Outsourcing

1. Outsourcing MTSU Accounting Alumni Day May 13, 2004 Jeannie Johnson Harrington

2. 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.

3. 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

4. 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.

5. 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.

6. 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.

7. 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.

8. 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

9. 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.

10. 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

11. 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

12. 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

13. 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

14. When to Outsource • Rapid sales growth • Mergers and acquisitions • When entering new markets • Staff are strained • Rapid employee turnover

15. 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

16. 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.

17. 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

18. 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)

19. 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

20. 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.

21. 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

22. 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?

23. 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

24. 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

25. 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

26. 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).

27. 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.”

28. 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.

29. 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.

30. 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.

31. 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.

32. 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.

33. 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

34. 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

35. 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.

36. 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.”

37. 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.”

38. 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.

39. 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.

40. 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.

41. 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.

42. 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.

43. 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

44. 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

45. 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

46. 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.

47. 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.

48. 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.

49. 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