Global outsourcing of back office services: lessons, trends, and enduring challenges
The Authors
Mary C. Lacity, University of Missouri-St Louis, St Louis, Missouri, USA
Leslie P. Willcocks, Information Systems and Innovation Group, London School of Economics, London, UK
Joseph W. Rottman, University of Missouri-St Louis, St Louis, Missouri, USA
Abstract
Purpose – To identify key lessons, trends and enduring challenges with global outsourcing of back office services.
Design/methodology/approach – The authors extract lessons, project trends, and discuss enduring challenges from a 20 year research program conducted by these authors and their extended network of co-authors and colleagues.
Findings – The authors identify seven important lessons for successfully exploiting the maturing Information Technology Outsourcing (ITO) and Business Process Outsourcing (BPO) markets. The lessons require back office executives to build significant internal capabilities and processes to manage global outsourcing. The authors predict 13 trends about the size and growth of ITO and BPO markets, about suppliers located around the world, and about particular sourcing models including application service provision, insourcing, nearshoring, rural sourcing, knowledge process outsourcing, freelance outsourcing, and captive centers. The authors identify five persistent, prickly issues on global outsourcing pertaining to back office alignment, client and supplier incentives, knowledge transfer, knowledge retention, and sustainability of outsourcing relationships.
Originality/value – The authors present some experimental innovations to address these issues.
Article Type:
General review
Keyword(s):
Outsourcing; International business.
Journal:
Strategic Outsourcing: An International Journal
Volume:
1
Number:
1
Year:
2008
pp:
13-34
Copyright ©
Emerald Group Publishing Limited
ISSN:
1753-8297
Introduction
In recent times, executives in charge of “back office” functions such as human resources, information technology, indirect procurement, finance, and accounting have been advised to adopt “front office” mentalities by operating their functions as a business within a business. Companies such as BAE Systems, General Electric, Lloyds of London, Procter & Gamble, and Reuters have successfully transformed their back offices by creating shared services, charging internal users for services, establishing service levels, and implementing self-service portals. Some organizations such as BAE Systems and Lloyds of London used outsourcing to help with the transformation. Other companies like Procter & Gamble and Reuters engaged outsourcing suppliers after the transformation was done in-house. Either way, the maturing Information Technology Outsourcing (ITO) and Business Process Outsourcing (BPO) markets offer back office executives tremendous opportunities to drive business value. But there are a dizzying set of evolving choices in terms of suppliers, sourcing locations, service offerings, and models of engagement. Back office executives must conquer a significant learning curve and build key in-house capabilities in order to successfully exploit outsourcing opportunities.
In this paper, we summarize seven of the most important lessons from our 20 year research program on the management and outsourcing of back office services. These lessons point to a considerable number of foundational practices that back office executives need to master in order to fully exploit opportunities in the ITO and BPO markets. We then identify 13 global sourcing trends based on substantial data from our own case studies and surveys as well as from secondary resources. We believe managers need to consider the implications of these emerging trends for their own back office services. Based on our early work, we know that experimentation is an important avenue of organizational learning and ultimately competitive advantage. Early adopters who leapt on emerging trends tended to extract more strategic benefits from global outsourcing because they became prestige accounts for ambitious suppliers and because they conquered the learning curve ahead of their competitors. (Alternatively, laggards benefited from waiting because they learned from the early adopters' many explicit mistakes, but they still could not completely bypass the experiential learning required to gain tacit knowing. In addition, laggards had more trouble gaining a supplier's attention.) Regardless of how back office executives choose to react (or not react) to these trends, it is important to understand them.
The paper concludes with five enduring challenges. In the 20 years we have been studying global outsourcing, clients and suppliers have expressed some persistent complaints about themselves, the industry, and each other. We present some experimental innovations to address these challenges, but more pioneers are needed to explore innovations in contracting, services, and relationship management. We anticipate that the Strategic Outsourcing: an International Journal will serve as a major forum in this regard.
Our research base
Our initial research projects focused on IT outsourcing. Since 1988, we have interviewed over 1,000 client and supplier stakeholders in nearly 300 companies in North America, Europe, and Australia and conducted four large-scale sample surveys. Our primary co-authors were David Feeny, Rudy Hirschheim, Thomas Kern, Sara Cullen, Peter Seddon, Eric Van Heck, John Hindle, and Guy Fitzgerald. In 2000, Lacity, Feeny, and Willcocks began to study BPO based on 70 interviews. We studied companies that outsourced business processes from human resources, policy administration, claims settlement, and indirect procurement (see Lacity et al., 2003; Feeny et al., 2005). In 2003, we began studying offshore outsourcing, primarily to Asian suppliers. Rottman and Lacity interviewed 238 people, including 53 supplier employees in India and 34 in China (Lacity and Rottman, 2008). Ilan Oshri, Julia Kotlarsky, and Leslie Willcocks also began a large research project on offshore outsourcing. So far, they have interviewed 150 executives in Mumbai, Guraon, Bangalore, Amsterdam, San Paulo, Zurich, and Luxemburg (Oshri et al., 2007).
Combined, this work forms a research base of over 500 companies on five continents. The research base covers all major economic sectors including chemical, defence/aerospace, energy, financial services, health care, manufacturing, IT services, retail, telecoms, transportation, and utilities. We have also studied central, state, and local governments. The sample includes client and supplier organizations of all sizes, ranging from start-up ventures to the world's largest multi-nationals. Most importantly, we have tracked many of our cases over the life of their outsourcing contracts, thus we have unique insights into clients' and suppliers' a prior expectations juxtaposed to actual outcomes.
We and other researchers have studied the proven practices to realize expected benefits. Overall, we know that client readiness, good strategy, rigorous processes, sound contracts, and good relationship management are the key success factors (Aubert et al., 1999; Choudhury and Sabherwal, 2003; Cullen et al., 2005; Dibbern et al., 2004; DiRomualdo and Gurbaxani, 1998; Feeny and Willcocks, 1998; Gopal et al., 2003; Henderson, 1990; Lacity and Willcocks, 1998; Levina and Ross, 2003; Teng et al., 1995). We know that clients must assure that suppliers earn a reasonable profit to avoid the winner's curse (Kern et al., 2002). Another vital factor is the people who execute these practices. On the client side, successful global sourcing requires people who can emancipate themselves from the back office silo mentality to envision and enact agile sourcing networks. On the supplier side, successful global sourcing requires people who can emancipate themselves from the sales role to become brutally honest about what can realistically be achieved (Willcocks and Lacity, 2006). Overall, we know that global outsourcing can deliver on its promises, but only if both clients and suppliers diligently manage the details.
Lessons from our research base
In this section, we share the most important lessons learned from our research base. The first few lessons require clients to first get their back offices in order before exploiting external market opportunities. The next set of lessons address practices to ensure that outsourcing expectations are realized. Each lesson requires a significant level of detail that we cannot adequately cover in a summary. Therefore, we have pointed to our other publications as a source for more in-depth discussion.
Lesson 1: manage the back office as a business
As noted above, back office executives have increasingly begun to manage back offices as a “business within a business.” For example, the IT infrastructure library framework has been widely adopted to transform internal IT functions into IT-enabled business services. A key concept here is that the organization's internal users are transformed into educated customers. Whereas users consume resources with little thought to costs, educated customers make informed choices about service levels, functionality and costs they incur. The identification and negotiation of internal service levels is an important practice to aid the transformation. Once complete, the shift from users to customers considerably empowers the back office executives to more meaningfully contribute to business objectives. Rather than responding to a user's request with, “I am sorry, it is not in my budget,” the back office executive works with the customer to consider the business value versus costs of customer requests.
External sourcing is another important part of running a back office as a business. Sound sourcing strategies begin with the assumption that any back office should be treated as a portfolio of activities and capabilities. Some of these activities must be insourced to ensure current and future business advantage and flexibility, while others may be safely outsourced.
Lesson 2: identify core capabilities for insourcing
Given that back offices should be treated as a portfolio, the next question is, “Which parts of the portfolio should be outsourced or insourced?” While common wisdom tells managers to insource core capabilities and to outsource non-core capabilities, the distinction is not very useful. A richer distinction is offered by Feeny and Willcocks (1998). They initially identified nine specific capabilities to keep in-house for IT functions. Their work has been cited hundreds of times and adopted by many large organizations. Their capabilities model was later extended to nine specific capabilities to keep in house for any back office function (Willcocks and Feeny, 2006) (Table I). These capabilities include leadership, business systems thinking, internal customer relationship building, architecture design, informed buying, contract facilitation, contract monitoring, and supplier development. They also identified that all back offices need to keep a team of “process doers” to troubleshoot issues, to scrutinize supplier activities and proposals, and to understand emerging innovations.
Lesson 3: best source non-core capabilities
Once the nine core capabilities are in place, it does not automatically mean that the remaining non-core capabilities should be outsourced. We found that clients who considered additional business, economic, and technical factors of non-core capabilities were most frequently satisfied with their sourcing decisions. Business factors consider a back office activity's contribution to competitive positioning and business operations. While very few back office activities serve to differentiate an organization's competitive positioning in the eyes of external customers, many activities may be crucial to effective and efficient business operations. Organizations can only outsource these activities with very close attention and care. Economic factors consider whether suppliers can truly perform the back office activity cheaper than in-house provision. We found that sound management practices like standardization were more important than economies of scale in keeping costs low. Many back offices will have more capabilities than the nine core capabilities identified above because suppliers cannot deliver the services cheaper than in-house provision. Finally, technical considerations include the degree to which the back office activity is integrated with other in-house activities. The ability to unbundle an activity for outsourcing is not always possible. For example, it may be difficult to outsource human resource activities when the HR data is highly integrated with other applications. For a full discussion of the strategic sourcing framework, see Lacity and Willcocks (2001).
Lesson 4: align the outsourcing strategy with the business strategy
Most advisors state that back office executives must align the sourcing strategy with the business strategy. But what exactly does this mean? One of the first steps is to understand how the external services market can help achieve business benefits. Overall, we identified 13 benefits (see Figure 1). Global outsourcing of back office services produces benefits ranging from operational improvements in back office costs to strategic commercialization by partnering with suppliers. In most instances, clients we interviewed achieved the first five benefits – lower operating costs, improvement in services, tighter controls, access to supplier resources, and capabilities, and increased flexibility by ramping staff up and down to match fluctuating demand. Among our cases, less than a dozen companies – such as BAE and Lloyd's of London – achieved more strategic benefits from outsourcing by creating and commercializing global shared services (see Lacity et al., 2003, 2004). See Lacity et al. (1994) for a more thorough discussion of expected benefits.
To illustrate sourcing-business alignment, we offer some examples from our IT offshore outsourcing cases. When considering an offshore destination for IT work, some CIOs did not just consider the best location from an IT perspective in terms of IT costs and IT services. Instead, these CIOs intelligently asked, “Does the business have or want to have a significant presence in this country?” The CIO from one aerospace company selected Malaysia as their IT offshore destination because his company is selling planes to that country's government. The Malaysian government requires that some of the manufacturing be done in Malaysia and the IT presence helped to meet that business requirement. Another CIO from a hardware company selected China because he knew his company wanted to sell their products there. One US CIO chose Canada because he wanted suppliers in close physical proximity to their external customers for rapid deployment. See Lacity and Rottman (2008) for more examples of sourcing-strategy alignment.
Whereas this lesson focuses on identifying what an organization can achieve with external sourcing, the next lessons focus on how to realize those benefits.
Lesson 5: follow a rigorous outsourcing process
Each of the nine core back office capabilities listed in Lesson 2 requires a significant number of specific competencies. Here we outline the specific competencies required for the four capabilities that deal with external sourcing – informed buying, contract facilitation, contract monitoring, and supplier development. Cullen et al. (2005) specifically identified 54 key activities that must be performed to ensure that outsourcing expectations are realized (see Figure 2). The important notion here is that these four external sourcing capabilities entail vigorous management of external suppliers through the entire sourcing life cycle. Furthermore, each of these 54 key activities requires yet another layer of detailed management. For example, we found that the “evaluate supplier” activity requires informed buyers to assess 12 supplier capabilities, including supplier leadership, program management, contracting, business management, governance, domain expertise, behavior management of supplier staff, technology exploitation, business process re-engineering, customer development, organizational interface design, and resource management (Feeny et al., 2005).
Lesson 6: design and manage an outsourcing portfolio
Just as the back office provides a portfolio of services to internal customers, relationships with suppliers comprise a rich and diverse portfolio. There are three main issues here – governance, number of suppliers, and appropriate engagement models.
Most of our client organizations erected a program management office (PMO) to manage the outsourcing portfolio. Our research found that a strong PMO significantly contributes to the success of outsourcing. Unfortunately, many PMOs we studied were woefully understaffed. Consequently, project managers were often forced to assume many of these roles, which overwhelmed them and distracted them from their other duties. However, in mature organizations, PMOs were fully staffed and provided critical capabilities to ensure success. We found that mature PMOs fulfilled 15 roles: evaluate sourcing locations, assess supplier capabilities, help to negotiate contracts, select engagement models, prepare the infrastructure, identify training needs for internal staff and supplier staff, design structural interfaces, design organizational processes, develop and monitor comprehensive metrics, authorize supplier invoices, resolve issues and conflicts, work with business units, diversify the supplier portfolio, monitor sourcing trends, gather and disseminate learning and best practices. These PMO roles are fully described in Lacity and Rottman (2008).
Concerning the number of suppliers, prior research has found that outsourcing to a single supplier, particularly under circumstances of high asset specificity, is riskier than using multiple suppliers. However, multi-sourcing creates higher transaction costs than outsourcing to a single supplier and too many suppliers means that each individual contract may be too small to successfully attract and excite good suppliers. Many clients have found that sourcing a particular activity to two preferred suppliers is sufficient to keep suppliers' prices competitive and work quality high. For example, one US retailer retains two offshore suppliers who compete for new IT development projects. Because the total contracts are worth $4 million per year, both suppliers are motivated to remain active partners in the relationship.
Concerning the types of engagement models, we have identified nine commonly used models (see Table II). The key learning point is that an engagement model must fit not only with the type of work, but must also match the client's capabilities and the supplier's capabilities. For example, clients can only successfully engage suppliers on turnkey projects when clients have mature processes for defining and freezing requirements and suppliers have mature project management processes. More detailed understanding of these models is found in Lacity and Rottman (2008) and Willcocks and Lacity (2006).
Lesson 7: plan learning
Thus far, we have highlighted the learning based on the experiences of many client organizations. However, executives can only learn so much through the vicarious experiences of others. Each organization cannot fully bypass the learning curve based on explicit practices identified from other organizations – there is no substitute for the tacit knowing that comes from actual experiences. Any organization that explores a new sourcing option in terms of new suppliers, new services, or new engagement models with existing suppliers, must plan on false starts and many mistakes. Executives often manage learning by pilot testing new sourcing options. This is a risk mitigating practice, but we also note that when pilot tests are too small, the learning is slow, supplier capabilities are not fully tested, and expected benefits are not often realized. We believe that this finding is attributable to (1) transaction costs and (2) supplier attention.
Concerning transaction costs, outsourcing has considerable transition costs associated with supplier search, negotiation, coordination, management, and communication. In order to achieve total cost savings, for example, the volume of work has to be large enough to compensate for the additional transaction costs. Of course, large commitments to suppliers must be made cautiously, but the lesson may be that client managers should not expect significant cost savings while they are still conducting pilot projects and getting to know their suppliers. Concerning supplier attention, executives may not be able to attract the best suppliers or receive the supplier's best resources if initial pilot projects are too small. Suppliers must be confident that success on a pilot project will likely lead to a significantly sized contract. The question we are most frequently asked is “how big should pilot projects be?” A reasonable heuristic from our data is that pilot projects had to be worth at least $200,000 with the sincere possibility of future contracts worth $10 million annually to excite the large global suppliers. Small start-up suppliers were often interested in pilots worth $50,000 with the possibility of future contracts worth $250,000 annually.
In the next section, we identify 13 global outsourcing trends. In reviewing the past, we are able to confidently project the trends based on the substantial evidence from our case companies. For example, in 1998 large billion dollar outsourcing deals – like DuPont's $4 billion deal with CSC and Andersen Consulting – were dominating headlines, but we predicted that contracts would get smaller, not larger. Our prediction was based on a sample of 61 cases at the time. We showed that large contracts only had a 29 per cent success rate compared to smaller contracts that had an 85 per cent success rate (Lacity and Willcocks, 1998). Indeed, our predicted trend continues today (see trend number 2 below).
Trends 2008-2012
In this section, we make two predictions about the size and growth of ITO and BPO markets, three predictions about suppliers located around the world, and seven predictions about particular sourcing models including application service provision (ASP), insourcing, nearshoring, rural sourcing, knowledge process outsourcing (KPO), freelance outsourcing, and captive centers. Our final trend predicts that despite the immense learning about global outsourcing, many individual organizations will still experience disappointments because of the risks, learning curves, and detailed practices required to realize expectations.
Trend 1: spending will continue to rise in all global sourcing markets, but BPO will overtake ITO
The global IT outsourcing (ITO) market has increased each year since we have been tracking it. Back in 1989, global ITO was only a $9-$12 billion market (Krass, 1990; Lacity and Hirschheim, 1993). In 2007, the global ITO market is estimated to be between a $200 and $250 billion market (Balackmore et al., 2005; Willcocks and Lacity, 2006). The BPO market is currently less than the ITO market, but growing at a faster rate. We estimate that the market for mainstream BPO expenditure is likely to grow worldwide by 10-20 per cent a year from $140 billion in 2005 to potentially $350 billion by 2010. BPO expenditure will be in areas such as the human resource function, procurement, back office administration, call centers, legal, finance and accounting, customer facing operations, and asset management.
BPO is outpacing ITO because many executives recognize that they under-manage their back offices, and do not wish to invest in back office innovations. Suppliers are rapidly building capabilities to reap the benefits from improving inefficient processes and functions. IT provides major underpinning for, and payoff from, reformed business processes. Thus, many of the BPO deals will swallow much of the back office IT systems. This is also evidenced by the shift in strategy of traditional IT suppliers like IBM, HP, and EDS to provide more business process services. Suppliers will increasingly replace clients' disparate back office IT systems with web-enabled, self-serve portals.
There have been some high profile backsourcing (returning services in-house) cases in recent years, for example Sears (1997), The Bank of Scotland (2002), JP Morgan Chase (2004), and Sainsbury (2005). Although media-worthy, these cases have never represented a dominant trend towards backsourcing. Based on our case studies and surveys, the most popular course of action at the end of a contract will continue to be contract renewal with the incumbent supplier. We also estimate that a quarter will be re-tendered and awarded to new suppliers, and only a tenth back-sourced. However a frequent occurrence within deals will continue to be “adjustment sourcing”. With adjustment sourcing, clients take back or further outsource specific tasks, people or processes as a result of learning and changing circumstances.
Trend 2: the ITO and BPO outsourcing markets will continue to grow through multi-sourcing
Although ITO and BPO spend is increasing, the average size of individual contracts and the duration of contracts is decreasing. For example, the Everest Group found that among the ITO contracts signed in 1998, 24 per cent of contracts were worth more than $400 million and 33 per cent of contracts were worth between $50 and $100 million. In 2005, only 11 per cent of contracts were worth more than $400 million, and 57 per cent of contracts were worth between $50 and $100 million. Concerning contract duration, the Everest Group found that 37 per cent of contracts signed in 1998 were more than nine years in duration compared to 18 per cent in 2005 (Tisnovsky, 2006).
How can we reconcile smaller, shorter deals with an overall increase in the ITO/BPO markets? All these figures suggest that client organizations are actively pursuing more multi-sourcing. Multi-sourcing has always been the dominant practice and the overall growth is driven by client organizations signing more contracts with more suppliers. While multi-sourcing helps clients access best-of-breed suppliers and mitigates the risks of reliance on a single supplier, it also means increased transaction costs as clients manage more suppliers. Multi-sourcing also means that suppliers incur more transaction costs – suppliers must bid more frequently because contracts are shorter, suppliers face more competition because smaller-sized deals means that more suppliers qualify to bid, and suppliers need to attract more customers in order to meet growth targets.
Trend 3: global clients will stop viewing India primarily as a destination to lower costs, but rather as a destination for excellence
Within our case studies, we saw considerable evidence that US clients initially engaged Indian suppliers to provide technical services such as programming and platform upgrades. But as these relationships matured, US clients assigned more challenging work to Indian suppliers. For example, a US retailer first engaged their Indian supplier to help with Y2K compliance. As the relationship matured, the retailer assigned development and support tasks for critical business applications to the supplier. From this retailer and other satisfied clients we heard, “We went to India for lower costs, but we stayed for quality”.
From the supplier perspective, the interviews we conducted with young Indian professionals found that the main determinant of their job satisfaction was interesting work (Lacity et al., 2008). These Indians were eager to develop new software for clients, to learn new skill sets, to work on emerging technologies, and to manage other people. They complained about performing monotonous maintenance on a client's existing applications and merely coding and testing programs from predefined specifications – the bulk of what many Western clients send offshore. Moreover, the extent to which the Indian professionals were satisfied with their jobs, determined their intentions to remain with their current employer. Thus, interesting work is the key to preventing high turnover among Indian professionals.
Supplier executives we interviewed from three of the large Indian suppliers all mentioned their desire to assume higher-value tasks for their clients, like research and development. According to a Vice President from one of the largest Indian suppliers:
Our customers are beginning to come to us for entire turnkey solutions and research. I think Indian firms have had the long standing reputation as being able to “automate, not innovate”. Our relationships are moving towards more partnerships and away from strictly staff augmentation.Trend 4: China's investment in ITO/BPO services signals promise, but Western clients are still wary
Within China's ITO and BPO markets, China invested $142.3 billion in information and communication technologies (ICT) in 2006 (Lacity and Rottman, 2008). China hopes that its huge investment in ICT will pay off in terms of its ability to compete globally in the offshore services market. Although Rottman's 2007 trip to China confirms that China's service offering are currently immature, China's long term ITO/BPO future is expected to be strong. For example, The Everest Group estimated that the Chinese offshore services market was only $2 billion in 2006, but it predicts that China's market will grow 38 per cent annually to reach $7 billion by 2010 (Bahl et al., 2007).
So far, the main ITO/BPO suppliers in China are either large US-based suppliers like Accenture, Cap Gemini, Dell, EDS, HP, and IBM, or large Indian-based suppliers like Genpact, Infosys, Satyam, and TCS. Like Indian suppliers, many Chinese suppliers do not want to compete solely on low-level technical skills. Chinese suppliers are trying to show they can fill the needs for product development, systems design and consulting services. According to the CTO of China-based Neusoft, “China has become the leading offshore destination for product development, with 41 per cent of the Chinese offshore work being done in product research and development. The $2.5 billion investment by Intel in a chip manufacturing plant in Dalian, also signals that China may be moving up in the value chain for engineering services.”
Despite the optimism, many of our Western client organizations are wary of China's ITO and BPO services. Only four US companies in our research base have established IT captive centers in China. Language barriers, cultural barriers, and fears over losing (IP) remain significant obstacles for the companies we talked to in North America and Western Europe. The Chinese government and Chinese business sectors are well aware of these barriers and are actively seeking ways to address them. For example, the Chinese government is investing $5 billion in English-language training to target the ITO/BPO markets.
Trend 5: developing countries beyond India and China will become important players in the global business and IT services market
In addition to India and China, suppliers from all six continents will develop centers of excellence. In the US, the recent passage of Central American Free Trade Agreement, will further open up ITO and BPO opportunities in Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua, and the Dominican Republic. In March 2005, CIO Insight Magazine listed Costa Rica as the third best offshore IT destination based on an overall index of costs and risks. Many US clients already use Central American suppliers for Spanish-speaking business processes like help desks, patient scheduling, and data entry. Synchronous time zones are another favorable factor for US firms looking to source in Central or South America.
In Western Europe, organizations will increasingly source IT and businesses services to providers located in Eastern Europe. For example, the Visegrad-Four Countries (Czech Republic, Hungary, Poland, and Slovakia) offer Western European firms closer proximity, less time zone differences, and lower transaction costs than Asian alternatives.
Even in Africa, many countries are actively seeking to become players in the global ITO and BPO markets. North Africa already exports IT services to Europe. One interesting study examined five Moroccan IT suppliers that provide services to clients in France (Bruno et al., 2004). The common language, similar time zone, and cultural capability make Morocco an attractive destination for French organizations. South Africa is also exporting IT and BP services, primarily to UK-based clients. South Africa appeals primarily to UK-based clients because of the similar time zone, cultural similarities, English-speaking capabilities and good infrastructure.
Even some sub-Saharan countries are building their future economies on IT. One country – Rwanda – completely refocused the economy after the genocide. Rwanda's economic development plan was released in October 1999 and is called “An Integrated Socio-economic and ICT Policy and Strategies for Accelerated Development”. Since the plan's ratification, a number of ICT investments have been made. Much of Rwanda has had wireless Internet access via radio-waves since 2005. As of August 2006, more than half of the 2,300 primary schools had at least one computer compared to only one school with a computer in 2000. By 2006, 300,000 people had cellular phones compared to fewer than 100,000 in 2000 (Mwangi, 2006). So far, hundreds of miles of fiber optic cables have been laid underground. Rwanda may indeed provide a bellwether for other sub-Saharan countries' emerging ICT capabilities.
Trend 6: large companies will give ASP a second look
When we first published our book on ASP called Netsourcing in 2002, we noted that many large companies were not interested in ASP because they already had ASP product offerings and expertise in-house, they wanted customized services, and they wanted to source to stable providers, not risky start-up ventures (Kern et al., 2002). Many thought that ASP died with the dot.com bust. But there are several reasons to believe that large organizations will reconsider ASP for targeted activities. First, large organizations will want net-native applications (proprietary applications designed and delivered specifically for Internet delivery) that are only available through ASP delivery (e.g. Salesforce.com). Second, large organizations may finally be ready to abandon their expensive proprietary suites, for cheaper ASP alternatives. For example, Stephen Wildstrom of BusinessWeek predicts that corporate America will eventually source their office suites through companies like Google. Third, ASP providers got the message: clients want customized services, even if the products are standardized. The need for customized services actually increases the service providers' viability because they can generate profits by charging for value-added services. Think of companies like Xchanging and Hewitt that have highly customized service contracts but deliver many services in an ASP manner.
Trend 7: outsourcing will help insourcing
As organizations become smarter at outsourcing, they also become smarter at insourcing. In-house operations are facing real competition in nearly every area and can no longer assume they will retain their monopoly status with the organization. As a result, in-house operations are adopting the techniques of the market. One such example is the use of service level agreements (SLAs). This typically defines the services provided, the metrics used to evaluate the services, as well as reporting and governance. Prior to outsourcing, few organizations employed SLAs internally. After outsourcing, nearly 60 per cent have internal SLAs in some fashion.
However, insourcing will be impeded by a supply shortage of talent within developed countries, particularly for IT skills. One of the unfortunate negative consequences of the offshore outsourcing press coverage has been the false impression that developed countries will no longer have vibrant career opportunities for domestic IT, call center, and other white collar workers. This message became prominent during the 2004 US Presidential and Congressional elections. Front-page headlines questioned, “Software: Will Outsourcing Hurt America's Supremacy?” and claimed offshore outsourcing was stealing American jobs and dragging down US pay (Hof and Kerttetter, 2004; McGee, 2003). This frightened many young college students from pursuing IT careers as evidenced by the 45 per cent decline in information systems and computer science majors at many large US universities.
The US is not alone. Nearly every research report suggests that other developed countries will suffer a shortage of domestic IT workers within the next five to ten years. In the UK, for example, some research has found that the UK will experience a shortage of 714,000 IT workers by 2010 (Aggarwal and Pandey, 2004). The shortages in developed countries will be caused by the gap between a strong demand for domestic IT workers and a dwindling supply of domestic IT workers due to the lingering effects of declining enrolments today and future effects of “baby boomers” retiring from IT.
Trend 8: nearshoring becomes more prevalent
We define “near-shoring” as outsourcing work to a supplier located in an adjacent country. Compared to offshore outsourcing, the benefits of nearshoring include less travel costs, less time zone differences, and closer cultural compatibility. Canada, for example, is a significant nearshore destination for US clients. US clients are attracted to Canada because of excellent labor skills, proven data security, 35 per cent lower labor costs than the US, low turnover, and great infrastructure. Some analysts argue that US clients can have lower total costs with nearshoring to Canada than with offshoring to India. For example, Ramanujam (2005) took a typical six month project – a web-based intranet application – and argued that the total cost of the project would cost $326,000 in Canada compared to $386,000 in India.
The Czech Republic, Poland, and Hungary are significant nearshore destinations for Western Europe. According to a report by Deutsche Bank Research (Meyer, 2006), imports of IT-based services from Central and Eastern Europe to Western Europe rose an average of 13 per cent per year between 1992 and 2004. This growth rate is nearly comparable to the import of IT services from India, which averaged 14 per cent per year over the same time period. Clients in Western Europe are attracted to Central and Eastern European suppliers for many of the same reasons that the US is attracted to Canadian suppliers: common language, cultural understanding, minimal time zone differences, and low labor costs. However, Central and Eastern Europe may be more attractive for BPO than ITO because these countries provide excellent general education, but have not graduated IT students at near the pace of India. For that reason, IDC predicts that Western Europe's growth in BPO will increased annually by 14.6 per cent compared to 7.2 per cent for ITO.
Of course, many suppliers offer blended, global models that combine onshore, nearshore, and offshore delivery for clients. CGI, the largest IT firm in Canada and the fifth largest in North America, provides one example. We interviewed 14 people from one of CGI's US clients. This client has an engagement with CGI worth $167 million over ten years. The client partly chose CGI because of its ability to distribute work among global development centers in Toronto, Montreal, Nova Scotia, Bangalore, and Mumbai. CGI uses nearshore development when the client requires significant and direct contact between developers and business units. CGI uses offshore for delivery of more standardized work. This way, issues of accent, culture, and time zones are CGI's responsibility to overcome, not their client's responsibility. According to the CIO of CGI's US client:
CGI has been great! Having two very different options, each with its own strengths and weaknesses makes our partnership work. CGI knows when we need high-touch and when we need low cost.Trend 9: Within the US, rural sourcing will meet a niche market
Within the United States, about 60 million people (20 per cent of Americans) live in 80 per cent of America's landmass classified as “rural” (Norris, 2007). With rural sourcing, suppliers locate development centers in these remote areas. Rural sourcing is a niche sourcing strategy that combines the high touch value of domestic outsourcers with the lower costs offered by offshore outsourcing. Lower cost of living in rural areas enables suppliers to pay lower salaries for employees without compromising on their employees' quality of life. Lower salaries are passed on to the customer in terms of lower prices. Rural sourcing offers prices that are 30-50 per cent less expensive per hour than urban rates.
We talked to two suppliers that offer rural sourcing – CrossUSA based in Minnesota and Rural Sourcing based in Arkansas. CrossUSA competes based on an experienced workforce (most workers are over 40-years old) whereas Rural Sourcing competes based on hot technologies (most workers under 40-years old). Their models are very different, but both companies offer US clients lower prices and good quality services.
Trend 10: KPO will increase
KPO is the outsourcing of business, market, and/or industry research. KPO requires a significant amount of domain knowledge and analytical skills. KPO suppliers design surveys, collect new data, mine existing data, statistically analyze data, and write reports. Although the KPO market is currently small, industry analysts expect a huge growth in this sector over the next five years. For example, the Everest Group (2007) evaluated the current offerings of the top 11 Indian suppliers and found that KPO is currently only 4 per cent of their revenues. However, this advisory firm predicts a rapid growth in KPO as suppliers cannibalize some of the onshore work and actively create demand for these services. Evalueserve (2007) estimated that the KPO market in 2007 was $3.05 billion and will grow annually by 39 per cent. They expect the KPO market to be $16 billion by 2010 or 2011 and will employ approximately 350,000 professionals globally.
The increase in KPO is directly related to our previous observation that offshore suppliers are moving up the value chain. As client/supplier relationships mature, the suppliers have gained an enormous amount of knowledge about the client's business domain as well as the expertise to find, analyze, and report on domain knowledge. US, Canadian, and UK clients value this deep knowledge and will pay Indian suppliers $20-$100 per hour for KPO services, compared to onshore rates of $80-$500 per hour. Offshore suppliers are struggling to find enough workers with advanced degrees to fill the demand. But once hired, we anticipate that supplier employee turnover in this space will be lower because professionals finally have the client-facing and intellectually challenging work they did not find in programming. This prediction is based on our research that found that interesting work – not pay – was the main determinant of an Indian employee's intentions to remain with their current employer.
Trend 11: freelance outsourcing will increase
Most of our research is based on interviews with client and offshore supplier organizations. While organizations will continue to be the predominant consumers and suppliers of global talent, there is an interesting trend in the use of freelance outsourcing. With freelance outsourcing, individuals offer their talents globally, primarily through freelance Internet sites. Internet portals that already have a significant number of registered freelancers and buyers include elance.com, guru.com, and rentacoder.com. Rentacoder.com, for example, had nearly 80,000 registered buyers and 200,000 registered coders in July 2007. The company had nearly 2,500 open bids on July 11, 2007. On that same date, Guru.com boasted over 700,000 registered gurus and 80,000 registered buyers. More than 60 per cent of the “gurus” are from low wage countries. Research by Evalueserve estimates that this market was worth $250 million in 2007, but will grow at least 25 per cent annually to reach over $2 billion by 2015 (Aggarwal, 2007).
Trend 12: more companies will sell their captive centers or create virtual captive centers
While it is widely recognized that Western companies are setting up sites offshore, we also note an emerging trend that might be called “The GE Effect.” General Electric may not have been the first US footprint in India, but certainly Jack Welch's enthusiasm for India made it acceptable for other CEOs to locate back offices in India. GE established GE Capital International Services (GECIS) as a captive center in India in 1997. In the winter of 2004, GE sold off 60 per cent of GECIS to two equity companies, Oak Hill Capital Partners, and General Atlantic Partners. A year later, the name was changed to Genpact, which is now one of the top ten BPO/ITO suppliers in India. Some have called GE's approach “the virtual captive center” because GE still maintains primary equity holding (Aggarwal, 2007). With a virtual captive center, the company owns the physical operations, but the staff is employed by a third party supplier. Presumably the virtual captive center offers the best of both worlds – the client investor still maintains strategic control but the supplier is better equipped to attract, develop, and retain local talent.
Among our US clients, we have several examples of organizations selling their captive centers. One financial services firm, for example, set up a joint venture with an Indian supplier in 2002 in Chennai, India. The client investor was the only “customer”. The financial services company used this model for security reasons:
One of the key issues with the joint venture was to be able to leverage offshore resources in a secure model. We can't just farm out work to anybody because of data sensitivity. – Director of Technologies, Financial Services.By 2004, the captive center had 250 IT workers providing services to the US client investor. The business case was that the financial services company would save $1 million for each 15 IT jobs based in India. The savings are calculated by comparing the higher costs of domestic contractor workers to labor in India. But costs were not the only driver:
Our take on cost savings with offshore, even if it's a wash on cost savings, I'd have a hard time finding and bringing in 250 employees here at headquarters. So there's a physical limitation issue. Also, if I can get the processes in place, we can do sunrise-to-sunrise development which will give me a speed and agility factor. I couldn't get that by having them here in the States. We are currently at 18 to 20 hours of development time a day, which is pretty good. – Director of Technologies.In late 2005, the US client sold the captive center to a large Indian supplier. The US client thought the large Indian supplier would be better equipped to deal with the high turnover of Indian staff and would be better able to provide critical skill shortages in Java, Pearl, and web-based development. Also, the US client was confident the supplier was well-equipped to ensure data security, which was the impetus for erecting the captive center in the first place.
Beyond the anecdotes of GE and the US financial services firm, the Black Book of Outsourcing (2007) survey of 18,272 buyers found that selling captive centers may indeed be a significant trend. Among the survey respondents were 487 companies with captive centers in India and the Philippines. The survey found that 29 per cent of these companies were actively seeking to sell out or already had an exist strategy in place. Respondents from large organizations were more likely to investigate a sell out than mid-sized businesses. The main reasons for selling captive centers were:
- Captive center was built to protect data and IP which is no longer viewed as a threat if provided by a third-party supplier.
- Senior executives are no longer committed to captive centers.
- It is no longer necessary to keep decision making authority in-house.
- Third parties are now able to handle complex processes.
There is a difference between the ITO and BPO captive centers: companies are much more likely to erect a captive center for BPO than ITO. For example, The Everest Group tracked 150 captive centers in India. In the BPO space, about half of Indian offshore services were provided through captive centers in 2006, compared to less than 25 per cent in the ITO space. We reason that the differences are attributed to higher maturity of Indian IT services compared to BPO, as well as the client view that BPO services are more critical to operations.
Trend 13: outsourcing failures and disappointments will continue
Outsourcing will continue to be a high-risk practice with significant hidden costs in organizations where learning is sometimes painfully slow, in deals where suppliers do not make reasonable margins, and when client organizations do not strategize, configure, contract for, monitor, and manage their deals effectively. There will also be those suppliers who over-promise and under-deliver.
Extrapolating from past evidence, we estimate some 70 per cent of selective sourcing deals will be considered relatively successful. Typically clients will be spending anything between 15-58 per cent of their operating budgets on outsourcing. In contrast, we estimate that only 50 per cent of large-scale deals involving complex processes that represent more than 80 per cent of the operating budgets will be successful. Ironically, the client organizations with the messiest back offices will benefit the most from total outsourcing – if they can successfully manage the outsourcing life cycle. In contrast, companies that successfully clean up their back offices prior to outsourcing leave few opportunities for suppliers to add value.
Enduring challenges
The enduring challenges are widely known, but solutions are still anecdotal and experimental. In the 20 years we have been studying global sourcing, clients and suppliers have expressed some persistent complaints about themselves, the industry, and each other. In this section, we identify the unresolved issues in global sourcing and present some experimental innovations to address them. Clearly, more pioneers are needed to validate experimental innovations and to develop and test new ones.
Challenge 1: how can back offices become truly aligned with the business?
Before outsourcing can be successful, the client organizations must resolve some of their own enduring challenges. In many large organization we have researched, the back offices are not truly aligned with the business. While senior executives may use the rhetoric of the “vital role” back offices provide, they still treat back offices as cost burdens. Consider the following example.
The CEO of an $8 billion US manufacturing company had to address eroding profit margins due to decreasing prices on their commodity products. Chinese companies were proving to be formidable competitors. One of the CEO's responses was to demand a 10 per cent reduction from each back office manager. This is certainly a reasonable response, and one we witnessed at many large companies facing financial crises. Or is it? The CIO at this manufacturing company had an interesting retort for his CEO. He said, “I can give you 10 per cent off of my $80 million budget, or you can give me 10 per cent more money so I can tackle our $800 million cost of goods sold. If you let me reduce that by 10 per cent, I can deliver $80 million in savings.” The CIO argued that the manufacturing company was highly inefficient because all 150 plants had disparate information systems. This was acceptable when 80 per cent of each plant's business was local. But increasingly, the manufacturer's customers are international accounts, and the information silos impede customer ordering, delivery, and service. The CIO wanted to replace these costly silos of systems with one integrated ERP package. He promised that the ERP system would reduce the costs of goods sold and that sales would increase through better customer relations. The capital budgeting committee approved his request for more money. We note, however, that this CIO's status in the organization is high because of his phenomenal record of past achievement. True strategic alignment between business units and back offices cannot occur until the back office managers have proven track records of operational performance.
Besides the clout of the back office manager, other structural issues must also be addressed before back offices can be aligned with the business. For example, large companies that have grown through mergers and acquisitions have typically neglected the back offices, resulting in a large number of low-stature back offices within each business unit. Back offices that are structured as centralized shared services for transactional activities and decentralized business systems thinkers and relationship builders for strategic activities can help alignment.
Challenge 2: how can suppliers' incentives be truly aligned with their clients' needs?
Since we first started to interview ITO clients and suppliers in 1988, the issue of strategic alignment between clients and suppliers has been a largely unresolved issue. Incentives are clearly mis-aligned because every dollar out of a client's pocket typically goes into the supplier's pocket. Clients are incented to demand more services from the supplier without wanting to pay more. Suppliers are incented to squeeze as much profit from existing contracts or to sell additional services to increase revenues.
During the 1990s, clients and suppliers attempted to resolve this issue with strategic partnerships and joint ventures. The idea was that the supplier investor would sell the client's assets or excess capacity to third parties and share the revenues with the client. Examples of these deals included Swiss Bank and Perot Systems, Xerox and EDS, and Delta Airlines, and AT&T. These deals did not work as planned. The suppliers had their plates full just servicing the client investors' internal needs. In addition, clients frequently oversold the value and portability of their assets. The deals we studied all reverted to fee-for-service relationships or were completely terminated.
The most innovative alignment we found is the enterprise partnership model described in Lacity et al., 2003, 2004. With an enterprise partnership, a client and supplier create a jointly-owned enterprise that first transforms the client investor's back office services, then seeks to commercialize the renovated services. With this model, the supplier initially only earns a profit based on the cost savings it delivers to the client investor. For example, if the client transfers $100 million in budget to the supplier and the supplier can deliver the agreed upon services for $80 million, the supplier earns $10 million and the client gets rebated $10 million (assuming a 50-50 per cent gain share.) While this is the best model of strategic alignment we have seen, it is most appropriate for clients with messy back offices. The suppliers have to be able to generate immense savings through consolidation, standardization, reduced headcount, better technology, and better processes. The model is also appropriate where economies of scale can deliver substantial savings, such as consolidating procurement across many large buyers.
Challenge 3: how can clients transfer knowledge to suppliers while at the same time protect IP?
What happens to knowledge when you outsource? With large-scale domestic outsourcing, knowledge transfer primarily happened by transferring client staff to the supplier. This provided adequate coverage provided the client and supplier managed the HR implications early in the negotiation process. In some cases, top client talent left before deals were finalized, thus leaving a knowledge vacuum after outsourcing.
In the offshore outsourcing market, knowledge transfer has been one of the biggest impediments to success. With offshore outsourcing, clients do not typically transfer knowledgeable employees to the supplier (like they typically do in large-scale domestic outsourcing). Clients complain that offshore employees have little understanding of their business domains. It is quite expensive to train offshore supplier employees, and the threat of supplier turnover and loss of IP is high.
Our research found that one of the best ways to transfer knowledge is to invest in social capital. Social capital is simply the idea that knowledge and resources are exchanged, work gets done, and value is created through social relationships. Our research found specific practices for building social capital by laying foundations of trust, creating shared systems of meaning among parties, and designing social linkages between client and suppliers. These practices show managers how to invest the right amount of social capital to ensure that they get overall value from offshore outsourcing in terms of quality and speed without completely eroding cost savings and without giving away too much IP.
One US manufacturing company illustrates the knowledge benefits of investing in social capital. The first time the manufacturing company engaged an Indian supplier to help create embedded software resulted in utter failure. The client only focused on costs and neglected to transfer important domain knowledge to the Indian supplier. But the company learned to get all they wanted from suppliers in terms of costs, quality, flexibility, control, and innovation by investing in social capital. To lay the foundation of trust, the client assured their internal staff that offshore outsourcing would not result in layoffs and demonstrated how the offshore outsourcing strategy would enhance internal career paths. To create shared systems of meaning among parties, the client indoctrinated the supplier employees into the client's world of language and meaning through co-training. To indoctrinate internal employees into the supplier's world of language and meaning, the client elevated their internal CMMI processes to better match suppliers' processes. The client designed social linkages by getting to know the suppliers' key power players, building strong ties with onsite supplier managers, and engaging multiple suppliers to broaden the social network. The client protected its social capital investment by requiring suppliers to have shadows for key supplier roles. But most importantly, the client prevented the transfer of too much knowledge by divvying IP across multiple suppliers (Rottman, 2006). They view their IP as a puzzle. By distributing small pieces among three suppliers, no one supplier can assemble the puzzle on their own. According to the manager of engineering:
We keep a very tight rein on where our IP is and who has it. We never let any one development team or any one vendor see too much at one time. We feel it would be impossible for our IP to be lost through offshore sourcing.Challenge 4: how can clients retain enough knowledge when engaging in large-scale outsourcing?
Whereas the previous challenge focused on knowledge transfer, this challenge focuses on the client's knowledge retention. After the first few years of a large outsourcing contract, the client's knowledge retention can dramatically erode through attrition. While all organizations deal with turnover, clients that extensively outsource have a smaller pool of talent to retain and develop. We have increasing heard clients say, “Where will the next generation of our project managers come from?” While the core capabilities model by Feeny and Willcocks (1998) addresses what types of talent to nurture, there are unresolved HR management issues associated with its implementation. These include: how can client organizations pay them enough to compete with service providers? How can client organizations consistently provide them with the level of challenge they look for in the job? How can client organizations provide them with a career path despite the very small numbers? We have not found organizations that have successfully dealt with all these issues.
Challenge 5: how can clients and suppliers sustain the early enthusiasm of budding relationships for the long term?
During the past 15 years, a number of pundits have referred to outsourcing relationships as marriages. With that analogy, clients and suppliers perceive each other as seductive partners during the wooing phase, enthusiastic partners during the honeymoon phase, then bored partners during the “seven year itch.” We have called this later phase the “mid-contract sag”, and we found that it usually occurs in year three, not seven. The mid-contract sag occurs after the supplier has dispensed all their transformational levers (consolidation, standardization, reduced headcount, better technology, and better processes). The suppliers' transformation leaders typically move on to new challenges on new accounts. The remaining staff on both client and supplier sides are either too exhausted or lack ideas for launching new rounds of transformation.
How can the relationship be invigorated? Throughout our work, we have addressed some practices to address this issue, such as the Supplier Development Capability and Xchanging's plans for sustainability discussed in Willcocks and Lacity (2006). Beyond our work, there are a few case studies that suggest that outsourcing relationships can evolve from a fee-for-service relationship to a “co-sourcing” or “insourcing” relationship (Friedman, 2005; Kaiser and Hawk, 2004).
But one thing is clear, contract renewal is not indicative of sustainable innovation. We found that contracts are renewed primarily because of the high switching costs, not because partners are still thrilled with each other. The issue here is not longevity, but sustainability of fresh ideas. Returning to the marriage analogy, the partners in sustainable relationships continually help each other actualize their potential as individuals and as partners.
Conclusion
In effect, our research has documented the 20 year rise to globalism of IT and business services outsourcing. The key quest for clients has been how to leverage the ever expanding services market for significant business advantage. The common denominator in the findings: there is no quick fix. Much depends on experiential learning and sheer hard work. Back office executives must conquer a significant learning curve and build key in-house capabilities in order to successfully exploit outsourcing opportunities. They need to accept that outsourcing is not about giving up management, but managing in a different way.
Suppliers have also faced learning curves in their attempts to differentiate their services, find new markets, and deal with new competition from potentially anywhere in the world. We find that a large player needs a mix of 12 key capabilities if it is to deliver on its full promise of cost-effective service delivery, strong relationships, and back-office transformation.
The sheer dynamism of modern business and public sectors makes our lessons more important to learn and apply, our trends more important to watch and take suitable action on, and our enduring challenges more important to deal with going forward. Moreover, as outsourcing spend increases, the alignment of business and sourcing strategy becomes a key issue, as does CEO and business executive involvement in outsourcing objectives, relationships, and implementation. This requires a further advance in client thinking and action. One way of looking at our work historically is to say we have documented how organizations have been learning, experientially and often painfully, how to manage back-office outsourcing. But the increased size, importance, complexity of the phenomena, and the risks they engender, suggest that in the next phase we will be researching how organizations seek to provide leadership in outsourcing. Leadership is about shaping the context and mobilizing resources to deal with the adaptive challenges organizations face. In our glimpse into the future, it is pretty clear that changing business needs, globalizing and technologizing supply of business services, and the much greater use of outsourcing, will provide challenges that will require this shift from management to leadership – if governance, control, flexibility and superior business outcomes are to be outsourcing's consequences.
Figure 1Benefits from global outsourcing
Figure 2The sourcing process
Table INine core back office capabilities
Table IICommon client/supplier engagement models
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Further reading
Lacity, M., Willcocks, L., Feeny, D. (1996), "The value of selective IT sourcing", Sloan Management Review, Vol. 37 No.3, pp.13-25.
Corresponding author
Mary C. Lacity can be contacted at: Mary.Lacity@umsl.edu