You'd have to be crazy not to outsource, they say. Just look at the cost savings in India and China. But there are perils beneath the surface of these deals.

Business process outsourcing (BPO), after a decade of false dawns, is finally moving into a new level of maturity. Check out the momentum: the latest estimate from PwC, published in September, suggests that activity is set to double in the financial services sector – the sector that’s embraced offshore BPO with the greatest brio – by 2008. Global BPO growth is set to hit 8.6 per cent this year.

And while offshoring to date has mainly been about IT services, the growth areas, says PwC, will be HR, customer services and even knowledge-based activities like financial modelling. In other words, it’s time to look at outsourcing everything.
“There’s not one FD who isn’t looking at it right now because they know what the savings can be – and they know their competition is looking at it,” says Graham Pascoe, BPO engagement partner at PwC. “The real driver is offshoring, because the numbers are so attractive.”

But the numbers are only the visible part of the iceberg. Huge risks lurk beneath the surface – knowledge transfer and loss of IP, for a start. Will vendors sell your proprietary software to third parties? Are you losing ownership of strategic data? How secure is that Indian data centre? And what about the sustainability of the outsourcing model? What happens if your circumstances or markets change radically? Even the most sophisticated, well-drafted, lawyer-enriching service level agreement cannot cover all the bases.

One FD, who wishes to remain anonymous, endorses his company’s decision to farm out manufacturing to the Far East. But despite that success, he has no plans to outsource anything else. “It’s our policy only to outsource the manufacturing,” he says. “Any added-value part of the business, such as R&D, we like to keep in-house. And we have no plans to outsource anything like IT or finance. We just don’t want to lose those skills.”

Losing skills – call it knowledge, IP, human capital or whatever – is a huge hidden risk in outsourcing. For example, once you’ve handed over your IT department to, say, CapGemini, that’s it. IT development is no longer part of your company’s DNA. If you change your mind five years later, you’ll have to build your entire team from scratch – and they’ll have none of the ingrained knowledge about your company and its systems that the original employees built up.

When you shift activities out of house, you also lose speed. “One drawback of having production in China is the loss of flexibility,” says our non-BPO FD. “You need eight to 12 weeks’ lead time for changing production and when you take into account shipping times, June becomes decision-time for your end-of-year output. This makes it difficult for us to react to spikes in demand.”

So unexpected changes in the short term (let alone market shifts over the lifetime of an outsourcing contract) can create problems. Look at BA, whose run-in with catering supplier Gate Gourmet earlier this year is reckoned to have cost it £40m. It’s doubtful anyone in the BA team negotiating the in-flight catering contracts said, “You know, we ought to work out what’ll happen if baggage handlers come out on strike in sympathy with the production line staff at Gate Gourmet. Let’s scenario plan for that and work contingencies into the SLA.” That’s the trouble with the bit of the iceberg below the water-line: you never know exactly what it looks like until it’s too late.

The right stuff

The outsourcer’s holy trinity is cost, quality and flexibility. But it’s worth noting that in most cases, making gains in one of these areas means making sacrifices in another. David Bishop, a partner in PwC’s Risk Assurance Services group, sees BPO as a major potential risk. “Companies have been jumping on the offshoring bandwagon because everybody else is doing it,” he says. “The trouble is they don’t look holistically at where the risk arises. For example, many organisations don’t fully understand the cost of providing IT in-house. So when they outsource, a number of things come out of the woodwork.” In other words, a lot more creeps into the outsourcing contract than you bargained for. “Without having a full handle on cost, it’s not possible to structure a contract – but by this time the service provider has the upper hand.”

“A lot of organisations outsource on an almost emotional basis,” says Steve Turner, general manager of UK advisory boutique Stratic. “They need to step back and ask themselves how much it would really cost to do the same in-house. If the tasks are scalable, outsourcing might be a good option. But there are only two ways an outsourcer can make a profit: from economies of scale and from trimming fat. We say if you trim the fat for yourself, you’ll be in a much better shape to outsource later.” So BPO only really works when it’s improving the quality of the business function.

The other factor – a crucial one – is the complexity of the function you’re parceling out. “Outsourcing the finance function is the most complicated place to start because of the judgement involved,” says Pascoe. “Lots of companies start with the catering, the cleaning and logistics before they feel ready to tackle something as complex and strategic as finance.”

The long game

It’s not just loss of control and the suitability of any given function for outsourcing. It’s the deal itself. A recent survey by Deloitte Consulting has found that hidden costs are a major reason for suspicion of outsourcing. Other concerns include a fear that there will need to be greater management involvement than first anticipated; difficulty in achieving economies of scale; and rising labour costs – outsourcing firms are currently opening in Bangalore at the rate of three a week and that’s pushing up the wage bill. (According to IT analysts Butler Group, IT salaries in India rose 12 per cent last year and are expected to gain even more in 2005.) Rather than freeing up management time and cash, in some cases respondents found that outsourcing did the opposite.

In all, 70 per cent of respondents had “significant negative experiences” from outsourcing. Around 25 per cent have brought functions back in-house as a result – promised savings failing to materialise being the biggest reason. Even in the outsourcing-friendly financial services sector, some deals are falling apart. In July, Schroders announced it would be getting a £20m windfall from JP Morgan. Why? The latter had been handling the UK firm’s fund accounting in a five-year outsourcing project – which had been canned by mutual agreement.

If five years turned out to be too long in that case, remember that BPO contracts are generally based on even longer terms. They have to be: the supplier is taking on huge commitments; and the customer needs predictability – you can’t just shop around for the best deal on the maintenance of your IT infrastructure every other year.

Much of this is true even if you’re outsourcing “commodity” business processes – mundane tasks such as accounts-to-reporting or order-to-cash, for example. Will Waggott is COO of Europe’s largest tour operator TUI, and was CFO when the company embarked on an ambitious plan to shift its back office functions to India. But the firm is taking a considered, three-stage approach to offshoring.

“First we harmonised our different systems, each running different ledgers and accounting codes, into a shared service centre,” he says. “Now we’re moving the functions offshore. We’ve categorised them into three grades: easy, medium and hard. We’ve started by outsourcing the easy and medium ones. But we’ll take a view on the difficult ones later. A typical example of a ‘difficult’ process for us is payment of hoteliers. If something goes wrong there, our customers don’t get a room for the night. On the other hand, if someone messes up my expenses, that’s just an inconvenience.”

TUI’s offshoring policy has brought multi-million pound savings – and it could lead to more in the future, says Waggott. “At the moment, we’ve got four main areas of outsourcing: finance back office; other back office such as HR admin; ticket production; and IT, which is PC support and virtually all our web development work. We don’t know if this will be the end of it. We’re considering outsourcing letter-writing, but we’re still shying away from moving voice work to India. If we did move voice functions it would be the information-based tasks, maybe order-taking. But we’re nervous about moving sales calls offshore.”

So even the companies that currently have a BPO strategy in place are steering clear of full service outsourcing in favour of limiting it to “safer” processes. And the deal requires constant monitoring. “We are only in India for the labour arbitrage,” says Waggott. “If that disappears, we’ll have to look at it again.”

Terms and conditions apply

So how do you manage these below-the-water risks? A well-documented contract, with control points and service level agreements (SLAs) throughout, is essential. A good SLA gives targets against which to measure performance and provides for regular reviews – but also allows the service provider some freedom and shouldn’t get bogged down with minutiae.

You can also manage risk by using multiple service providers in a bid to lessen reliance on any one vendor or any one system. This is increasingly used by larger companies as a way of keeping a healthy level of competition amongst vendors and keeping the threat of disruption to a minimum in the event of a breakdown in relationship with one particular supplier (as happened with Gate Gourmet).

“The decline in average deal value for big IT outsourcing deals this year is partly due to the rise of multi-sourcing, where clients work with a number of best-of-breed IT services vendors, rather than a single outsourcer,” says Nick Mayes, lead analyst for Global Computing Services at Datamonitor. The only problem is that running with two or more providers means more management time on structuring and overseeing complex relationships.

Control is the key. PwC’s Bishop recommends building qualitative benchmarks into contracts. “Outsourcing is no longer a cost-plus type of relationship,” he says. "There’s a lot more ‘skin in the game’ now than you may have had in the past. The leading edge is pricing mechanisms based around satisfaction metrics. They’re subjective, not the usual objective measures. Basically, you don’t get paid if the customer is not happy. So it’s not just about sending out your contractual 10,000 invoices per day any more.” If this type of metric catches on, it may put strain on suppliers that rely solely on economies of scale and a low cost base.

Mind you, understanding the real risks of your outsourcing deal ten years down the line is still like trying to visualise the bottom of the iceberg. It’s almost impossible – but that’ll be the bit that sinks the ship. So plot your course with care.

Oliver Cann is a writer on management issues.

The relentless rise of BPO

“Outsourcing” technically means a company taking over the running of one of your business functions and, as a result, employing your former staff. But it’s now more commonly used for any arrangement where a third party undertakes significant parts of your business for you. And it’s played an important part in manufacturing for decades. The current enthusiasm for outsourcing business services and back office functions is no overnight success story, either.

“BPO started getting hyped in the early nineties when BP outsourced its North Sea admin activities to Andersen Consulting and everybody said that the market was going to grow by 30 to 40 per cent a year,” says Peter Moller (pictured), partner in consulting at Deloitte. “But it hardly moved until the late nineties when large corporations started moving their transaction processing to India. The first movers, such as HP, couldn’t find outsourcers there. So they had to do it themselves. The growth in BPO since then has been entirely driven by labour arbitrage opportunities with India.”

The current runaway market has brought structural challenges. Inexperienced BPO vendors, rising costs and high staff turnover have hit the supply side; ill-thought-out strategies by client companies have created doubts on the demand side. Enthusiastic but inexperienced customers have realised that outsourcing is no panacea for a poorly functioning back office. Worse, they’ve started to realise that BPO is a risk in itself which will only pay off if time, money and experience are invested first into getting it right. And if you’ve got it right, and you’re big enough, why not simply run a shared service centre?

Outsourcing checklist

- Get the rationale right. Aim for service improvement and cost saving, rather than to offload an under-performing unit. If it’s broke, fix it first.

- Get advice. It might be your first time negotiating an outsourcing contract, but you can guarantee the vendor knows exactly how to maximise their return from the deal.

- Factor in hidden costs and intangibles. It’s not down to the vendor to remind you about the man-hours management will lose through regular visits to the Far East, or the heavy penalty clauses in the small print for changing contract terms half-way through the deal.

- Get the SLA right. Keeping it clear and precise yet flexible needn’t be a contradiction in terms.

- Can it be done more efficiently through automation in-house? What’s the point of employing a factory full of cheap labour in an emerging market when new technology means you can eliminate costs and keep things close to home? Flexibility, knowledge and security all have a value.

Picture source

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