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Doing the dirty work

Despite the difficulties, there is money to be made running routine operations for other companies, according to McKinsey Quarterly.

The business of being a cog in another company's wheels might not be glamorous, but it can be lucrative. Third-party providers of routine operational services--such as the processing of payrolls, the movement of inventory and goods, the management of data centers, and the provision of extra manufacturing capacity--took in more than $1 trillion around the world in 2000, according to Dun & Bradstreet.

What is more, the market for these services doubled in size from 1997 to 2000. Analysts estimated that this eclectic sector, made up of companies that in essence take over activities other companies choose to outsource, would grow by 25 percent in 2001 and could experience similar growth in 2002.

What is propelling the expansion? In theory, providers of nuts-and-bolts services have long had a compelling pitch to make to the large and midsize companies that make up their customer base: "Why should you directly manage the routine operational activities that make up a substantial portion of any business? Overhead tasks such as billing and human resources, as well as supply chain processes such as procurement, manufacturing and logistics, are not an intrinsic part of your business; they are infrastructure activities. Let us manage them for you. As specialized providers of these tasks, we understand how to undertake them better than you can, and at lower cost."

Infraservice providers have entered the market in increasing numbers, and customers have become more accustomed to them. Before 1997, however, customers were more likely to nod their heads in agreement than to sign up. For one, they were wary of becoming hostage to providers for any activity they handed over--providers that might gradually raise prices and reduce service. For another, customers and providers alike found themselves saddled with interaction costs (such as managing the relationship, monitoring the delivery of services, and coordinating the exchange of information between customer and provider) that had not been anticipated and sometimes exceeded whatever value one or the other party had hoped to gain. And some providers couldn't deliver the promised efficiency or productivity improvement; either they were unable to exploit or even obtain economies of scale, or they couldn't streamline or transform the processes they managed. Ultimately, they did little that a customer couldn't do for itself.

But in the past few years, the realities of outsourcing have changed rapidly. The plummeting cost of communications, the widespread use of standard interfaces such as Web browsers, and the quickening pace at which companies are automating data have cut interaction costs sharply. Providers of infrastructure-management services, or "infraservice" providers, have entered the market in increasing numbers, and customers have become more accustomed to them. Providers and customers alike are learning how to structure deals to the benefit of both parties. Even so, we estimate that customers still manage in-house more than 90 percent of their routine operational services--an enormous opportunity for both start-up and established infraservice companies.

For every company that has met some success, however, several are languishing. Some, such as application service providers, have struggled from the outset, unable to turn commodity offerings into sustainable businesses. Even in more attractive segments, such as contract manufacturing, certain providers are failing to flourish.

Quite simply, providers succeed when they capture value that their customer base can't. They do so by carefully defining how much of a customer's process they will manage, by opting for fixed-price contracts when possible, and by minimizing the amount of customization they do. In the long run, the providers must realize not only economies of scale but also economies of skill--by codifying the process innovations developed while serving one customer so they can be used in work for other customers.

Creating value from scale and skill
Identifying opportunities to become an infraservice provider would seem to be fairly straightforward. Start by picking an operational activity. Specialists in payroll processing, for example, would typically handle this task for a number of companies, thus spreading fixed costs and achieving economies of scale. Because such specialists deliver only this service, they have the focus needed to identify areas that are susceptible to improvement and the knowledge needed to act successfully on that awareness (economies of skill). Any operational activity undertaken on a continuing basis would seem to be fair game: running call centers, managing warehouses, making meals served on airlines, and so on.

Some aspiring infraservice providers have failed to realize that unless they extend their innovations to a number of customers, their businesses will hit a wall. Some aspiring infraservice providers, though, have failed to realize that unless they extend their innovations to a number of customers, their businesses will hit a wall, for eventually individual customers are likely to bring the streamlined activity back in-house and to manage it just as effectively as a specialist could. Only economies of scale provided by a large client base and the economies of skill developed by confronting a variety of situations can enable specialists to maintain their advantage over their customers.

Moreover, infraservice firms and their customers are now more closely integrated than ever and are often in constant touch. Communications between the two must be transparent. For instance, infraservice firms and their customers may need to adopt technologies such as electronic data interchange or new Internet-based software that will allow the companies to transfer business information efficiently. Underestimating the cost of doing so can defeat the very logic of outsourcing.

Successful infraservice providers design their businesses knowing the answers to the following questions:

• How much of a customer's business will we take on?

• What pricing schemes will enable us to capture value from innovation and to limit interaction costs?

• How can the customer's demand for tailored service be reconciled with the infraservice provider's need to standardize?

Define boundaries to achieve scale economies
One pitfall for a company trying to determine what range of activities to offer lies in the fact that the boundaries of a potential infraservice business can be set almost anywhere. Such businesses must decide whether to carry out only a particular activity or to handle an entire function. To arrive at the right decision, an aspiring provider must, among other things, sort through its existing capabilities and assess the possibility of acquiring related skills.

Many of today's struggling infraservice providers have limited themselves to the precise task for which they had economies of scale at the outset. In doing so, these companies deprive their customers of the value that might have been gained had they offered to handle a larger portion of the function. Five years ago, for example, most providers of third-party information technology services managed only a sliver of the overall IT needs of a large business: data center management, applications development, network services, or the help desk. The customer gained some value but would have realized still more had a single innovative provider taken on the entire IT function. Moreover, any customer that contracted with different companies for a number of IT services incurred the incremental cost of managing the provider of each of them, while each provider incurred the cost of coordinating its activities with those of the other providers.

Infraservice firms that have defined their boundaries too narrowly can also constrain innovation. Some logistics firms, for instance, provide nonmanagement personnel for their customers' warehouses. But because such logistics firms have so little control over the way the warehouse as a whole runs, they cannot adequately distinguish the job that they do from the job that their customers did.

In most instances, service providers would be better off defining the boundaries more broadly, at the level of a process. Price to capture value
Price structures influence not only the incentives for both parties but also their interaction costs and the provider's future negotiating position.

The two most common pricing choices--costs plus and gain sharing--have more often destroyed value than created it. With costs-plus contracts, providers lack any incentive to reduce costs. Customers sometimes believe that such contracts will save them money by capping the provider's margins. But costs-plus contracts also limit the incentive of the provider to squeeze costs, because they guarantee it a profit margin that no longer depends on the efficiencies it can realize by innovating, by exercising its purchasing power, or by hiring more productive staff.

Price structures influence not only the incentives for both parties but also their interaction costs and the provider's future negotiating position. A gain-sharing contract better motivates the provider to innovate and to reduce operating costs, but it also raises interaction costs. This is the most expensive kind of contract to negotiate and monitor because the parties have to define and accept precise cost projections for every situation. Further negotiations, in which each party blames the other, are almost inevitable when the savings are lower than expected. The incentives to innovate are limited, too. Customers of one leading facility-management firm scrapped or modified gain-sharing contracts that had yet to expire because the infraservice provider, having reduced costs "too much," was reaping too large a windfall.

Fixed-price contracts are a better option. When prices are fixed, providers keep the rewards from process innovation. Fixed-price contracts are also less costly to negotiate and do not require customers to be continually auditing their providers' expenses, as they must under costs-plus and gain-sharing contracts. But this form of pricing, too, has its hazards, chief among them the difficulty of developing a strong understanding of the actual costs.

Decisions about which pricing models to adopt are tightly linked to decisions about where to set the boundaries of the infraservice firm. Fixed-price structures succeed only if the firm has decided on service boundaries that are wide enough to give it control of overall costs, for example.

While providers should try to negotiate fixed-price contracts for their services, they must recognize that in all likelihood they will have to adopt different pricing schemes for different services. The choice of pricing scheme will depend on the receptiveness of the customer and the underlying economics of the offering.

Modularize customization
Customization undermines economies of scale. To win business in a competitive market, Corio, an application service provider, bowed to its customers' demands for a high degree of customization. The further Corio went in that direction, the faster it saw its economies of scale disappear.

Decisions about which pricing models to adopt are tightly linked to decisions about where to set the boundaries of the infraservice firm. But providers can rarely maintain a strict no-customization policy. Exceptions include Sabre, which has standardized its airline reservation systems for travel agents, and Automated Data Processing, which has sufficient market power to resist the requests of its clients, mostly midsize companies, for a custom Web-based payroll offering. Successful infraservice firms can strike a balance by offering "standardized customization," or a modular set of services.

As more of the routine operational activities of a company become automated, the task of turning them over to third-party providers becomes easier and more economical. Meanwhile, the reduction of business processes to digital form brings the company and its providers closer together, further reducing costs.

If digitization means lower interaction costs and thus makes outsourcing more feasible economically, the plethora of firms that rush into the resulting competitive market will badly need some way to differentiate themselves once their scale-efficient services have become commodities. Some are already moving in this direction. A few contract manufacturers and logistics providers are maneuvering to control a bigger piece of their customers' supply chains, a step that will require them to be innovative managers of inventory and information and to change their customers' underlying supply-chain processes.

Today many infraservice providers can improve a particular customer's routine processes but face difficulties in codifying the lessons learned from serving one customer and then applying them to serve others. (Sometimes the problem is that separate management teams handle each large customer account.) In time, the kind of codification and general application that builds scale will become easier to achieve, causing more attention to be paid to economies of skill--that is, to the improvement of processes and the exploitation of insights.

Economies of skill will open opportunities for incumbent companies to launch infraservice businesses that use the knowledge and information that have been acquired from one business to create value in a new and seemingly unrelated one. A pure-play credit card company could create an information-based direct-marketing business to take the place of the in-house marketing departments of other businesses, for example.

While the new infraservice businesses are likely to be more knowledge based and less asset intensive than those that are already in operation, the infraservice businesses of the future can learn from their predecessors and avoid the snares that await them. Piloted correctly, these new companies could take their place among the great growth engines of the next decade.

For more insight, go to the McKinsey Quarterly Web site.

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