Why analysts appear racist

The following experiment caught my eye: Professor Stephen Sauer, from Clarkson University,
together with two colleagues recruited 101 analysts to review information to value the stock of currently privately held company. All analysts were given the exact same information with two “minor” adaptations: In some of them the CEO had gone to a prestigious university; in some of them to a second-tier school. In some of them the CEO was white; in some of them the CEO was black, thus basically creating four groups (prestigious & white; prestigious & black; second-tier & white; second-tier & black). Then the compared the analysts’ valuations…

In spite of it being “the exact same (fictitious) companies” there were major differences in valuation. By far the highest value the analysts assigned to companies whose CEO was white and from a prestigious university, followed by those from second-tier schools who were black, and second-tier schools who were white. Rock bottom were those companies headed by a CEO from a prestigious university who was black…

Stephen and colleagues found this a rather scary find…

So they decided to run yet another experiment: They recruited another 62 analysts and gave them the same company information. However, this time on half of them, they explicitly stated the following about student recruitment at the CEO’s alma mater:
“The university [had used] a double-blind procedure with no special consideration for gender, race, or ethnicity”, so that it was unambiguous that the CEO had made it into the (prestigious) school purely based on merit, and nothing else.

Now the results changed spectacularly: The companies with CEOs from a prestigious university who were black received the exact same valuation as companies with CEOs from a prestigious university who were white. Apparently, people do not just devalue a company because its CEO is black – phew! – there is something else at play.

Why did they then in the first experiment assign the lowest value to those companies with a CEO of a prestigious company who is black? Well, apparently, whenever people see a black person from a prestigious university, they are inclined to assume that he might have been admitted there not based on merit but because of some sort of affirmative action…: positive discrimination. And hence, that it is likely that he is not as good as his credentials might suggest. And of course, statistically they are right…; black males are more likely to have been admitted to B-school due to affirmative action than white males (for the simple reason that the number of white males admitted due to affirmative action is quite certain to be zero). Take away that possibility and analysts don’t care about the colour of someone’s skin.

But that of course does not mean that all black males are admitted to a prestigious school due to affirmative action. It doesn’t even mean that most black males are admitted to a prestigious university for that reason. So analysts do get it wrong rather often, and that must be one darn annoying thing, if you’re a black male at a prestigious university who simply made it in based on merit, and nothing else.

The quintessential bureaucrat

All bureaucrats are the same, but some are better than the others ! Each nation is blessed with a liberal sprinkling of "homo sapiens pointless bureaucracy-ensis". But the ancient land of India is surely the world leader in this matter. Meet Ramamritham - the quintessential member of this species.

Readers of this blog will know of my partiality to caricaturing a typical member of a group by a name. The Indian female has featured here so often that her name is now acquiring legendary proportions (pun intended). Having been accused of gender bias, I shall now strive to correct it with describing the masculine equivalent.

India abounds in Ramamrithams. Typically he comes from the state of Tamil Nadu or West Bengal - these two cultures seem to have a huge affinity for inhabiting the corridors of babudom. He takes great pleasure in designing the most elaborate and pointless of procedures. He squeals with orgasmic delight when he has the opportunity to add one more procedural step in an already lengthy treatise on pointlessness. The more the paperwork, the greater is his joy. The airport procedures that I alluded to here and here were designed by a particularly bright specimen of this tribe. He has also been behind the need to wave your photo identity card every 5 minutes at all and sundry - I think he is protecting you and me from an acute case of amnesia of our names and how we look. We shall pass lightly over the fact that being forced to look at my photo every now and then and being reminded of the passage of years is not improving my mood.

You can't escape meeting him. If you want a mobile phone, he's there. If you ask for a gas connection he's there. If you want a passport, a credit card ......, actually anything at all, you will have the full pleasure of meeting this wonderful man. If you are returning from abroad, and have to pick up the pieces of living in India, you will have the privilege of cohabiting with him intimately for a long time. Its now 4 months since I returned back, and he still hasn't left my house.

His latest fancy has been to give me his full attention in the small matter of obtaining a new credit card. He has decreed that not only should my address be verified, but my phone lines have also to be verified. Fair enough. Call me on my mobile, and you can verify it easily enough. He then wants to check on my land line as well. But then, our Ramamritham works only from 11.00 to 4.00 Mondays to Fridays. At that time, I am, alas, away toiling for my daily bread. Tring Tring he rings. No answer. He then calls me on my mobile and complains that I am not answering the landline ! Explanations of lack of geographical proximity don't cut much ice. Right; he can sit on my application grandly. As with wine, the older it gets, the sweeter it is.

I have movingly expressed my willingness to coo sweet nothings to him anytime on Saturday or Sunday , but weekend romance does not seem to catch his fancy. I have offered to bring the sainted instrument for him to caress in person, but his idea of intimacy does not seem to extend in that direction. I have even offered to overdose him with his first love - enough paper - to prove that the landline number is indeed mine , but he refuses to be titillated even by that ruse. He is steadfast, upright and represents the best of his tribe.

I hereby award the gold medal in bureaucracy to Ramamritham. May he flourish and conquer many new heights. May he continue to bring laurels to the country. And , no doubt, he will appear time and again, in this humble blog.

PS . All characters in this post are entirely fictional and the subject of this blogger's imagination and have no resemblance to any person living or dead.

Does an MBA make you unethical? Finally some evidence

While, a year or two ago, the dust clouds of the fallen giant investment banks were still settling, at many a place the discussion opened whether it was these CEOs' business school education that caused him (invariably him…) to act in such a selfish, destructive and unethical way.

For example, Forbes debated the issue heavily under the title “are B-schools to blame?” while at the Harvard Business Review a discussion raged under the highly similar header of “are business schools to blame?” (as if they plagiarised each other… which I thought would add some juice to an ethics discussion…). Although there was the occasional stern defendant of the system, most treated the question as a rhetorical one (“yes, of course!”) and vehemently declared denial itself to be almost as unethical as the destructive actions themselves.

But what’s the evidence; was there any presented? Do we actually know whether earning an MBA makes one behave more unethical and less socially responsive? No we don’t. I was asked by a BBC World presenter, after giving a speech at the Rotterdam School of Management, whether it wasn’t true that most of the corporate villains had MBAs? I had to admit I didn’t know but, even if it were true – that most of the disgraced (and sometimes jailed) corporate villains were lauded with an MBA – what does it prove?

Suppose that 60 percent of the villains had MBAs; perhaps 70 percent of all major corporations in the world are headed by MBAs; this would actually imply that of the villains relatively fewer have an MBA than of all (non-villain) corporate big shots! It is irrelevant whether most villains had an MBA; the relevant question is whether getting the MBA made them more likely to be vile. And frankly, that we did not know.

And I say “did” because now we do – at least sort of. Professors Daniel Slater from Union University and Heather Dixon-Fowler from Appalachian State University decided to, rather than contribute yet another 'informed opinion' and 'point of view', actually test the conjecture. And, in retrospect, that wasn’t so hard to do…

Because they simply looked up the “corporate environmental performance” score for 416 Standard & Poors 500 firms as put together by the company KLD Research and Analytics Inc. Nowadays there are quite a few corporate social responsibility rating agencies and systems around but KLD’s is generally regarded a very good one, because they are fully independent and really track a variety of indicators, gathering the information from multiple sources, including extensive inspection of public records, surveys, and on-site facility inspections. Dan and Heather also looked up whether those companies had CEOs with or without an MBA, and used that to compute whether firms with MBAs at the helm performed any worse in terms of corporate environmental performance than firms with a CEO who did not go to B-school.

And the answer was a resounding no. They checked whether this effect could be due to all sorts of confounding variables (like the CEO's functional background, age, education level, firm size, prior financial performance, type of industry, etc.) but, nope, really: the companies headed by MBAs were no more likely to be vile.

As a matter of fact, they were less likely to be vile! Companies with CEOs with an MBA generally did better in terms of corporate environmental performance; it were the non-business-educated chief executives that engaged in the bad stuff. I reckon that’s quite a shocker to the average righteous blogger in leftish spheres: business school actually makes one more socially aware and responsive!

And, on a final note, it didn’t make any difference whether you were from Ivey League Harvard or had your MBA from the University of New South Nebraska State; programme rank had no influence on these blissful results.

And now I am going to take a walk down our corridor to the office of our Ethics Professor and apologise for calling her course “pointless”… See you later.

Chicken Tikka Masala in Old Blighty

Chicken Tikka Masala is reputed to have taken over as the national dish of Britain. Perhaps the best example of reverse colonisation, although it must be said that overthrowing "British food" is not as great an achievement; such being the epicurean significance of the cuisine in Her Majesty's land. Actually its a Bangladeshi takeover, given that 99% of the curry houses in Britain are run by Bangladeshis. But we shall lightly pass over Bangladesh propagating "Balti"cusine" and such other monstrosities.

Stay with the chicken. British affinity to consuming this hapless avian is the only logic I can find (after much scratching of the head in vain) to explain the take over of Blackburn Rovers , a Premier League football team, by Venky's - an obscure chicken farming company from India.

Firstly the facts. Blackburn Rovers is a struggling middling football side in England. Its been bought out by Sri Venkateswara Hatcheries for £ 53 m , an Indian family firm, run by Anuradha Desai and her brothers. The takeover was completed yesterday and the team's home grounds are henceforth to be known as Venky's Ewood Park !

Foreigners taking over English clubs is not something new. It is mostly rich tycoons doing it for vanity - witness Roman Abramovic and Chelsea. They lose pots of money, but they don't care, for it barely makes a dent in their fortune. Owning a football club is like digging a hole and pouring money into it endlessly. Its the biggest dud when it comes to a business investment. Even Manchester United the most famous and richest of them all is financially in ruins. Nobody makes money except the players - its the only field where you can make outrageous salaries (think of a salary of £35000, ie Rs 25 lakhs per day) whether you perform or not.

Anuradha Desai does not fall in that boat. She is no playboy. She isn't a household name, even in India. She is known for prudently growing the company that her more illustrious father built. If she had a passion for football, it has thus far been well hidden. Beyond the usual blah blah that is made after any acquisition - we will grow together, we see a bright future, and such other rubbish, she displayed her ignorance of football by saying she is not going to pour money in to buy players. The economically challenged rabid English fan wants his favourite club to be owned by a zillionarie who'll write a blank cheque to buy every player on earth. He doesn't want to see prudent business principles.

There is zero brand value for this investment - can't imagine Venky's Chicken Tikka Masala in the menu. Sitting in the owner's box and watching Blackburn lose on a miserable cold and windy winter's day cannot be her idea of happiness. Back home in India, seeing handsome hulks sporting the Venky's logo on their football shirts is not going to make Rajalakshmi eat chicken.

Of all the bewildering acquisitions that happen in the business world, this must surely take the cake.

Management myths

Have you ever heard that the Great Wall of China is visible from outer space? Well, it is a myth. But also a very persistent one, despite there being clear evidence that it is not. Similarly, there are quite a few myths in business that are very persistent, despite clear evidence exposing them. Let me tell you about three types of business myths, and give you some examples.

Self-perpetuating myths

First there are self-perpetuating myths, and they exist in pretty much any industry. Take the film industry. Film distributors have preconceived ideas about which films will be really successful. For example, it is generally expected that films with a larger number of stars in them, actors with ample prior successes and an experienced production team will do better at the box office.

And sure enough, usually those films have higher attendance numbers. However, professors Olav Sorenson from Yale and David Waguespack from the University of Maryland discovered that, because of their beliefs, film distributors assign a much bigger proportion of their marketing budget to those films. Once they acknowledged this factor in their statistical models, it became evident that those films, by themselves, did not do any better at all. The distributors’ beliefs were a complete myth, which they subsequently made come true through their own actions. And there are other examples for different industries.

Management fads

The second type of business myths are known as management fads. They concern management practices that at some point emerge and become popular, such as the old Total Quality Management, ISO9000 system or SixSigma. They usually behave like popular fashions, like the ones in design or clothing: they come and go, and sometimes reappear many years later under a slightly different guise.

Although often quite harmless (yet seldom really useful), some of them can actually be quite detrimental, without the adopting firms realising it. Take ISO9000. ISO9000, in a nutshell, helps firms to identify best practices within their organisation, document them, and make sure that everyone in the firm follows that one standardised best practice. Thus it leads to efficiency and productivity gains.

However, unexpectedly and unfortunately, as professors Mary Benner from the University of Minnesota and Mike Tushman from Harvard Business School discovered, the firms that adopted ISO9000 several years down the line saw a decrease in their innovativeness, in terms of new technological inventions. The system of homogenised best practices stimulated efficiency but it also blocked deviations from the standard, consequently limiting the discovery of new innovations.

Reversing cause and effect

The third type of business myth pertains to the issue of so-called reverse causality. Over the years, popular business books such as In Search of Excellence, Built to Last, and Profit from the Core made recommendations to managers by comparing highly successful companies and finding out what they have in common. Although at first sight this may seem like a logical approach, there is one big catch to it: the risk of reversing cause and effect.

Several of these books, for example, recommend that firms should develop a strong, coherent organisational culture. That is because most of these highly successful firms had one at the time of writing the book. However, research tells us that firms often develop a strong coherent culture as a result of having been successful for several years. Hence, their strong culture is not the cause of their success; it is the consequence of it. Trying to develop a strong coherent culture might not help you to become successful at all. Quite possibly it could even be harmful and counterproductive, because a coherent culture could also lead to ‘groupthink’ and a lack of innovation, which could be dangerous especially in a fast-changing business environment.

There are many myths in business; some specific to particular industries and some more general. Some myths merge but also disappear after a while. Other myths though are surprisingly persistent. They almost act like business viruses; they have a detrimental effect on their “host” (the adopting organisation) but they also spread rapidly, because they are easy to replicate.

You could describe this as “the sneeze theory of management myths”; companies affect each other because they do business with one another. For example, ISO9000 is easy to imitate because it concerns a standardised set of rules and procedures. Moreover, firms that have adopted it often start to expect that their suppliers follow the same system, making the practice spread.

Furthermore, we know from research – among others by Professor Mark Zbaracki at the University of Western Ontario – that executives are inclined to overstate the benefits from the adoption of systems such as ISO9000 to other people within their firm and to other firms in their industry, thus stimulating the further diffusion of “the virus” and keeping the business myth alive.

The sheer bliss inside the airport

It took us 74 minutes two weeks ago to enter the airport. It is now time to experience the blissful experience of actually being in.

Lets concretise the experience. Imagining you are taking an international flight out of Chennai airport, arguably the worst airport in the land. You may recall that the last step before being allowed entry into the hallowed portal is a painful check of your ticket and papers by an uniformed worthy. Immediately after you enter, within 10 yards, the same process repeats itself as you enter a fenced off area - another queue, another check.

You then proceed to yet another queue - this time to screen your baggage through an Xray machine . Not even in Timbuktu airport in Mali, which is essentially a cowshed, does this process take place. Huge queue. People on overloaded trolleys banging you from the back. Since Indians have a general disdain for queues, seven sub queues form which ultimately merge into one chaotic rugby scrum . And unique Chennai practice dictates that your bags be fed into the conveyor upside down - ostensibly the logic is that giving a through shaking of your bag is good for general health.

Having navigated this successfully, you then proceed to check in where it is an axiom that larger the flight, the smaller will be the number of open counters. No less than 5 persons will be at each counter - one operating and the others interfering. Inevitably each person checking in will have a slanging match on overweight baggage - after all every worthy has checked in with 100kgs which she is expecting to be taking for free. When told a firm No - she proceeds to open all her bags right here to retransfer stuff from one bag to another so that at least one bag could be left behind with the adoring multitudes who have come to see her off. So enough entertainment to occupy you for a full hour.

If you successfully navigate check in then you proceed to immigration. After the fall of the Soviet Union, India and North Korea stand unique among the league of nations where the immigration check for home nationals is more intense on the way out, than on the way in. He patiently flips through each page on your passport and wants to know why you are adding to his work by going somewhere - why can you not simply stay at home.

Then comes the famous security line. India stands unique in demanding that you put a silly baggage tag on your hand baggage which has got to be stamped - the most useless security measure I have seen anywhere in the world. Only one xray machine is working. There are no less than 7 people manning it - one feeding the bags, one seeing the stuff on the machine, one stamping that silly tag, and four resting. Just as your turn comes after 54 minutes of waiting, there come the cabin crew trooping in for your flight. They have priority, of course and you sigh as that lot jumps the queue. And just as you get ready to finally "make it" you are rudely shoved aside, by the Minister coming with a retinue of 12 all of whom have priority.

Phew. Past the security check, at last. Immediately your ears are bombarded with shrill announcements delivered at 1000 decibels and completely unintelligible. I am firmly convinced that the only criteria airlines use to select ground crew is that they must be completely in love with the sound of their own voices. Totally pointless announcements non stop, yelled in English, Hindi and the local language. Yelling for some passenger or the other to contact somebody or the other - and since they cannot get their names right, it makes for some comedy; the only saving grace. Announcing "boarding procedure" for a 20 seater aircraft which everybody ignores anyway. Asking you to check your baggage tack. Asking you to go to the loo.

The getting on to the plane. A long line has formed 2 hours before the plane is due to board. And since its late coming in from wherever its supposed to come from, its a three hour wait. Yet people love to queue up - there must be some intense satisfaction in getting on to the plane first ; a joy that has thus far eluded me. Maybe the fear that your seat may not be there if you are not the first to get in.

Aerobridges are only for ornamental purposes; they are not meant to be used. So you are told to stand on a rickety bus hanging on for dear life by the boot straps as the Lewis Hamilton wannabe shows off his braking and acceleration skills.

At last you get in. Only to find that the blighters before you have stuffed every available space overhead. The seat has basically been built for the pygmies of Andamans. You are wedged in the middle between two fat ladies who should have bought two tickets each to accommodate their bulk. Its 3 AM in the morning. Ah ! What bliss it has been.

Communicating strategy

Whether you are heading up a team, a business unit, or an entire Plc, you’re going to need a strategy. And you are going to have to communicate that strategy clearly to others, because only if others are aware of it can they actually contribute to it, and will it have any effect – a carefully crafted strategy document, no matter how elaborate and sophisticated, is not going to resort to much if it merely disappears in a drawer unnoticed.

There are several rules – litmus tests – that any strategy must adhere to, for it to be communicated effectively, whether you are the CEO or a team leader.

Rule 1: Make some genuine, tough choices. Often you hear things like “our strategy is to be a good employer”, but that is not really a strategic choice. Something is only a genuine, tough choice if the converse is meaningful. “Our strategy is to be a lousy employer” is unlikely to be anyone’s preferred choice. CEO Stevie Spring’s choice for Future plc to focus on making magazines for young males is one; magazines for middle aged women, for example, could have been a genuine option.

Rule 2: You should be able to capture the essence of your strategy in just three of four points. One point (e.g. “we do magazines”) is meaningless and does not provide any direction. If you provide twenty pointers you are basically telling people what to do – moreover, no-one will actually remember them. We “1) do specialty magazines, 2) for young males, 3) in english” provides lots of direction but also leaves ample room for creativity and growth.

Rule 3: Communicate not only the “what” but also the “why”. Trinity Mirror’s CEO Sly Bailey told me recently that if there was one thing she learned about strategy communication it is that we are always inclined to carefully explain what the choice is, but underestimate communicating the reasons behind it. Research on “procedural justice” proves her right; if people understand and believe that the decision making process had been solid and just, they are inclined to cooperate, even if they do not entirely agree with its outcome. Vice versa, people who agree with the choices but feel the process used to arrive at them was wrong are inclined to withold cooperation regardless of their agreement. Hence, carefully explaining the “why” is at least as important as explaining what the strategy is.

The porpoise–Jack Welch connection

Porpoises truly are very cute animals. They are fun, playful, cuddly, bubbly, and social. Moreover, in many countries and cultures, stories exist about how porpoises saved sailors whose ships sank in stormy weathers far from land, by tirelessly pushing them to safety with their snout. The saved sailors, once firmly ashore, would of course tell everyone the tale of their miraculous saviour, and the porpoises became revered and adorned.

Yet, somehow, whenever I see one (in SeaWorld or on television), they make me think of Jack Welch…

Not because Jack Welch is fun, playful, cuddly, bubbly, and social – not many would put Neutron Jack in that category – but because of selection bias.

“Selection bias” thou might wonder, “what the heck is that?” Well, it basically is a statistical term that explains how we make mistakes and draw erroneous conclusions if we base our analysis only on what we observe, and not on what we don’t see. Let me explain.

Given the abundance of stories, there probably really are sailors who were pushed ashore by a rather helpful porpoise. Porpoises are playful animals and they like pushing things around – including swimming sailors. However, it is quite likely that they don’t give a rat’s ass where they push their newly found toy. They probably push the sailors found in open sea in all sorts of directions; some of them happen to be headed toward land. Yet, for every sailor safely pushed ashore there probably are several seamen who were pushed in all sorts of directions but to land. Unfortunately, they just did not live to tell…

The sailor who was pushed ashore by the porpoise told everyone about his miraculous rescue but his unfortunate colleague who each time was pushed back into open sea whenever he got land in sight, vigorously cursing the bloody animal, did not quite get to tell his version of events.

That’s selection bias, and the world of business is full of it. We analyze companies, investment strategies, and the chief executives of the cases that became a success, but we don’t quite see how many went under following pretty much the same path. Jack Welch’s famously hard-headed management style worked well for GE and pushed it ashore, but who is to tell how many companies drowned receiving the exact same treatment? Basically, we just don’t know, but it would be unwise to just take any “successful” strategy for granted, and mimic the actions in the determined (but possibly false) belief it will lead us to safety too.

The bridesmaid's hour cometh

Beijing, everybody knows. Shanghai, is equally well known. But most people's knowledge of China stops right there. The more enterprising will know of Shenzhen. But then , that's about it. The rest of China remains a mystery to many who have not ventured in that direction.

Well, its now Guangzhou's turn to be in the spotlight (pronounce the zh, like a j). The Asian Games start in Guangzhou on Friday, the 12th. It was my home city, until recently, and so, if I may, I will dress up the long suffering bridesmaid, as the bride that she will be for the next two weeks.

You may know Guangzhou better as Canton. The province in which Guangzhou is situated is called Guangdong which the British , long ago, transliterated to Canton. Confusingly, they ascribed the name to the city, not the province. But, even in Guangdong, the bride is often, the brash noveau riche, Shenzhen. Even in her backyard, Guangzhou remains a bridesmaid.

But for most of China's history, when the culture turned inward, the outside face was Guangzhou. It was always the most open and outward looking city. The Cantonese traveled far and wide in the world. Most of the "Chinatowns" that you see in every city in the world, is far more likely to be Cantonese. The Chinese food that you see internationally is mostly Cantonese. Even the infamous "Hakka Noodles" abomination that you see in India is of Cantonese origin.

What of the Asian Games ?? It will no doubt be a huge success ; Guangzhou has been preparing for it for years. It will have the usual Chinese efficiency, but it is likely to have more of a "heart" - something the Beijing Olympics lacked a bit. Cantonese are like that - they are less regimented and more spontaneous. The writ of Beijing lies like a heavy hand, up north, but down South where Guangzhou is, it is usually ignored.

The sport will be tremendous. In many disciplines, it will be a virtual World Championship - the only events where it will be short of world class will be Athletics and Swimming. China will sweep the medals, like always, but others will have their time in the sun too. For India, it will be a thud after the Commonwealth Games - those were far short of world class and India garnered a rich haul of medals. It won't be like that in Guangzhou where the standards will be much higher. But there will be quite a few high points.

From an Indian point of view, the star event will be the unglamorous 10m Air Rifle Event. In the Beijing Olympics, Gagan Narang, India's best bet faded away, but Abhinav Bhindra rose to win gold beating Zhu Qinan of China who had won the gold in Athens and was the favourite. Zhu was inconsolable and is desperate for revenge. But Narang is in terrific form as is Bhindra; it will be a great fight.

Vijender will win in boxing, but Sushil Kumar will have a tough fight against the Iranians in wrestling. Saina Nehwal, India's golden girl may struggle. Three Wangs stand in her way. On her day she can beat anybody, but to beat all three of them is a tall order. The women's 4*400 metres relay team will win gold. But the real high point for India may be the emergence of Tintu Luka. She's the favourite for the women's 800m, for long the domain of Shiny Wilson. She's a truly world class athlete emerging under the tutelage of PT Usha. In the Commonwealth Games she stood no chance against the Africans. But in Asia, she can, and should, win. She's young and rapidly growing, and will be the star of the future for Indian athletics.

So tune on the Telly. Watch the sport, but also enjoy the sights and sounds of "my city". She'll be at her best and wonderfully beautiful. Viva Guangzhou.

The hidden costs of outsourcing

I’d say there are even more hidden dangers to outsourcing than giving up control of key activities. What is also a major risk, is that of the loss of particular capabilities which – and you might not quite realise this at present – are crucial to your performance in further downstream activities.

Let me give you an example. My colleague at the London Business School Markus Reitzig, together with his co-author Stefan Wagner, examined outsourcing in one particular process; a firm’s filing and enforcement of patents. Firms that do R&D usually try to protect their inventions by getting a patent. Once the patent is granted they often need to engage in enforcing it, for example through proactive and reactive litigation. These different types of activities – patent filing and patent enforcement – are such specialised activities that usually they are carried out by different individuals within an organisation.

And now comes the trick: Quite often, firms would chose to outsource the patent filing to some external, specialised law firm – “because they’re the experts and can do it more efficiently than we can”. At first sight, that seems to make sense. However, one of the crucial activities conducted for patent filing is the identification of “prior art”. Prior art encompasses all knowledge disclosed to the public before the patent is applied for. And if a firm outsources the entire patent-filing activity, it also leaves this identification and interpretation of prior art to the external solicitors. The problem is that, in the process, the firm will also lose a rather important “by-product”, namely knowledge about the firm’s technology competitors. That is because, as a result of investigating prior art, firms usually learn an awful lot about competitors working on similar issues. And that knowledge is rather relevant further down the line…

Markus and Stefan examined the firms that had outsourced patent filing and statistically compared them to a bunch of firms which continued to do both activities in-house (despite many telling them “you should really stop doing that, you know; it’s old-fashioned; haven’t you ever heard of outsourcing?!”). And they found that the firms that had not outsourced their patent filing activities were much better at identifying potential technology competitors (and their weaknesses) early on. This gave them the possibly to successfully attack them proactively. Firms that gave up on their own in-house patent filing function, and outsourced it to some external specialist, found themselves ill-equipped for patent enforcement activities. Consequently, their downstream performance plummeted.

My guess is that what Markus and Stefan found for patenting is true for many activities; outsourcing one sub-process might have undesirably (hidden) consequences for some other function somewhere else within the firm. These linkages are largely unknown and often impossible to observe, quantify and measure. However, that does not mean that the costs are not very real!

You have to be careful with outsourcing. What may seem like a relatively tangential activity to you, which you could safely put in some externals’ hands, might accidentally make you lose a capability which is critical further down the line. And once you’ve lost that in-house capability, it will be very hard to get it back.