The key to outsourcing success

Outsourcing is not the same as contracting. At Everest Group, we define outsourcing as: “Handing over control of three or more business processes to an external party.” The transferee in turn sells contracted services back to the transferor for a time, typically more than one year. By Peter Barta

Outsourcing is a complex process filled with conflicting agendas, heartfelt emotions and commercial realities. The process must be executed correctly so that the buyer achieves its strategic objective and gains the greatest value through a healthy relationship with its supplier. The highest order issue for a buyer to consider is the binding nature of the relationship between parties. The parties to the arrangements must be able to conduct their business within a durable relationship of mutual dependence. This special type of commercial relationship is sometimes described as a highly structured joint venture. Naturally, a decision to venture with an external party is not one to be taken lightly. There are many issues for a buyer to consider and, because every buyer is different (and indeed every supplier is different), an outsourcing decision must be carefully planned, executed and controlled.

Outsourcing has been a successfully exploited business strategy since the 1960s when sometime US Presidential hopeful, Ross Perot, founded the industry. His company, EDS, leased excess nighttime capacity from early buyers of mainframe computers and sold it on to organizations that otherwise would not have access to IBM’s great new technology. Since then, outsourcers have both pioneered and mimicked new technologies and services delivery models in their efforts to offer clients a substantially unchanged value proposition – ready access to benefits enabled by economies of scope and scale, at a high quality standard, for a low budget price.

Offshore outsourcing has recently emerged as a topical innovation wave in this mammoth global industry. The following example highlights some of the complicating issues for the buyer in an offshore outsourcing deal. By handing over control of an appropriate scope of work to a third party, a business may be able to reduce its fixed cost of applications maintenance and support through:

• Substantial reduction of the fixed costs of keeping a skills bench of in-house personnel on the books.
• Exploitation of wage cost arbitrage opportunities that may be available from an offshore outsourcing arrangement.

Generally, offshore outsourcing will involve entering either into an arrangement for work to be performed in another country at “offshore” rates; or for the work to be performed in a mixed delivery model using both offsite resources (within country) and offshore resources, at a blended rate.

Each of the options will generate different savings to the buyer, because each of them presents a different combination of trade-offs with regard to outsourced scope, accountability, risks, governance complexity, flexibility and associated economic impact. Put differently, the options present the buyer with opportunities for optimizing benefits and risks through negotiated trade-off, by tailoring the deal to meet the parties’ needs. This process could potentially allow for a greater proportion of personnel and work to be included in scope, increasing gross savings potential while reducing the buyers’ counterparty performance and recourse risks. These increased benefits would be partially offset by complexity costs of governance and, in the case of the second option, the supplier’s higher costs of delivery due to local content costs.

Savings in hourly rates offered by offshore outsourcers are attributable to their effectively combining two key delivery levers, namely low personnel costs and high quality processes.

Low personnel costs are a given for the typical offshore outsourcing value proposition, but there are associated, important buyer considerations such as location attractiveness. This requires informed comparison of potential offshore locations on cost and maturity dimensions to identify the correct location for the work to be performed to an acceptable standard.

In the case of India, for example, Everest Group has identified that although all four major Indian delivery locations are attractive from a risk-neutral buyer’s perspective, Bangalore and Mumbai are clear leaders.

High quality processes are typically evidenced by suppliers through independently awarded certifications for process maturity, such as the capability maturity model (CMM) accreditation, which ranks individual development centers on a progressive quality scale from one to five. CMM 5 is a prized standard that many suppliers will offer to buyers and, because it is a measure of both efficiency and effectiveness, the highest grading can in fact result in the lowest hourly rates. However, the risks of realizing these savings benefits are high if the buying organizations’ own ‘applications maturity’ is low. Notwithstanding a supplier’s CMM grading, outsourced work cannot be consistently performed to a quality standard greater than that of the buyers’ own maturity and ability at the interface with the supplier. In other words, the degree to which the supplier’s hourly rates do in fact translate into buyers’ savings are materially influenced by the quantity of work and quality of design that are enabled by the buyers’ own organizational capability.

In selecting its applications outsourcing options, a buyer must consider the complexity of its own applications support/business interface environment. Today’s reality dictates that each of the viable options will provide a unique opportunity with associated limitations, benefits and risks for the buyer. As discussed above, the real and sustainable savings potential is critically dependent on the maturity and portability of the applications in scope. The Everest Group’s Applications Suitability Assessment model provides buyers with a structured basis for assessing the correct scope of applications and levels of business support that may yield benefits from offshore outsourcing.

For each branch of this issue tree, a prospective buyer must assess and respond to a wide range of relevant fundamental issues before proceeding. These may include answering such questions as: What is the ability of business users to define requirements and specifications? Are the requisite skills available from an outsourcer?

Given that not all applications and activities will be suitable for outsourcing, a further important consideration for buyers is the proper determination of the firm boundary between fixed expenditure (i.e., non-discretionary) on applications maintenance, and the discretionary expenditures on applications enhancements and new capital projects.

A buyer faces substantial challenges in undertaking such a fundamental transformation of its applications delivery model. Most importantly, it needs to ensure that its rationalized applications support group will be able to align with business needs in the future. Furthermore, it needs to echo a successful implementation in the business units to ensure that full value from its future development efforts is realized.

On proceeding with its offshore choices, a buyer faces two fundamental questions. First, how does it know that it has been provided a fair price for the outsourced scope? And second, by entering this type of deal, it will make a substantial skills disinvestment when it separates surplus personnel – does this make good business sense?

The board of directors needs answers to both of these questions. A market competition can address the first. Addressing the second problem of building certainty with regard to the business outcomes that can be expected is more difficult as it is necessary establish the linkages between the IT strategy and business outcomes. However, this effort provides important input to the deal evaluation criteria and business case for the strategy.

Outsourcing choices are inherently complex. Given their complexity and risks, the choices cannot be oversimplified and compared on an ‘apples-to-apples’ basis. Conceptually, outsourcing buyers and suppliers seek the optimal risk-sharing boundary between themselves. Risks are assignable within a deal, but total risk is shared between the buyer and supplier and importantly, some risks are not transferable between the parties – in other words, outsourcing is not an insurance transaction. Typically, there will be an asymmetrical risk footprint, biased against the buyer who often has material business interests at risk, in contrast with the supplier who is able to substantially ring-fence a deals risk to a single client account in its portfolio. A buyer’s outsourcing risks can be broken down to several dimensions.

Many buyers today are concerned about security and confidentiality when outsourcing. In fact, there are security and confidentiality risks whether they outsource work to a company in town, across the ocean or keep it in-house.

In many situations, buyers can have more data security and less risk when utilizing an outsourcing provider than if the work remains in-house. If a hospital’s disgruntled employee threatens to post patient histories on the internet, all they can do is fire him or her. If an outsourcing provider breaches privacy regulations, it has a huge legal problem. In addition to the damage to its reputation, if publicly traded, shareholder value could be destroyed.

The correct way to ensure the safety of your data when outsourcing, is to assess your points of risk and to structure the outsourcing agreement to mitigate them. This might be as simple as having a clause in an agreement giving the buyer rights to review and veto all subcontractors used by its outsourcing service provider. When a buyer has entrenched oversight and control of the outsourcing supply chain, confidential data will not go astray.

Protecting data should be a concern when selecting an outsourcing service provider. Using a supplier with a brand name and reputation that they are proud of is an effective risk mitigation technique. These service providers will use effective security measures. For example, a New York service provider with an Indian office processes US tax returns in Bangalore. It uses armed guards at all doors and forbids employees to have pencils or paper in the building. Elsewhere, a call center outsourcer based in Florida processes credit cards in this era of identity theft. The firm has installed the latest in network security, but the CEO worries about their people. The company makes all potential employees put up US$1000 to take a psychological test that assesses their honesty.

The bottom line is that a buyer must assess all risk points in any process involving sensitive data – whether the outsourcer is in town or offshore, the risks remain the same. Address those risks in the structure of the outsourcing contract.

Outsourcers are all too easily tempted to promise strategic alignment, value focus and business impact during their sales process. However, these good intentions are often lost once the delivery team moves in and internal business pressures within the outsourcer realign priorities. It is therefore critical that the outsourcing contract and governance processes that are put in place are designed to create an alignment between the outsourcer’s interests and the business needs of the buyer. In serving its own selfish objectives, the outsourcer must be driven to achieve the business objectives of the buyer. Moreover, governance processes need to be designed to ensure that the buyer can leverage access to the best and most experienced available talent within the outsourcer once the deal is in place.