

“Nobody is replacing the retiring baby boomers. This will put a squeeze on companies. I see a trend toward outsourcing of every sort to plug the gap,” Daniel Maisler, president of Accountants 4 Contract

Hopefully, outsourcing services will make allow workers to get jobs more suitable to their competencies and all companies will become more efficient.

Sources Accounting Today America’s Intelligence Wire Bank Accounting & Finance Business and Management Practices CPA Journal The Financial Times Journal of Accountancy Payroll Manager’s Report Wall Street Journal Barker, Kyle, Valerie Rego and Erica Smith,

ACTG 6310 Presentation, April 22, 2004