Why settle for less, say Deloitte

After the initial exuberance had died down, most companies that had embarked on major IT or business process outsourcing projects discovered that there were 'hidden costs' in outsourcing to a third party provider.

As time and experience of outsourcing wore on, companies realised it was not simply a case of outsourcing a process to a third party and watching the cost savings pour in. The outsourcing process itself needed to be managed, monitored and governed, which entailed costs in and of itself.

Well Deloitte has just published some interesting findings on outsourcing based on its survey of 300 executives involved in outsourcing worldwide. More than 80% of respondents to its survey indicated a return on their investment of more than 25%.

However, while 70% said they were satisfied or very satisfied with their outsourcing. 39% said they had terminated at least one contract, and 50% of those that reported dissatisfaction with outsourcing had brought the process back in-house. In the first year of the contract, 61% of firms also indicated that they had "escalated problems" to senior management.

Therein perhaps lies the greatest challenge for both outsourcers and the firms that employ them, demonstrating not only one-off process improvements, but ongoing improvements on a continuous basis that satisfies customers' expectations.

As Deloitte's findings bear out, firms that outsource while financially gratified, would like to see a lot more benefits stem from the arrangement in terms of access to new ideas and innovation and better quality communications.

More than 30% wished they had spent more time on evaluating vendors before signing contracts, and if they had their time over again, almost 50% said they would have better defined service levels in line with their business goals, which just goes to show that a lot of firms have rushed into outsourcing mesmerised by the potential cost savings, without considering the processes, workflow and governance that needs to be put in place to ensure a better outsourcing experience.

So those businesses thinking that outsourcing or offshoring may be the solution to all their problems, particularly in an economic downturn when reducing costs is paramount, think again. Outsourcing is not a panacea and often entails 'hidden costs' which need to be considered in the overall cost/benefit analysis.

Martyn Hart, chairman of the UK National Outsourcing Association, says we could see the nature of outsourcing deals change in light of a recession. "In the past couple of years the ‘mega-deal’ has largely been consigned to the outsourcing scrap heap, in favour of multi-shoring and choosing separate suppliers for each process. Organisations will have to balance how to do this in the most cost effective manner," he says.

With mega-outsourcing deals a thing of the past, fixed price contracts are also likely to be abandoned for a more utility-based approach based on cost per unit.

Outsourcing crunch time

Regular readers of this blog will know that I have regularly commented on the hype surrounding outsourcing. Outsourcing is definitely here to stay, but as firms' experiences of outsourcing have matured and some of the gloss has gone off outsourcing as being a cost-effective panacea for companies' woes, outsourcing entered the 'trough of disillusionment' for some firms.

Having said that, the latest quarterly stats from sourcing advisers, TPI, suggests that outsourcing is on the rise, particularly in Europe, which has now surpassed the US in terms of total number of contracts signed (220 valued at €32.7 billion) compared to 194 contracts signed in the US valued at €21.3 billion.

While in the past a significant portion of contracts signed were renewals of existing outsourcing business, according to TPI, in 2007, the annualised value of new contracts awarded in Europe was up almost 31% on 2006 levels, compared with an increase of 13% globally.

And it seems financial services firms are once again leading the way in the demand for outsourcing, representing more than 38% of the total value of outsourcing contracts signed. According to TPI, the worldwide market for Financial Service Operations (FSO) outsourcing has grown by 22.5% since 2003.

I think we have only seen the tip of the iceberg when it comes to outsourcing by financial service providers. A number of regulatory imperatives (Basel II, MiFID, SEPA) is placing significant demands on banks' back offices, and not all banks are well positioned to meet those demands in terms of their systems and investment capability.

Some difficult decisions have yet to be made by financial institutions regarding their back office processing, whether it is in the securities or payments business. Crunch time is rapidly approaching for them to decide what is strategic to their business and what they can outsource or white label.

Some IT outsourcers will "cease to exist"

I keep banging on about a strategic shift in firms' appetite for traditional outsourcing, but with good reason it seems. In its Top Predictions for IT Organisations and Users, 2007 and Beyond, Gartner paints a not too rosy picture for the Top 10 IT outsourcers.

According to Gartner, the reduced number of large contracts above $250 million, increased competition, and a reduction in contract sizes have placed great pressure on traditional "takeover outsourcing" providers, and the move towards selective outsourcing has paved the way for non-traditional providers(software-as-a-service, utility computing, managed services and specialised hosters) to enter the bidding.

"Through 2009, at least three of the top 10 IT outsourcers will cease to exist in name, with their services and product portfolios divided into spin-off companies, divestitures, longtime partners and faceless third-party aggregators. Providers of all sizes will rationalize portfolios based on desired regions, service lines and vertical industries," says Gartner.

It is no secret that revenue growth for the top IT outsourcers in Western Europe, North America and Japan has been slowing and contract terms and values have been declining.

Interestingly, while revenue margins for Indian IT outsourcing firms such as Tata Consultancy Services and Infosys have been increasing, Gartner predicts that only one Asia/Pacific-based service provider will make the global top 20 IT service providers (based on IT services revenue) through 2010. Currently, Fujitsu is the only Asia/Pacific vendor in the global top 20 based on revenue.

Gartner says Tata Consulting Services (TCS) is the only Asia/Pacific-based service provider in the global top 50. Infosys is close behind, but at its current growth rate, Gartner predicts that it will likely be in the top 50 in the next two years.

"Indian service providers generally have been growing 30% to 40% annually and are gaining market share. However, this growth is difficult to sustain and would still not be enough to put TCS or Infosys in the global top 20 without a major acquisition," says Gartner.

Move over traditional outsourcing

I have been watching the outsourcing market with interest for some months and am somewhat bemused by the conflicting stories one reads about firms' appetite for outsourcing, particularly offshore outsourcing.

As the initial hype around outsourcing has died down and firms that were early adopters have had the chance to learn from and share their experiences, there is no doubt that some of the lustre has gone off outsourcing in terms of the initial 50% cost savings some firms touted and the "hidden costs" that have emerged when it comes to the need to actively manage and monitor offshore outsourcing relationships.

Data privacy concerns have also been raised following allegations that offshore call centres were selling customer data. Eager to preserve its reputation as a major outsourcing and offshoring centre, India recently announced the formation of the Data Security Council of India (DSCI), a self-regulatory member organisation that will be run by the Indian IT and software association, Nasscom.

Arguably the Council's formation is a long overdue measure that recognises the concerns of foreign firms outsourcing customer data to India. The National Outsourcing Association says concerns have grown over the past few years over data security lapses that have occurred, fuelled by 'mud slinging' by the British tabloid press about alleged security breaches.

Although the NOA says that security breaches are few and far between it stated that the Indian government - and the governments of other offshore and nearshore destinations - needed to openly demonstrate that they recognise the problems around data security and are actively doing something about it.

Securing data that is outsourced or offshored to a third party provider is even more important now that the next wave of outsourcing is encompassing content and document management, as well as “knowledge process outsourcing” or KPO.

According to EquaTerra research, KPO, which encompasses a broad range of processes such as market research, financial analysis, M&A due diligence and related M&A legal work, is gathering momentum.

While the Indian market may be suited to this form of outsourcing, with some major investment banks outsourcing financial analysis and research to India in recent months, KPO is a surprising trend given banks' general reluctant to outsource data, which is the lifeblood of most companies.

John Boyle, EquaTerra’s managing director, Financial Services, says:

“The growth in KPO is intriguing because it involves work that was traditionally viewed as too strategic to outsource, or where outsourcing was not viable because candidate services providers lacked the skills or experience required to perform the work. But these perceptions are changing. While in most cases KPO today involves rote work and number crunching, the breadth and depth of work being performed is expanding as buyers gain comfort with the model and suppliers’ skills and levels of context improve."

However, instead of directly outsourcing KPO work to an offshore third party provider, Boyle says financial services firms still prefer to manage the process themselves by establishing captive operations to perform KPO and related work in offshore locations. Increasingly it seems traditional outsourcing models are being challenged by alternative approaches such as captives and shared service operations.

I Can't Get No Satisfaction

Now that the outsourcing trend has well and truly passed the 'hype cycle' and plunged into the proverbial 'trough of disillusionment', global outsourcing advisory firm TPI has shed some light on why firms are becoming increasingly dissatisfied with outsourcing.

For those non-believers that strongly contest firms' dissatisfaction with outsourcing, TPI says it witnessed "a record number of re-negotiations" of outsourcing contracts in 2006, representing almost a quarter of all commercial contract awards made during 2006. "And this trend shows no sign of abating," according to TPI partner Stuart Harris.

TPI's summer 2006 survey of 40 international firms on their experiences of restructuring or renegotiating outsourcing contracts, found that 28% of respondents achieved less value than originally anticipated from outsourcing, with some companies restructuring their agreements within 18 months of having signed them.

But while it may be easy to point the finger at outsourcing providers as the source of dissatisfaction, TPI's research found that 61% of firms conceded that they had placed more emphasis on setting up the outsourcing contract rather than on managing it, and another 52% of respondents blamed their own "unrealistic expectations" as a key barrier to success.

Almost half of the companies surveyed by TPI blamed their "inexperience" in managing outsourcing and 46% said they had failed to fully implement a proper governance structure, with 35% failing to convene regular meetings of governance boards. It harks back to the age old adage, 'You may outsource the problem, but you still need to manage it.'

Yet, while firms have been remiss in terms of their expectations and ability to manage the outsourcing process, outsourcing providers are not entirely blameless. Historically, they have tended to emphasise the 'pros' as opposed to the 'cons' of outsourcing, by highlighting aspects such as cost savings in the region of 50%, without underlining the 'hidden costs' often involved in outsourcing.

Yet, whilst dissatisfaction with outsourcing contracts may be at an all time high, few firms surveyed by TPI had actually severed their relationships. Of the 42% that considered soliciting bids from other outsourcing providers during renegotiation, only 18% actually did so. Similarly, 41% said they considered bringing some of their outsourced work back in-house, but only 13% did.

Yet, as any bank or asset manager will know, moving to a new outsourcing service provider is not as easy as it sounds. "TPI has found that the friction typically involved in making the switch can be quite considerable,” says Harris. And as providers of outsourcing services are aware of buyers' 'weaknesses' when it comes to managing outsourcing contracts, Harris says that perhaps explains why 29% of buyers surveyed said they found their bargaining position weakened at renegotiation, compared with when the deal was originally struck.

It would seem that some outsourcing providers have firms over a barrel as once they are in the relationship, depending on how deep it is and the services it encompasses, it may be difficult for some firms to get out out of a dissatisfying outsourcing contract. And while we occasionally hear of outsourcing deals gone sour, they are just the publicised ones, and are perhaps not a true reflection of the general level of dissatisfaction firms may feel about outsourcing.

Living up to the hype

Has IT and back office outsourcing surpassed the hype cycle and fallen into the trough of disillusionment? I keep hearing conflicting reports about companies' appetite for IT and traditional back office outsourcing.

In the early days a lot of the hype around outsourcing was centred round the cost savings with some estimates putting it in the region of 50%. No firm worth their salt could afford not to outsource, companies were told, prompting the mass exodus of Wall Street IT back offices to India.

Then came the backlash. Local unions were up in arms about jobs being outsourced to offshore centres and some early proponents found those 50% cost savings somewhat elusive when 'hidden costs' were factored in. There has also been a backlash against outsourcing call centres to India, following concerns over the privacy of customer data.



However, one only has to look at the financials of leading Indian BPO providers such as Infosys, Tata and Wipro to realise that Indian outsourcing companies seem to be defying the trend against outsourcing. Although the fourth quarter last year was the worst in five years in terms of the value of outsourcing contracts awarded, according to TPI's Quarterly Index, leading Indian outsourcing provider Tata Consultancy Services increased its revenues by more than 40% to $1.1 billion for the quarter ended 30 December 2006.

The value of new outsourcing contracts declined by 8% in 2006 from the previous year's levels but as more shorter and smaller outsourcing contracts were awarded, the total number of contracts agreed in 2006 increased from 341 in 2005 to 350 in 2006.

Once again a lot of the business was won by Indian providers such as Wipro, Tata, and Infosys, whose business models are geared towards "single-process" and specialist deals. According to TCI, these providers, alongside the Big Five in Europe and other smaller and niche providers, are stealing market share from the Big Six outsourcing companies (CSC, EDS, Accenture, HP, IBM, ACS). In 2006, the Indian-based providers achieved a total market share of 7%, a massive increase on 200's figures of less than half a percentage point.

The rise and rise of India Inc continues with companies like Infosys becoming the first Indian company to enter the elite Nasdaq-100 club back in December. And the pundits say we are likely to see the Indian providers seriously challenging the Big Six outsourcing providers for larger-scale outsourcing deals, although I must admit I have been hearing that for some time.

But is this trend of outsourcing to offshore centres such as India sustainable? Will labor costs in India remain as competitive as competing offshore centres in China and Central and Eastern Europe, and more importantly has outsourcing be it offshore or near shore, really lived up to the hype? The Indian outsourcing market has to peak at some point and level out. What then for the Wipro's, Infosys' and Tata's of the world?