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Financial Accounting Outsourcing (FAO) Annual Report - January 2007

IT Outsourcing in the Small and Medium Businesses

Finance and accounting outsourcing (FAO) suppliers are enjoying enviable growth rates. The Everest Research Institute reports in its November 2005 annual FAO market report that their current compound annual growth rate is 24 percent. This double-digit growth is encouraging new entrants into the market. http://www.outsourcing-journal.com/jan2006-everest.html This is a heady time for FAO suppliers.

But almost all of that volume is driven by labor arbitrage; the growth is purely a cost play. Buyers are now having accounting personnel in Bangalore doing the work at half the price or less than the accountants in their home town. Good deal!

Buyers are finding the idea of outsourcing the transactional aspects of their finance and accounting processes enticing because they can reap significant savings without changing much: they can use the same financial systems and the same processes to get the job done offshore. The resultant savings are found money to the corporate bottom line.

But here's the catch, suppliers: Enjoy the profits and growth now, because the work is going to go away later. Here's why:

Every year buyers get smarter. The longer they send work offshore, the more they understand the underlying dynamics of the process. They are fine-tuning their processes to make them more efficient and to wring even more cost from their offshoring efforts. And they are standardizing processes. Even more important: they are automating these processes as much as possible.

Why the Future Is Changing

New technologies such as Web services and radio frequency ID (RFID) are making this possible. Take RFID, for example. Today each pallet that arrives at a Wal-Mart from a major supplier has an RFID tag. Scanning the tag tells the accounting system exactly what just arrived in inventory. The goods flow through the system, which also generates a payment to the shipper, closing out the transaction. The process is paperless and automatic.

How many people does Wal-Mart need in Bangalore to handle this type of transaction? Answer: None.

I predict the same thing will happen to manual check-processing and manual journal entry vouchers (JEV). FAO is putting a spotlight on manual processes such as manual JEVs. Every month the buyer has to write a check to the supplier for these; in the past they had no idea what manual JEVs cost them each month. Suddenly CFOs have great visibility into the cost of a manual transaction. Buyers don't want to pay this fee, so they restructure and automate their processes so that the manual processing goes away by bits and bytes.

All in all, the end game can be ugly. I predict a slow death spiral in the transactional work as volumes slowly trickle away. This is not a problem this year or even in the next several years. The problem for suppliers for the next couple of years will be how to address all of the potential buyers who want to offshore these manual processes as market penetration increases. However, if you have a longer horizon, you need to consider how you will handle the slowdown in adoption combined with shrinking volumes from each client as the market matures.

What Should Buyers Do?

What does this mean for captives? Many buyers are interested in setting up captives to produce big savings from labor arbitrage on F&A transactional work. I posit buyers need to factor in the future before making a decision if the primary goal is savings on transactional work.

Given my prognostications, I believe it may be unwise to set up an offshore captive to handle your finance and accounting transactional work. Setting up a captive can be a costly experience--assuming you can find the qualified people to work for you. If you decide to go ahead, know you are making a large investment in what may be a short-term play, depending upon the speed at which you can reengineer and automate the work away.

An alternative is to outsource your F&A functions to an offshore player. They're already in the game; they have already constructed an office building with a thirty-year useful life, they have obtained the necessary business permits, and they have set up recruiting processes, et cetera. If you outsource, and then take the savings generated and invest in process engineering and automation, you are literally using the savings to eventually take the business away you're your supplier. Ironically, offshoring savings to buyers who are successful at process automation will eventually drive some of these offshore outsourcers out of business--or force them to find a new business in the FAO space.

What the Future Will Look Like for Suppliers

Some suppliers see a future that's not about labor arbitrage. It's in handling processes that have nothing to do with offshoring or low prices. Order-to-cash is one area that some suppliers see as so bright they have to wear shades, to quote an old Corey Hart song. Order-to-cash outsourcing is about making the accounting process more efficient. The result: buyers can cut the number of day sales outstanding, shorten the cash flow cycle time, increase the velocity of money, and reduce the amount of capital needed to run the business.

Labor arbitrage is a red dot deal, in Everest parlance. It's all about cost savings. Order-to-cash, on the other hand, is a blue dot deal. It's about making the business more efficient by increasing the velocity of cash and reducing the need for hard-to-find capital.

Today, order-to-cash is not a huge business. But two suppliers are banking on its future. Last year IBM purchased Equitant and Genpact bought CreditTek, two niche players specializing in order-to-cash transactions. I predict every order-to-cash customer Genpact and IBM sign up will probably be a customer forever.

According to an Ohio State study, 60 percent of restaurants fail by the end of their third year. Current FAO suppliers have to act like they own the hottest restaurant in town. Lines are out the door now. For FAO suppliers, there's nothing wrong with the current business model. Bank the money today, but act like the doors will close down the road when someone else opens the coolest eatery in town. Act like you're in the restaurant business. Suppliers who don't will be in for a rude awakening.

Lessons from the Outsourcing Journal:

• FAO suppliers are experiencing enviable 24 percent growth thanks to the significant savings they can generate through labor arbitrage. Smart buyers, however, are using the savings generated to automate and standardize their F&A processes. The result: eventually the offshore transactional work will disappear.
• Order-to-cash is one F&A process that is not dependent on direct labor cost savings. This is an area where FAO suppliers can continue to make money.
• Buyers should avoid starting F&A offshore captives if the primary purpose is labor savings on transactional work, because the opportunity is short term. Outsourcing produces a higher ROI; buyers can use the savings to automate and thereby eliminate the outsourced manual processing.

Publish Date: February 2006

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Everest Research Institute's 2005 FAO Report: Growth, Offshore Key Findings

Copyright © 2006 - Everest Partners, L.P.

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