Why corporations outsource

From Knowledge@Wharton
Special to CNET News.com
October 18, 2003, 6:00 AM PT

As global supply chains of information are forged, what impact will they have on corporations?

Knowledge@Wharton discussed this issue with Peter Bendor-Samuel, founder and CEO of Everest Group, a consulting firm in Dallas; and Michael Quinn, president of Strategic Management Solutions. Until recently, Quinn was a senior vice president at Citigroup, responsible for e-business global customer service.

Q: Why do firms really outsource processes?
A: Quinn: The majority of firms I have spoken with about outsourcing are primarily looking at cost savings, though when you discuss the issue in more detail with them, you often find that they are trying to solve a problem within that process. These problems are typically quality- or productivity-related.

Bendor-Samuel: To save money. Most of our clients who are seeking to leverage labor arbitrage are looking to achieve total process savings between 35 percent and 70 percent. This is much higher than traditional outsourcing arrangements in which the cost savings often were in the range of 15 percent to 25 percent.

What are the principal benefits from outsourcing these firms experience?
Quinn: In outsourcing efforts for which I was directly responsible, our goal was to improve the quality of the output of the process. In each case, we believed that we were not meeting our customers' expectations and needed to radically redesign the process. We created a new iSixSigma quality process in the offshore center and then directed new transactions to the center while "sending" management work through the remaining transactions. We were able to deliver quality of execution due to our focus on standards, and we gained the benefit of reduced costs as well.

Bendor-Samuel: We typically expect to see some combination of the above benefits with most clients: immediate cost savings with an initial improvement in the intrinsic quality of service, followed by a gradual improvement in business and strategic impact. Improvement in strategic impact is the rarest benefit--and the most difficult to achieve. However, where the potential exists, it can quickly become the key driving force behind the decision to outsource.

Is there a possibility that some important functions can get outsourced? Could this result in an erosion of organizational competence? How do you rate this danger?
Quinn: It is highly unlikely that an important function would be outsourced, if there was an outsourcing strategy developed, and all functions were evaluated in light of that strategy. Using a strategic approach, identification of key functions that provide the firm with competitive advantage would not be considered for outsourcing. However, there is a risk of this happening if only one criterion--such as cost--is used to evaluate the functions that are candidates for outsourcing.

I can't think of a single outsourced process I have seen that our client doesn't think is important.

If an important function that was crucial to the firm's competitive advantage were outsourced, it could over time reduce the organization's competence, if the quality execution of the function by the third party is not at or above the level the firm performs. That would hurt the firm's reputation. Secondly, if execution is maintained at the required levels, competence could still be eroded, if the output of the function is critical to future product development or market distinction.

If, because of outsourcing, the function the market feedback "loop" is broken, the firm risks no longer innovating and increasing the effectiveness of its products. However, I rate this danger as low, if firms evaluate all their functions before beginning to outsource.

Bendor-Samuel: I can't think of a single outsourced process I have seen that our client doesn't think is important. However, almost universally, our clients do not consider them to be core processes that differentiate them in the market. This is a key point. It is hard to imagine a process such as transaction processing, finance and administration (F&A) or human resources (HR) as not critical and important, yet they are clearly not core and are increasingly being outsourced.

Almost without exception, the thoughtful divesting of noncore processes improves organizational competence, because the firm can now focus on processes and issues that are in fact core. Doing so improves its competitive position and competences.

Companies that outsource in haste or without sufficient consideration of change management and governance issues may have to spend unnecessary time and resources to implement or reimplement these functions. In these cases, outsourcing sets back an organization temporarily. Given a thoughtful outsourcing approach with a realistic time frame and the appropriate resources, we find that it is extremely rare for the firm to experience any erosion in capability. In cases in which companies make mistakes, we find that these setbacks are short-term and can be rectified--though at considerable expense.

These days, some three-quarters of the processes off-shored by volume are going to India. What other regions do you see playing a role in the next two to three years? What kinds of processes may migrate to these?
Quinn: The Philippines, China, Hungary, the Czech Republic (Eastern Europe in general), Canada and Mexico. The Philippines are very competitive in call-center services and accounting functions. China has broad Asian language skills and a large labor pool for data entry and maintenance functions. Hungary and the Czech Republic have highly educated people, strong language skills to support Western Europe and a growing technical skill base.

Canada has the English language skills, an educated labor force and service capabilities for incoming and outgoing call centers while being considered "lowest-risk." Mexico has an increasing base of educated, technical labor and language skills to cover most of Latin America. India still has the best mix of breadth and depth of labor with strong English-language skills and extremely well-educated people.

We do not expect any other nation to seriously challenge India for U.S.-based business over the next two years.

Bendor-Samuel: Clearly at this time, India has the largest capability for English speaking labor arbitrage and has the most significant momentum with organic in-country firms. We do not expect any other nation to seriously challenge India for U.S.-based business over the next two years.

For Europe, we expect Eastern European nations to emerge as the destinations of choice--though at a higher cost point to India. We also expect the nascent markets in South America and South Africa, along with additional markets in Asia such as the Philippines and China, to emerge. However, given the growth in this market, it is unclear that they will have a significant market share impact.

We believe that the most significant development in offshore outsourcing will be the growth of large, sustainable business processes such as claims processing, back-office functions such as F&A and HR, and application support. We expect BPO (business processing outsourcing) to overtake the current information technology-focused, projects-oriented work.

The right governance structure is an issue C-level executives wrestle with all the time. When would you recommend a company to consider an outsourcing option as opposed to migrating to a captive center? Why? What other governance forms--joint ventures, build-operate-transfer (BOT) models--would you consider?
Quinn: From my perspective, an outsourcing option is more viable than a captive center, when there are established competencies that are superior to what is available in a captive. There is no reason to "reinvent the wheel," if an established provider can deliver against your requirements. Of course, that provider has to meet your requirements for financial stability and viability, critical mass, a proven track record of superior performance and cost-effective delivery.

Geographic availability may also make an outsourcing option more viable. If the firm has no presence or infrastructure in a region and has a need for immediate capabilities in that region, an outsourcing service provider may be the path of least resistance. So long as a provider meets these criteria, it may not be cost-effective to invest in establishing a legal vehicle and related infrastructure in every region in which you choose to do business. In either case, if the volume of activity that needs to be supported is significantly greater than the outsourcer's reasonable capacity, a captive center becomes more attractive.

The BOT model is very appealing to a firm that would like to have a captive center but lacks the critical mass or physical presence outside its home territory. Establishing a relationship with a proven provider that has the infrastructure, people and expertise, and migrating functions over time serves the firm well, as they get the benefits of outsourcing without the immediate capital investment necessary to launch a de novo site.

It would take a midsize financial institution up to three years to migrate the processes and functions best-suited for outsourcing, so they can "rent" the capability while they build scale. The BOT model works best for all parties, if it is at least three to five years in duration.

Bendor-Samuel: Where our clients have sufficient size and scope to allow them to deal adequately with these advantages of the outsource providers, and where they have adequate sophistication and resolve to stay the course, captive solutions can be an attractive option. A captive strategy is also appropriate when the process that's moved offshore is deemed core or critical enough that it requires the company to maintain control.

Joint ventures and other partnership structures are the most difficult to govern. Given their inherent difficulties, we feel there are more sustainable and productive governance structures to utilize.

What industries or functions do you expect to see outsourced or migrated in the near future?
Quinn: As it is the area with which I am most familiar, I see a lot of interest in the financial services industry (broadly defined as banking, investment banking, asset management, insurance, consumer finance, credit cards). While last spring, investment bankers were not interested in exploring outsourcing, they are now leading frenetic activity in the area. Insurance providers are probably still lagging their industry colleagues, but I expect more action in that sector during the next 12 to 18 months.

Where last spring investment bankers were not interested in exploring outsourcing, they are now leading frenetic activity in the area.

Call center activity is becoming almost a commodity, and there is an expectation that whoever is considering outsourcing is first targeting some aspects of their call centers. Other service activities, such as account opening and maintenance, fulfillment and inquiry resolution, are also gaining momentum.

We have already seen domestically, and now internationally, various HR functions and basic accounting (payables, receivables, expense reporting) being outsourced. Now, we are seeing more complex and time-sensitive accounting functions (legal reporting, intraday reconcilements, fund accounting) being teed up for possible migration.

Along with those activities, a number of transaction processing support activities that require near real-time response are also being considered. Even paper-intensive, highly controlled processes such as mortgage origination, booking and maintenance have been completely outsourced by the leaders. Higher up the value chain are various analytic functions from risk management and control to equity research.

Firms are becoming increasingly comfortable with the concept of outsourcing and, as they are successful in migrating simple functions, they begin to understand the "power" of rethinking their processes. Technology continues to become faster and cheaper, providing virtual real-time access across thousands of miles. Competitive pressures are starting to become evident as well. Second-tier financial institutions are seeing the quality and cost improvements being achieved by their more advanced competitors. Outsource suppliers are becoming more mature and increasingly are providing creative input into process improvement.

Bendor-Samuel: As you look at the power and sustainability of the offshore model, it is hard to imagine that companies will not seek to exploit its benefits in a more systematic and sustainable manner. A simple analysis of the work companies can send offshore illustrates vividly its wide applicability.

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