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IT Outsourcing in the Small and Medium Businesses

If a major reason to offshore is to save money, corporations ought to make decisions that maximize those savings. However, in our experience, companies often make choices that limit savings before transition even begins. This article describes the most common issues that often hamper companies in their efforts to reduce costs through offshoring and how to avoid them.

Before we begin, let's recap the variables that determine cost savings (per our previous article):

Net savings = Gross savings percent reinvested - (setup costs / length of contract) - governance costs as a percentage of original costs

where Gross savings = (percent of services offshored X labor arbitrage) + percent productivity improvement

Five Factors that Limit Offshore Savings

Based on Everest Group's 2004 Offshore RFI Survey as well as more than 50 cases from Everest's offshore work, we found that companies fail to realize the total potential of offshoring due to one or more of the following factors (in order of decreasing importance):

1. "Opt in" approach/lack of a top-down mandate
2. Lack of competition on rates and terms during the sourcing process
3. Focus only on direct costs
4. Benefits restricted to one-time improvement
5. Lack of post-transition plan

Unfortunately, companies often make these decisions by default and/or without a clear understanding of the resulting reduction of savings. Exhibit 1 shows how each of these decisions negatively impacts these variables.

Exhibit 1

	Variables affected*
Limiting factors	% Services Offshored	% Labor Arbitrage	% Productivity Improvement	% Reinvested	Governance cost
"Opt in" approach	x			x	x
Lack of competition		x	x
Focus only on direct costs		x	x
Benefits restricted to one time improvement	x		x
Lack of post-transition plan	x			x	x
*Contract length and setup costs have been omitted. Contract length has been omitted because this affects the calculation of NPV (Net Present Value) and amortization of the setup costs, but is not intrinsically a value driver (unless it is unduly short and thus results in undue switching costs). Setup costs have been omitted because they are generally relatively minor compared to total value generated and are easily managed with some competition/forethought.

1. "Opt in" approach/lack of a top-down mandate

The presence of a top-down mandate, ideally created at the CxO level and endorsed by the senior leadership team, is probably the single biggest key factor for successful implementation of a sourcing strategy. Put simply, this factor directly correlates with the percentage of services offshored. When the top-down mandate exists, the organization objectively reviews the function under consideration and offshores those sub-functions that meet an agreed set of criteria.

However, when this mandate is absent, the most typical result is that the company adopts an "opt in" approach to the use of offshore operations. Given the sensitivity of the topic, "opt in" quickly morphs into "opt out," which limits savings as the scope of services offshored is narrower than warranted.

Exhibit 2 demonstrates the different paths that Everest has seen companies take in adoption of offshore resources. Within the last year, Everest is now witnessing (and advising) many corporations to fast-forward through the pilot stage and into a broad-based transformation. The main reasons appear to be the increased credibility and perceived lower risk resulting from both the size of the market and suppliers.

Exhibit 2

2. Lack of competition on rates and terms during the sourcing process

While there may be times when a competitive process is inadvisable, competition does produce the most favorable rates and terms. Exhibit 3 shows the blended offshore rates for ADM resources offered during the first stage of a competitive process and the final negotiated rate.

Exhibit 3

While the results shown in Exhibit 3 are likely no surprise, equally important are the terms agreed to during the competitive process. There are many terms that can affect pricing (and thus savings), but some of the more important ones are listed below.

• Cost of living adjustment. How are rates adjusted upwards over time to account for inflation? This can result in uncompetitive rates over time, particularly when the market is flat.
• Billable hours. What hours are considered billable? Are overtime hours billable? At what rate? Is work billed on an hourly basis or some other basis entirely (e.g., full-time equivalent)?
• Other expenses. What other costs are borne by the buyer? Travel? Communication links? The list of possible charges is very long.
• Benchmarking. Does the buyer have the right to benchmark rates and reset them if the benchmark indicates that the rates are not competitive?

It is important that the buyer of offshore services ensure competitive rates and terms. While a competitive process is not the only way to arrive at market rates, it is by far the most common. Of course, this assumes that the buyer is using an offshore supplier. Companies can use other avenues to obtain offshore resources, of which the most common is a captive operation. A later article will address the cost implications of using a captive.

3. Focus only on direct costs

Many companies focus only on "labor arbitrage" as the benefits lever in offshore sourcing while ignoring other potential improvements, particularly while negotiating with suppliers. Two of the primary value drivers beyond labor arbitrage are productivity improvements (e.g., through increased efficiency, increased utilization, reduction in average handling time) and quality improvements (e.g., increased accuracy per invoice, improved customer satisfaction). Exhibit 4 shows the proportion of case studies in a recent Everest study of the offshore market in which the buyer did not experience a productivity improvement (38%) or a quality improvement (50%). Given the frequency with which buyers experienced 50%+ productivity improvements, these represent significant value left on the table.

Exhibit 4

This lack of management attention could result in one of these three primary negative impacts:

1. The potential for savings exists but is never captured.
2. The potential for savings exists, but the benefit goes to the supplier. For example, a supplier might promise a 40 percent cost reduction based on labor arbitrage and achieve it. However, the supplier might continue by achieving an additional 25 percent productivity improvement that goes straight to its bottom line rather than the buyer's.
3. Quality and productivity worsen, thereby creating hidden costs that are felt but not understood.

Additionally, many companies have used offshore to achieve other important business goals such as reduction of bad debt and increased cross-selling. However, companies will only realize these benefits through thoughtful planning and strong execution.

4. Benefits restricted to one time improvement

Both suppliers and buyers tend to focus solely on the one-time impact on the bottom line and neglect the equally important commitment to long-term continuous improvement. This is because buyers often do not understand the potential for continuous improvement. In addition, there is no incentive for suppliers to pursue long-term continuous improvement even though many certainly have the means due to their investments in process, methodology, tracking, and quality programs such as SEI/CMM and Six Sigma. Our advice: buyers should include continuous improvement in the contractual documents and then use the resulting benefits to offset any cost increases driven by cost of living adjustments and/or additional business demands.

5. Lack of a post-transition plan

At its simplest level, the supplier and buyer often neglect the significant costs that arise due to retraining, the transition bubble, governance, etc. For example, the Meta Group estimates that the hidden costs of offshore can vary from 6 percent to as high as 43 percent. The costs include reduced efficiency, process changes, cultural differences, increased travel, additional turnover, and higher communication costs. Of these, it's most important to focus on the on-going costs post-transition, since the one-time costs associated with transition (e.g., process changes and reduced efficiency) are relatively low when amortized over a five-to-ten year contract period.

More subtly, companies should decide where and how many resources to redeploy after transitioning work offshore. For example, many companies would like to increase the amount of strategic application development work that can be done in any given year. Thus, a key goal of any offshoring effort should be to understand what high-value tasks can be done with the resources that are in scope for the offshore work.

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Conclusion

Everest strongly advises any company that is offshoring (or outsourcing) to think carefully through the key cost savings drivers and other potential benefits. Companies should build a robust financial model, then use it to select the supplier that will drive the most benefit, measure success over time, and finally ensure that the expected value is obtained or exceeded through strong execution.

The third part of this series will outline how to avoid the pitfalls discussed in this article and leverage offshore most effectively.

Publish Date: December 2004

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Copyright © 2004 - Everest Partners, L.P.

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