The Facts Regarding the Outsourcing Business Model

Executive Summary

The outsourcing of Information Technology operations has been a cornerstone of the technology services industry during the past 15 years. Recent market conjecture, largely surrounding the financial disclosures of a few heritage ITO providers, has raised some doubts in the media regarding the viability of the outsourcing business model. TPI, the world’s leading authority on large-scale outsourcing, outlines the facts related to the effectiveness of the outsourcing business model on the achievement of buyer business objectives and the sustained growth in service provider profitability. Enterprises that have sourced in the past are continuing to do so, well-constructed sourcing relationships are yielding the results originally envisioned, and the market is growing in terms of capability, providers, and dollar volume. The market for ITO and business process outsourcing remains robust.

Introduction

Since the earliest days of Information Technology Outsourcing (ITO), market analysts and corporate observers have generally offered praise for the outsourcing business model. The virtues of outsourcing were seen as equally beneficial to the corporate enterprises that were the buyers of outsourced services and to the service providers that delivered on these relatively long-term contracts.

Simply stated, the firms that elected to outsource in a meaningful way were seen as being focused on their core competencies and being judicious in their use of valuable capital resources. They understood the economic tenet — that of the beneficial effects offered by scale achieved by a third party that is able to leverage resources across multiple clients. To the analysts that tracked them, outsourcing consumers were deemed progressive in the conversion of G&A costs into a variable spend profile.

For the service providers in the marketplace that were fortunate enough to capture a share of the global outsourcing contract awards, the perceptions were equally as bullish. The leading ITO providers were thought to enjoy a more predictable revenue stream from the larger contracts, be best positioned to drive costs out of the service model through the efficiencies offered by scale of similar business requirements, and be adept at applying technical expertise to the transformation of legacy technology support processes. They also were positioned to be the recipients of additional business from their ITO clients in the form of discretionary spending on technology-related consulting and systems integration requirements.

All in all, everyone was happy with the business model and the results it achieved for buyer and provider alike.

Then along came the economic downturn of 2001, just on the heels of the dot-com collapse. As the market for consulting and systems integration projects had just about disappeared, many clients of ITO services exercised their discretion in the use of the terms of their agreements regarding variability. A fundamental tenet of outsourcing is the variable nature of the costs. Clients pay only for that which they consume. With increased economic uncertainty, many ITO clients were turning down their rate of consumption.

The net effect was declining revenues and erosion of profit margins for providers in the technology services industry, especially those with considerable dependency on consulting and systems integration assignments. The ITO providers in the industry felt the effect as well.

Shareholders and market analysts began to question the benefits of the outsourcing business model. Focusing first on the risks being carried by the service providers, they asked whether the revenue was truly as predictable as they had once believed. They also challenged the merits of a service provider carrying the burden of capital investments, notably hardware and software costs, in absence of certainty of future revenue related to the services these investments were meant to deliver. And, as the promised incremental revenue was now declining, the service providers were facing the fact that their ITO relationships were being marginalized to the core service volumes allowed by their contracts.

As the problems experienced by Electronic Data Systems (EDS) in late 2002 illustrated, the providers that had a high concentration of ITO contracts carried an equally high requirement for financial and operational management controls to anticipate changes in the spending habits of their clients and respond accordingly. Computer Sciences Corporation (CSC) had done so almost 18 months earlier and had felt the impact on its stock price at that time. In September 2002, it was EDS’ turn to face the facts regarding the downturn in “discretionary spending” (as they called it) from their ITO clients.

Following the logic that these outsourcing relationships, once thought to be win-win, had a clear ‘loss’ dimension on one side of the equation, many market observers opined that the corporate subscribers to ITO service offerings must be dissatisfied as well. Various market metrics emerged claiming a high percentage of “failed” ITO transactions. It was asserted that dissatisfied clients were now pursuing in-sourcing, repatriating the workforce, systems, and responsibilities that had been outsourced in the recent past. Projections of an increased rate of contract renegotiations and “pricing restructuring” were offered as indications of fundamental flaws in the outsourcing business model.

Having advised on over 40 percent of the global larger-sized outsourcing contract dollars awarded in 2002, TPI is uniquely positioned to comment on the integrity of the current business model. The firm has supported over 550 client sourcing engagements in the past 13 years, with involvement in over $330 billion of outsourcing contract award value. No other firm possesses more insight into the facts and realities of the states of the outsourcing industry than TPI. Fully 30 percent of TPI’s engagements reach the conclusion that sourcing is not the appropriate approach for achievement of a client’s goals. TPI’s services span the spectrum of the sourcing lifecycle, from pre-transaction strategy development and business case assessment, to negotiating and implementing a sourcing transaction, to providing post-transaction sourcing management services that ensure that the value envisioned is the value received. TPI derives no revenue from the representation of service providers. The firm is devoid of conflicts of interest and measures itself by the value delivered to its clients in the form of successful long-term sourcing relationships.

This Position Paper, one in a series that addresses timely market topics, responds to some of the more common questions being asked about the health of the outsourcing business model. Specifically, it speaks to the topics of beneficial effects of an outsourcing relationship on the corporate buyers, generally Global-1000 firms, and the leading service providers. Conversely, it conveys the facts regarding the perceived and real risks of the business model.

While the heritage of the industry is ITO, the observations offered in this paper include perspectives related to business process outsourcing (BPO). BPO is among the fastest growing segment of the technology and business services market and most enterprises engaging in BPO contracts are applying the lessons learned from the past 15 years of ITO to their initiatives.

The Outsourcing Business Model – What Is It?

An outsourcing contract, whether ITO or BPO, is an agreement between a buyer (typically a corporate or government enterprise) and a service provider for the receipt of defined services at defined prices and defined levels of service quality. Structured much like a subscription to a cable television provider, the buyer pays a base service charge for a base level of service and then pays for any incremental consumption above the baseline volumes. The quality with which the services are delivered is measured by Service Level Agreements (SLAs).

Reaching this sort of relationship comprises a process through which certain assets of the buyer (employees, third-party contracts, systems and data, and the like) are transferred to the provider. Attendant to these assets is the capital responsibility for their maintenance, disposal and refresh. That is, for example, the people employed by a corporate enterprise related to the provision of a service that is to be outsourced will transition to the service provider in the course of implementing the outsourcing relationship. As such, the service provider assumes responsibility for the training, direction, deployment, and eventual separation of those employees, whether through voluntary or involuntary termination. Likewise, a software application used to deliver a service will also transition from the buyer to the service provider. In making this transition, the service provider will typically purchase the asset at net present value and will assume responsibility for the maintenance and upgrade of that asset, to include responsibility for the remaining depreciation of the asset’s costs.

Thus, the “defined services” that comprise the outsourcing agreement is bounded by the description of scope and the measures of quality related to the services provided. The “defined prices” encompass the service provider’s base charge and any unit prices for additional (or reduced) consumption of those services. The prices cover all costs related to the provision of the services.

Whereas, prior to outsourcing, the corporate buyer experienced a relatively fixed cost for the people, systems, and related assets associated with the provision of the in-scope services, these costs have now been made more variable. After outsourcing, the corporate buyer pays a base service charge for a baseline volume of services and unit pricing for increments/decrements from that baseline volume.

From the perspective of the service provider, each service is offered at unit prices that reflect the provider’s treatment of transitioned assets and a consideration for the likely consumption rates of individual services within the relationship. The costs for capital expenditures to maintain, upgrade, or replace the assets (human or otherwise) necessary to deliver the services are included in the base charge and unit prices. The client has achieved variability and predictability. The service provider has gained a “subscriber” to his service offerings.

Included within the service provider’s pricing is the commitment to continually improve the quality with which the services are delivered. Measured by SLAs, clients and providers generally agree that the quality of the services will improve during time as both parties work towards clarity of expectations and leverage of the scale and expertise of a focused delivery model.

What Can Go Wrong?

There are always risks in business, and many of these risks exist regardless of the service delivery model — insourced or outsourced. Yet, there are certain risks uniquely associated with the outsourcing business model. The categories of risks described most often in the marketplace are the following:

• Costs are higher than anticipated; savings are not realized
• Service quality degrades
• Loss of intellectual property and control over proprietary data
• Attrition of critical expertise

These, and others, are very real risks to the attainment of a successful outsourcing relationship. Yet, they are not without precedent in the industry in all types of service delivery models.

Costs can indeed be higher than originally estimated if clients consume more services than they had envisioned. Expenditures can also be higher if the scope of the services is not defined appropriately. Service providers are generally adept at “up selling” new services and additional projects, some of which may already be “in scope” of the base agreement. It is incumbent upon the corporate buyer that appropriate monitoring of consumption rates and authorization of additional services be part of the governance culture in an outsourcing relationship.

Degradation of service quality can occur for a multitude of reasons, not the least of which is the tendency of service provider to delay the upgrade of aging infrastructure in order to preserve capital. Cash flow is a critical metric to most public companies and the efficient use of assets is a core competency of most service providers. An active and informed dialogue between the buyer and the service provider on consumption rates and future needs will help to make informed decisions in capital investments. Service quality issues may also derive from inattention to detail, lack of training, negligence, and other matters that speak to the provider’s controls and expertise in the services being provided.

The area of intellectual property and control rights over data has become even more acute with the growth of business process outsourcing. Service providers may place their clients at risk due to poor controls over the critical information related to the business operations of the client and/or the provision of the services. Finally, the risks related to attrition of critical expertise can be experienced if the provider’s culture for attracting, developing and retaining talented individuals is not aligned with the analogous culture of the corporate buyer. Interestingly, some clients express concern over the opposite effect. That is, their transitioned staff is retained on their account too long, preventing the introduction of innovation and fresh approaches.

The net of these perceptions is the conclusion that risks do exist in the achievement of the desired win-win relationship. Issues do arise and problems can mount. The operative question asked of the industry is: “Does this mean that the outsourcing business model is fundamentally flawed?”

Measures of Defect in the Outsourcing Business Model

Some of the more common points of conjecture offered in the face of recent service provider financial challenges include assertions of fundamental flaws in the outsourcing business model. They include claims of inordinately high “failure” rate in outsourcing relationships. These are defined as decisions to “insource” functions that had been previously outsourced, contentious litigation, contract renegotiations of significance, and even contract terminations prior to the end of the term.

As TPI has negotiated more outsourcing contracts on behalf of corporate enterprises and for more years than any other advisory firm, the firm’s statistics in these regards provide a standard for use in weighing the true defective nature of the outsourcing business model. TPI’s review of the sourcing transactions completed in the past 10 years reveals less than 1 percent failure rate (as defined in the previous paragraph). Buyers attribute this rate of success to three principal factors: the anticipation of change that occurs in the course of constructing a long-term services relationship; the empowering effect of leveraging a proven transaction process that puts the buyer in control, supported by a strong, market-tested contract; and the deployment of a comprehensive sourcing management culture.

While some may point to renegotiations as an indication of failure, the fact is that no outsourcing relationship will run its term in the original form due to the evolving business needs of individual companies attributed to such issues as acquisitions, divestitures or global expansion. Many well-engineered sourcing relationships are designed to accommodate this level of change through a prescribed process. Most contract adjustments entail scope expansion and/or term extension, and all are bi-lateral agreements that are deemed business-worthy by both parties.

Recent surveys of outsourcing buyers at TPI’s Sourcing Leadership Exchange – an invitation-only membership of firms that are making strategic use of sourcing – reveals that over 90 percent of the survey respondents, if given the opportunity, would outsource again. A related indicator of this conviction is the fact that 70 percent of TPI’s 2002 revenues, which grew 38 percent over the prior year, were derived from clients in prior years or referrals from clients. If outsourcing was not deemed effective and successful, neither would TPI in the basis of the transactions negotiated. To TPI’s knowledge, only two of the 550 outsourcing transactions negotiated in the past 10 years has been insourced, and neither of these has occurred in the past four years.

Finally, the BPO trend is providing ample evidence that outsourcing is a valuable tool for the achievement of efficiency in non-core business operations. TPI’s BPO engagements represent over 20 percent of its current business volume, and these are largely supporting clients that have enjoyed the benefit of prior ITO relationships.

To present these conclusions in balance, TPI recently surveyed the leading service providers. 130 participants from 55 service provider firms participated. TPI found that fully 70 percent of the survey respondents believe that a win-win relationship is attainable if it is a priority for both parties. When asked for the percentage of their outsourcing contracts that would be deemed successful by both their clients and themselves, 80 percent of the service providers surveyed cited at least 70 percent of their relationships falling into this category. Fully 98 percent of the respondents cited a mutual satisfaction level of greater than 50 percent for their outsourcing relationships.

The contention that there is a failure rate of 50 percent for outsourcing contracts is simply not supportable based on recent surveys of buyers’ experience or objective surveys of the service provider community.

Conclusions

Successful outsourcing relationships are the result of a thorough process to align service delivery models and market-tested contract terms with corporate business objectives. Admittedly, risks exist in all facets of business, and the outsourcing business model has been tested during 15 years of practice experience. The challenges of 2002 were real for those service providers that were over-reaching their risk tolerance levels or which did not anticipate the willingness of outsourcing clients to exercise their rights related to variability.

Today, however, service providers that are serious contenders for long-term sustainability are approaching market opportunities with the appropriate degree of diligence and are taking on relationships that meet judicious cash flow and profitability profiles.

Furthermore, there is no evidence of fundamental flaws in the outsourcing business model. The risks to long-term success are managed through a well defined governance model and strong contract terms supporting a relationship built on the principles of service excellence that have been tested in the ITO marketplace. In addition, BPO transactions will benefit from the lessons and processes refined through ITO.

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