Ben, as you know, outsourcing is a hot topic these days particularly when dealing with the outsourcing of business processes that used to be in-house. According to our research, most large enterprises are in the midst of evaluating many processes in HR and finance to determine whether they are candidates for outsourcing. So here's my first question. Based on your experience working with companies considering outsourcing, how does the process of evaluating outsourcing options get started?

Process evaluation initiatives usually get started based on 3 types of drivers:

1. Sometimes suggestions are made at the BOD level based on the feeling of a member who has a sense that too much money is being spent.
2. Or, management may have a quest to improve their operating costs and reduce the need for capital; they look to outsource as a “change agent” in order to standardize and consolidate processes.
3. And finally, unsolicited bids from providers are received and drive an evaluation.
   

Often a company will not have a complete understanding of their current costs, which can make the evaluation problematic and even delay the decision

What are the most common areas that are evaluated?

Historically it has been IT, finance, and to some degree, HR. We are seeing a real increase in HR evaluations and an ever-increasing number of requests for procurement and a resurgence of call center. These areas are evaluated either separately or together.

Do you see companies systematically studying all their business processes as the result of a corporate mandate to cut costs, or are they primarily assessing only those functions they have identified as “broken”?

Some companies have a constant mandate for continual process improvement within their operating groups and their non-customer facing functions. This can drive a lot of the initial evaluations. But more often, process evaluation for outsourcing is part of a large corporate initiative or is brought about by a leadership change or a request from new board members. Lou Dobbs brings it up every night on the CNN evening news, so it is always on top of mind.

Regardless of what the public announcements say, the biggest driver for outsourcing is cost – whether companies admit this publicly or not. The cost driver is about either reducing or controlling. Interestingly, one of the advantages of outsourcing that reduces cost is conversion of fixed costs to variable costs. This may sound like it conflicts with cost control objectives, but by paying for things as you use them, you can end up paying far less than with a fixed price arrangement.

What about quality being the primary driver for outsourcing? Many companies tell us that the motivating factor for outsourcing was to improve the quality of service.

Some companies will claim quality improvements were the motivating factor, but our experience is that companies are driven to outsourcing because of the cost savings and stay with it because of improved quality. Cost reduction cannot be forgotten as the ticket to beginning the discussion. Vendors who try to promote only soft savings as the reason for outsourcing are not always seen as serious competitors who have operational scale and excellence in cost containment.

What kinds of economic analysis are most companies doing when evaluating a business process for outsourcing? IRR, EVA, ROI?

Every company has a different decision process and different ways in how they build and evaluate a business case. Typically though, most companies use a balanced business case approach that includes IRR, NPV and time to payback. Our recommendation is that companies consider and compare the economics of the current state, the cost of change to a future state using their own resources and the offer of the outsourcing firm to either outsource the current or future state environments.

What is interesting is that even when this exercise reveals a very strong business case for outsourcing, the decision is still not a slam-dunk. The decision to outsource is not just based on financial impact. Outsourcing often requires significant change driven by the migration, which de-stabilizes the functional area for a time. In some business environments, there are other more critical battles to fight and de-stabilization could make this situations even worse. It is not unusual for companies to hold on an outsourcing decision until key problems have been resolved sufficiently to be able to withstand the disruption of the changes resulting from outsourcing.

Price Waterhouse-Coopers (PwC) just released a report from a study that found that most large US and European companies are not seeing economic returns from outsourcing. How do you respond to this and why do you think this is?

There will always be some failed outsourcing attempts. Failed outsourcing can take many forms if a properly constructed relationship and contract are not developed. At the root of these failures is either a poorly constructed outsourcing business case (e.g. one that doesn’t take account of all considerations) that will drive a bad contractual relationship, or a business case based on metrics and drivers that are analytically correct but not appropriate to the situation. One size does not fit all. We encourage clients to use an enlightened business case and outsourcing vendor engagement model that is lead by experienced team leaders supported by tools, methods and techniques that are proven.

What kinds of things make an outsourced contract “go wrong?”

There is a long list. And at the top is failing to accurately identify and define the true business case. Here are the other big ones:

• Undisciplined and poorly thought out sourcing process.
• Lack of objectivity in approaching the outsourcing business case due to a pre-exiting bias toward outsourcing or shared services.
• Negotiation of a sub-optimal outsourcing contracts that lacks real working SLA (Service Level Agreement).
• Selection of the wrong outsourcing provider and the resultant service delivery failure.
• Failure to be realistic about your expected outcome; outsourcers will say yes to anything, which is how you end up with over-promising and under-delivering.
• Not paying attention to the vendor post-engagement; you need monthly audits and tracking to catch problems in the bud not to mention enforcement of the SLA terms.
• Creation of unsustainable joint venture alliances – these are great vehicles for contract management but not all joint ventures will work especially when the client and the provider have different needs and growth objectives.
• Being impatient. The Service Provider must take a client to best practices over an 18-month to 2-year period. But initially they have to take on the processes as is.

What do you believe is the single largest driver of cost reduction in an outsourced business case?

Staff cost reductions driven by labor arbitrage or automation are the largest cost driver. Some large BPO contracts are generating savings that are 50-75% driven by the offshore labor costs.

Aside from staff reductions, what do you find to be the key drivers of ROI for an outsourcing scenario? Are there other intangible value drivers that are overlooked?

The key tangible drivers outside of labor arbitrage are several and related to cost savings from the shift of fixed to variable costs, lower transition costs from the ability to ramp up quicker to more efficient processes, avoided overhead costs, eliminating software and hardware licenses and maintenance, and the internal IT support team, and in some cases, the more effective use of the offshore and outsourced infrastructure. All of these cost savings translate into a lower cost per transaction.
There are also a number of important “non-cash” benefits from outsourcing including:

• Supports development of a more effective business model
• Provides increased flexibility to meet changing requirements
• Enables a more responsive delivery of information
• Forces better quality and consistency of data
• Supports standardization across functions, geographies and business units
• Forces sea change in culture (new way of working) Improves career development for remaining staff

When doing an economic comparative cost/benefit analysis of in-sourcing versus outsourcing for a particular business process, is the reduction in FTE’s always the strongest driver that favors outsourcing? What are the primary drivers that determine the comparative outcome? In other words, which areas are the ones that most strongly contribute to the outcome?

Well yes – dramatically lower cost labor is the main difference. But the second biggest difference comes from facilities cost. An outsourcing provider (particularly an off-shore provider) can optimize utilization of their facilities better than companies can do on their own. With better utilization capacity of facilities you get huge economies from increased throughput of the same physical office space by running two or more shifts.

So for example if your current state cost for a transaction was $1, $.55 of that is direct labor and the remainder is IT and facilities costs. For an outsourced provider the main cost component is still labor but their facilities cost component is much smaller. Effective use of facilities is the second largest difference in the comparative costs of outsourcing versus in-sourcing.

As you know, another hot spot is 'off-shoring'. What should a company do to support a decision to outsource with an offshore solution provider?

You need to consider how off-shoring will impact the on-shore end of the relationship. And potentially added costs to either manage or effect change in the future. You may need to hire people with different skills to deal with cultural and time zone differences. A rule of thumb is that an on-shore outsourcing arrangement will require you to spend 1-5% of your budget on managing the contract; for off-shoring you must allocate 3-8%.

How do the ROI drivers differ for on-shore versus offshore outsourcing?

The ROI drivers are generally the same, but timing and realization of cost and benefits will be different. Specifically, labor costs overseas will be cheaper, while telecommunications and travel costs will be higher. Also the cost of migrating the processes will likely be higher offshore. Netting this all out, a higher upfront investment is required to move the work, which is offset by the significantly cheaper labor costs found in many offshore locations. When you move the work offshore, the big difference arises when you apply the risk premium to the offshore case, derived from currency risks and political or country risks. Although the risk analysis is soft because it is based on probabilities, it should still be a factor in the ROI. Currency risk premiums largely affect the labor costs while country risks are more applicable to facilities and operating costs. These factors clearly can impact the ROI if you apply them to various “what if” scenarios.

Of course off-shoring is a very sensitive area these days since it is perceived as taking away US jobs. Lately there is a lot of press about major firms, such as Dell and Lehman Brothers, pulling back on their offshore outsourcing efforts for business customer service. Is Dell viewing off-shoring as politically incorrect? Or is it because the company was truly not seeing the economic gain?

First off, very few companies will admit to their offshore strategy for political and PR reasons. Many of us in the industry believe that companies are actually increasing their offshore activities - both through the establishment of company-owned, captive-shared, service centers in low cost locations and through outsourcing. My understanding is that the problems Dell experienced were driven by factors that could have occurred in South Dakota or Southern India. Business drivers forced the deployment to be rushed and Dell didn’t have time to do proper training of the employees. Our view is that Dell and other market leading companies will increase their off-shoring through a “right location” approach that mixes on- and off-shore tactics. Based on the nature of these technical support calls and the level of expertise that is needed, calls are routed to the right people with the right expertise, in the right country, with the ability to relate to the call or business need.

Are there “hidden costs” associated with outsourcing offshore that companies are not including in their initial business case? And if so, what are some of these costs?

The biggest “gotcha” is that companies don’t scope the complete cost of migrating the work. Time zones, the shear distance to move teams around, the overlap of managing the current work while moving to the offshore environment. These all cause a variety of complications that will drive up costs. Effectively you end up with an extended period of double costs during migration. Again, this additional upfront cost is offset by the future savings, but you need to be careful to manage the migration or the business case can be destroyed.

You referred earlier to “captive shared services”. Can you define this and identify how the benefits differ from traditional outsourcing?

"Captive shared services" describes a strategy used by companies to bypass the outsourcing provider and directly hire and train a work force, and fit out their own in-source centers in the various low cost regions (India, Philippines, Czech Republic and others). A number of data points say that over 60% of the jobs moved offshore by US companies are in fact not outsourced but off-shored in a captive client owned center. The mission of these captive shared services centers is to provide various IT, accounting and HR services using the same low cost labor that is tapped by a third party outsourced provider. Clients choose this strategy most often for reasons driven by control and intellectual property concerns.

Obviously, captive shared service arrangements are made only by very large companies with significant volume and scale to make this cost-effective. Captive shared service models are becoming even more prevalent than outsourcing over the last few years, which is putting pressure on offshore outsourcing providers to drive down their costs even further or provide access to skills and processes that otherwise would be difficult for companies to access.

The major difference in ROI comes from the risk and control trade-off between the two options. In the case of captive shared services, you have complete control and an implied view of better security. You have theoretically eliminated paying the profit and overhead of an outsource provider. In theory, that should be the cheapest implementation scenario based on the assumption that there is such a ready pool of labor that you can just “go do it yourself.” But there is extra risk involved - particularly if you are going to operate in another country. You need to build out the facilities and plant, as well as establish legal status in that country. This adds 3-6 months to the process. Then you have to hire not just the US manager, but also a local management team that knows how to manage the operation on your behalf.

With traditional outsourcing you have access to a team that knows how to operate in the country they are in. They understand local tax requirements. They know how to standardize and migrate the work. The business case may look better for captive shared services on paper, but rarely will companies really achieve those savings. The question at hand is execution of a plan, not theory. In most cases, companies will not be able to execute the business case as well. They may have access to the local labor pool, but they won’t necessarily have access to leadership. Careful analysis is required and risk adjusted scenarios should be run to make a prudent decision to outsource or run your own captive shared service center.

What kind of economic return do you see for the different types of Business Process Outsourcing? (e.g. on-shore, offshore, captive offshore)? And how do you know which is right for you?

Most companies can save money no matter which strategy is adopted. The offshore option is clearly a better business case, if you can manage the risk. Once you have chosen to go off-shore the company needs to decide if the soft factors such as control and process retention are more important than having access to the professional management team provided by an outsourcing provider.

Scenario		Savings (Before Investment)		NPV Potential
On-shore/Outsourced		15-20%		Neutral
Off-shore/Outsourced		20-40%		High
Off-shore/Captive Shared		20-45%		High

Ben, our research indicates that many companies are following an outsourcing strategy that is staged. That is, they start slow with outsourcing a few functions and then gradually build out, depending upon the success of the outsourcing projects. What do you think of this approach? Does it impact the expected ROI?

How you deploy an outsourcing arrangement has tremendous impact on the real ROI of a project. Timing and scale are big drivers once you have made the decision to outsource. I can guarantee that you will make a flawed decision if you don’t start with a complete business case that assumes the full scope. You can always stage the implementation, but you should plan and negotiate for the complete scope. You will get a better price and a better solution if you sign a larger scoped deal even if the deployment is staged.

The biggest flaw in going with a staged business case is that it is often based on the results from a pilot process. These results are not representative of scale, and therefore, are not representative of real costs. Very often companies start outsourcing processes that require the lower levels of expertise. The real cost savings come when you replace the mid-grade workers.

Another common belief is that offshore outsourcing is always being done in India. What other countries do you see becoming prominent in the offshore outsourcing landscape and how are they different? How do you decide which location is right for a company?

Clearly it's not just India. There are numerous alternative countries to evaluate and there are different reasons to choose each one as a target location, based on specific company-unique drivers. The main issue is the availability and quality of labor. Based on English speaking graduates per year, India is the highest at around 2.1 million per year. The US produces about 2 million and the next highest is the Philippines with 350,000 per year. The remaining countries are statistically irrelevant talent pools in terms of English speaking, reasonably high-skilled labor. Sure you can set a center in almost any country based on cheap labor. But can you find English-speaking accountants who understand Sarbanes-Oxley reporting requirements? Depending on your needs, we like Singapore and Malaysia in Asia. In Europe, there are another 4-5 core countries to look at as potential locations for outsourcing: Hungary, Czech Rep, Poland, Slovakia and Romania. And another 5 or so are just over the horizon as far as being ready to provide substantial offshore services.

Is the answer different for a US English language driven company when compared to a global company with far-flung operations in Europe and Asia and the US?

Clearly a US company has to look to a single or cluster of Asia countries to meet its needs. Asian locations can provide the lowest cost English language based process work.

We think the global company's outsourcing and offshore answer to getting the best cost and span of control is what we call the “2-1/2 center” solution broken down as follows. For the non-English European work it is best to source the work with a center located in Eastern Europe. The English speaking work should go to a major pan-Asia location that has a large English speaking labor pool such as Philippines or India. The work based in the Asia/Pac Rim region that is not English-based would stay in that region in a reduced scope “½ center”.

The outliers to the global answer are usually Japan and China since they are both difficult to outsource in another country. If you have substantial language driven operations in Japan or China, you usually have to outsource in that country to standardize and outsource in that geography.

About the Gantry Group

The Gantry Group is the only management consulting firm specializing in technology ROI. The Gantry Group’s ROI impact analyses are validated by primary market research to ensure accurate capture of the real value drivers and costs. With over 200 technology clients, 3,000 business process interviewers and profiles in their knowledge base, and more than 1,000 ROI business processes and value drivers modeled, Gantry offers its clients the greatest depth and breadth of ROI experience and invaluable objectivity.

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