Systems integrators such as Accenture, Cap Gemini Ernst & Young, and IBM prospered by implementing large enterprise resource planning (ERP), supply chain management (SCM) and customer relationship management (CRM) application packages developed by vendors including i2 Technologies, SAP and Siebel Systems. The price of a project, often running into the tens of millions of dollars, was based on estimated labor costs and a standard profit margin, without any guarantee that business benefits would follow.
Meanwhile, outsourcers such as Electronic Data Systems and IBM offered to free chief information officers from the burden of operating complex IT systems. Unlike systems integrators, outsourcers took responsibility for meeting agreed-upon productivity targets. The broad and long-term scope of outsourcing contracts covered the operation of data centers, the management of desktop computing, help-desk support, network management and, more recently, services such as World Wide Web hosting and applications management. By 2000, the global markets for systems integration and for outsourcing--the two pillars of the IT services industry--had surged to $125 billion and $100 billion a year, respectively.
That was then. After a decade of double-digit gains, the sector suddenly went flat in 2001, as an economic slowdown forced companies to rein in their overall IT spending. Contrary to projections of a near-term return to growth, we see indications that IT spending will remain flat or even shrink. Many customers voice dissatisfaction with their large investments in enterprise software and question the value of long-term outsourcing.
Even worse for service providers, an abundance of IT talent is now on the market, to say nothing of competition from low-cost offshore service providers in places such as India and China. The result, our research suggests, will probably be an enduring shift toward reduced spending on IT services, increased pressure on prices, a preference for narrow projects and tough demands for quick and hard economic benefits.
This new climate is more than sobering. The dramatic shift in demand is challenging the providers and in some cases may even threaten their survival. As the operating-profit margins of companies in the IT services industry declined from an average of 7.4 percent in 1999 to 4.6 percent in 2002--a 38 percent fall--valuations, too, plummeted. From a peak of over 100 in 1999, the P/E (price-to-earnings) multiples of the world's top 100 IT services companies fell to 30 in 2000, and then collapsed again to 3, by the end of 2002.
Small wonder the IT services industry faces another shakeout, as flat markets become the battleground for a wide range of providers. The competitors include systems integrators, outsourcers, full-service powerhouses offering both systems integration and outsourcing, offshore competitors and hardware and software providers hoping that services will compensate for lost revenue from flagging core businesses.
Small wonder the IT services industry faces another shakeout, as flat markets become the battleground for a wide range of providers.
The winners will be companies that reinvent their business models for an era when customers spend less, demand more and have an abundance of IT talent to carry out a larger share of the work in-house.
IT spending on hold
In response to slowing economic growth, companies began cutting their IT budgets in 2001 by freezing new investment. In 2002, many CIOs we interviewed had already gone one step further: reducing the cost of maintaining and supporting their existing applications and infrastructures.
Indeed, companies are hacking away at the cost of maintaining and supporting the enterprise applications that often serve as the backbone for business processes that include customer management, accounting and supplier management. Not surprisingly, the application-maintenance business of many service providers and software vendors is under significant pressure; many companies are simplifying their IT infrastructures and reducing overcapacity and related labor costs by consolidating heterogeneous systems. Another symptom of the cost cutting is the fact that many companies are automating administrative tasks to increase the workload that each IT staff member manages.
As a result, service providers are now finding fewer business opportunities because customers have less information-technology infrastructure to operate and maintain, and a larger number of companies can handle their simplified needs with internal resources. And since greater capacity is currently being wrung from existing equipment, the market for new hardware (and for the associated installation and maintenance services) will probably remain soft.
Besides reducing the total demand for IT services, the freeze on new investment and the focus on reducing costs have shifted the remaining demand away both from traditional systems integration, which primarily involves adding new IT features, and from outsourcing, in which an outside vendor manages a complex IT infrastructure. These shifts not only threaten traditional IT services lines but also give providers an opportunity to meet the new needs of customers by helping them cut their IT costs and by delivering a measurable business impact.
Many CIOs and leaders of business units are dissatisfied with the inconsistent results of large IT investments, especially for hugely expensive ERP, SCM and CRM installations. These executives now realize that many such applications are unlikely to deliver benefits unless companies also make basic and difficult changes in their business processes and in the way they work. What is more, most enterprises now realize that some business processes and applications are riskier than others: The financial-services firm, for instance, doubts it will ever get value from its CRM system. It isn't alone. Demand for enterprise software has dropped and probably won't rise soon--bad news for systems integrators.
Many CIOs question the value of long-term outsourcing as well. Some of those we spoke to believe that their outsourcers, rather than continually reducing operating costs to the best levels in their industries, merely fulfill the letter of contracts. In addition, many companies have learned to consolidate and standardize their infrastructure before outsourcing it, so it is harder for an outsourcer to offer substantial savings and make a profit for itself.
Negative experiences in many service areas have turned enterprises into more sophisticated and demanding buyers of IT services. Such companies now manage their expenditures and analyze the returns on their IT investments more rigorously. Customers that still want to outsource now demand shorter contracts with quicker paybacks and use external counselors to help negotiate deals. Companies in general are keen to tie pricing to performance through such means as value sharing and contingency pricing (basing payments on measurable data by setting specific performance levels or cost targets). Service providers now face tougher customers with a sharp eye for services that have a real impact on business.
The end of the dot-com boom and the subsequent economic slowdown have also flooded the market with cheaper labor. IT talent laid off by struggling third-party service companies is coming back to serve enterprises either as direct hires (working in-house) or as employees of small, low-cost service providers. This competition further reduces demand for the services of the large providers and may force them to make additional layoffs. And companies with better staff are running more services in-house and becoming more sophisticated about buying the remainder from IT services firms.
Furthermore, talent is now available offshore at even lower rates and at quality levels higher than those of typical U.S. providers. With low wages, higher productivity than is usual in the United States and task-oriented offers--as opposed to the sweeping large-scope value propositions put forward by many incumbents--offshore competitors are perfectly positioned for the new market. They are thriving.
Offshore competitors are perfectly positioned for the new market. They are thriving.
The rocky road to recovery
IT services providers have reacted instinctively to these harsh pressures. Many of them are responding to waning sales by slashing their prices and by pushing all the harder to market their current services. CIOs report receiving offers of dramatic price reductions from longtime service providers and unsolicited offers from their competitors. Other CIOs speak of a surge in proposals that they can regard only as increasingly irrelevant to the new needs of their companies.
Systems integrators and outsourcers will follow different routes to recovery, with some common elements. To meet the customers' new needs, providers will have to rethink their offers so that they deliver cheaper, more easily measured benefits. And to compete profitably with low-cost offshore providers, incumbent systems integrators and outsourcers will have to trim their costs by expanding offshore themselves.
With dwindling demand for large enterprise software packages and cutthroat competition for the remaining projects, systems integrators must transform their traditional megaproject model into one that customers are willing to pay for. Projects that have a relatively narrow scope, can deliver hard economic benefits quickly and don't require wholesale changes in the customers' business processes are the order of the day. Service providers must also be open to the idea of pricing their contracts in new ways, and sometimes, even, to guaranteeing the results of their work.
One of the most promising approaches may be to offer consolidation services, which help customers clean up their messy mix of applications--usually the result of undisciplined past customization. (One multinational company saved more than $400 million by consolidating upward of 250 slightly different versions of the same ERP application.) Such services could be provided either by systems integrators or by application software companies; customers will have to decide which is more valuable: the systems integrator's neutrality or the software vendor's deeper technical skills. A customer with redundant applications from more than one vendor, for example, may wish to have a neutral third party advise it on which application to choose as a standard.
The key to unlocking this opportunity will be the way customers pay. They won't want to make large up-front investments before benefits have been realized, and they will want those benefits to be guaranteed. One way of doing so would be a gains-sharing contract: The provider benchmarks the customer's IT cost structure, estimates how much overall improvement in the system is possible and guarantees a certain level of cost reduction. The customer can make the deal unfavorable for a provider that falls short of the guarantee, and in return, the IT services provider benefits from any improvements beyond it.
Another promising approach for systems integrators may be to build practices around the installation of low-risk applications that deliver improvements rapidly, without the need to consult on business processes. Low-risk applications typically involve automating tasks now undertaken manually; the application vendor Kronos, for example, developed software that lets companies automate the work of data-entry clerks who type time-card data into accounting systems.
This application requires little change in the process; it automates a manual activity. Installing such applications normally involves no guarantees or new financing models because the risk for the customer is modest and the payback period short.
Outsourcers: Focus on costs
Outsourcers, too, are watching their traditional business model erode, as companies move to build in-house IT skills and pick apart bundled agreements. In response, outsourcers should think about how to preserve their margins by managing their engagement costs more carefully and lowering the cost of service delivery.
One of the most promising approaches may be to offer consolidation services, which help customers clean up their messy mix of applications--usually the result of undisciplined past customization.
And now more than ever, outsourcers must rebuild sales around a strategy that segments customers by their needs and takes account of their buying behavior. Although the most potent weapon an outsourcer has to boost its profits is an ability to compete at the lower pricing levels the market now expects, it is almost as important to match up-front business-development expenditures more closely to the size and scope of prospective deals. Large, complex ones may take 6 to 12 months to negotiate, pushing an outsourcing company's sales expenses into the seven figures.
Segmenting prospective clients according to their actual needs helps outsourcers identify those among them that will probably seek shorter or more narrowly focused contracts. For these customers, outsourcers can tailor their offers and limit their sales expenses appropriately. Though the use of such market intelligence may seem routine, many CIOs reported that their stated needs have been ignored by many providers that are submitting excessively ambitious proposals.
Our interviews suggest that the growth of business with large customers seeking fully integrated outsourcing deals is slowing down and may even have gone into reverse. Newcomers to outsourcing services lean toward shorter, narrower deals. Existing customers are intent on renegotiating their agreements. Certain CIOs also expressed some unwillingness to turn over their IT operations to outsiders, largely because they had been disappointed by the failure of outsourcers to improve productivity in the past.
Because of this desire for greater transparency and shorter contracts, some providers, such as EDS and Tigris, now offer to take responsibility for making specific performance improvements in existing systems and then turn them over to customers, typically in two years or less. This fee-based approach differs from a typical outsourcing contract, in which the provider assumes long-term responsibility for operating the whole IT function and guarantees certain results.
It seems to meet a demand for deals that improve existing operations in the near term, with no need to enter into the long-term operating arrangements the traditional approach requires. The benefit of the new approach for customers is that they retain control over their infrastructures and staffs, and can shape the scope of the contract.
As for the outsourcers, they should aim to preserve their profit margins by looking closely at ways to reduce their delivery costs. Customers have learned to cut the cost of operations before outsourcing them, so the margins of outsourcers will be under pressure regardless of the segment served or the scope of a contract.
To stay competitive during the operational phase, providers must deliver their services at cost levels customers can't match internally. Several CIOs we spoke with doubted that providers could do so unless they applied proprietary know-how or could offer facilities their customers lacked, such as large-scale data centers that maximize the use of computing power, data storage and operators.
It's cheaper offshore
For both integrators and outsourcers, keeping up with prevailing market prices for IT services means expanding offshore. Prices for typical systems-integration projects have dropped by 20 percent to 30 percent over the past 18 months and are likely to fall still further. One reason is that customers are getting more comfortable with offshore providers, which, given their low costs and high quality, constitute a serious threat to incumbent systems integrators. In fact, offshore competitors can already compete to install as much as half of all packaged software, and do four-fifths of the work of developing custom applications.
Onshore systems integrators have the advantage of personal familiarity with their client base. They are also closer at hand for work (such as installing hardware) that must be done on the customer's premises and for tasks (such as training in the use of new systems) that involve working with its employees.
But to remain both cost-competitive and profitable, onshore IT services companies will have to supplement their present delivery model by gaining access to offshore labor for those services that can be supplied remotely. To gain this access, they must intensify their efforts to build or expand offshore centers or, in the case of smaller providers, to develop partnerships with offshore companies.
North American and European outsourcing providers facing similar challenges are rushing to develop their own offshore capabilities or to team up with or acquire centers in low-cost countries. Some 80 percent of the work of applications management, for example, can now be performed remotely; and an offshore applications-management or help-desk center can improve an outsourcer's cost structure a good deal.
If the new generation of offshore outsourcing providers and systems integrators can succeed in building up its sales and service capabilities to compete with the onshore incumbents, it may well succeed in emerging as the group with the power to set prices across the whole IT services industry.
IT services providers face an upheaval: Demand is down, costs are too high, and customers are hiring IT staff more cheaply than they have in years. As customers increasingly call the shots and new offshore competitors emerge, incumbent providers may have no choice but to rewrite large parts of their business models.
For more insight, go to the McKinsey Quarterly Web site.
Copyright © 1992-2003 McKinsey & Company, Inc.