This paper covers:

• Low Operating Margins for Providers Challenge Innovation
• Growth Creates Competitive Marketplace But Also More Margin Pressure
• Offshore Providers Add to Pricing Pressure
• What it Means to Buyers
• Conclusion – Complexity and Low Provider Margins Require Change

Low Operating Margins for Providers Challenge Innovation

Over the past three decades, the outsourcing industry has evolved and matured to where it is a common business practice. While the genesis of outsourcing began with obvious, non-core business processes such as manufacturing, payroll and computer operations; today outsourcing extends across finance and accounting, human resources, procurement and call centers. Growth continues to be fueled by an increasing number of functional areas being outsourced followed by an associated number of new providers entering the market.

Lowest-cost contracts affect service levels, customer satisfaction and innovation. Buyers and providers who collaborate under out dated, price-driven contracts will fail to realize anything other than cost reduction at the expense of customer satisfaction and new business models. And in some cases, they may cause the failure of providers that are unable to survive at sub-par operating margins.

Evaluating the operating margins of the leading outsourcing providers over three decades points out a disturbing reality – providers are at their breaking point. As margins dropped below 10 percent, providers lost the ability to hire and maintain the best people, create research and development centers, or compete with the in-house offerings developed by their customers. Ignoring the U.S. recession in the early 1990s (identified as 1 in Figure 1) and the short-lived relief of the Y2K and dot com bubble around 2000 (identified as 2 in Figure 1), the margins of outsourcing providers steadily fell to a sustained flat-line at six percent.

At the same time, revenue growth of the top providers slowed by two-thirds. The result has been a growing dissatisfaction with outsourcing and an increase in failed deals.

Yet, outsourcing is by no means a declining industry. Companies are increasingly focusing on their core activities and outsourcing non-core business processes. Outsourcing has now become a $100+ billion industry where organizations can outsource almost any function to outside service providers in order to gain a unique competitive advantage.

However, buyers of outsourcing services must understand the forces affecting providers, as well as their own operations and the industry as a whole. These main forces include: increased provider competition domestically and from offshore; rock-bottom operating margins forced many times by overzealous procurement processes; and pressure from outside advisors to press for inflexible contracts and uncompromising service level agreements. The end goal is to change the way buyers and providers interact in developing outsourcing relationships such that both are incented to achieve the goals of the other.

Growth Creates Competitive Marketplace But Also More Margin Pressure

Beginning with manufacturing in the 1970s, U.S. companies looked to offshore locations for low-cost labor and access to raw materials. The success of those efforts gave credence to broaden outsourcing to other areas, particularly information technology services. This “Definition” period outlined the role of outsourcing as a strategic tool to be used for all non-core business functions.

As a series of economic slowdowns hit multi-national companies in the 1980s and 1990s, the outsourcing industry began a “Transition” period. Outsourcing again expanded to address functional areas, including business processes such as human resources, finance and accounting functions. In addition to the existing reasons for outsourcing, organizations started to broaden their perspective and built their strategic outsourcing decisions around the following objectives: to gain access to world-class capabilities and resources, to improve efficiency, to free internal resources for other purposes, to accelerate business process re-engineering benefits, to make capital funds available and to share risks.

By 2000, outsourcing had advanced to a $100 billion global industry and begun a new era of “Redefinition.” Yet, margins were at an all-time low for the global providers. Offshore providers fared better in current financial reports, but it was no secret how they competed. Traditional outsourcing providers rapidly began expanding into low-cost areas, which drove up competition for labor and increasing base labor costs for all. Offshore providers also began to feel the heat as the traditional providers dropped prices to be competitive. While the offshore providers maintained a higher percentage of operating margin, the lower market prices left smaller actual operating income. Again, buyers continue to suffer more dissatisfaction with restrictive service levels and lack of innovation.

Offshore Providers Add to Pricing Pressure

The Internet has allowed offshore providers to attack all jobs filled by knowledge-workers. Data can be shipped back and forth in minutes for pennies. Today, offshore transactions represent 25 percent of the total amount spent by companies on outsourcing deals as opposed to 75 percent for onshore outsourcing. These companies are characterized by a tremendous annual growth rate at 30 percent since 2003, which is double the industry average. Some of the rising stars, such as Infosys, Tata Consultancy Services and Wipro, score highly for the depth of its competencies, management capabilities and customer service.

The core cost of providing these services is low. This gap will continue barring a complete meltdown of the U.S. economy.

As a result, the leading domestic providers are seeing their dominance and their market share falling. Buyers often look for multiple vendors and specialists around the world. Examples of the most recent large outsourcing deals include ABM Amro Bank, which awarded its $2.2 billion contract to various outsourcing providers beside the established leaders. About $400 million worth of contracts went to TCS and Infosys.

A new trend also appears to be specialty outsourcing. Competitive pressures are forcing service providers to repackage and price their offering to make them more attractive to customers since buyers have become more experienced, selective and more often seek professional advice to be able to evaluate their outsourcing needs and alternatives. A significant amount of standardization in particular service segments, such as data center, desktop or telecommunications pushes companies toward one area of expertise where they can stand out.

The evolution and maturity of the BPO sector has caused another outsourcing segment to emerge at offshore locations -- knowledge process outsourcing (KPO). Organizations have been encouraged by the success in offshore outsourcing business process to start outsourcing their high-end knowledge. KPO will become increasingly important and will continue to influence the industry in the near future. In 2005 the KPO segment accounted for $1.2 billion and is expected to grow at 45 percent per year to reach $11 billion by 2010, with India expected to benefit the most.

What it Means to Buyers

Move Beyond Pure Cost Savings:

Corporations must deal with a number of challenges as they take advantage of outsourcing strategies. First, they have to recognize that outsourcing is a mandate, forced by their own burgeoning sales, general and administrative (SG&A) costs or their competitor’s adoption of offshore strategies. The next step is to identify how to evolve their sourcing strategy beyond simple labor arbitrage and to total sourcing value with shared and aligned goals.

Rethink Process:

Another challenge is growing dissatisfaction in the buyer space. Outsourcing has moved from a niche technology management tool to a strategic method. Buyers now require more complex outsourcing services and are more often dissatisfied with the outsourcing contracts because its results do not meet expectations.

Leadership:

Being able to procure an effective management team also confronts businesses. Firms that outsource their products or services are discovering that they need managers with a new blend of leadership and strategic thinking capabilities to create and oversee the work.

Look For New Areas to Outsource:

While information technology outsourcing matures, the rise of business process outsourcing increases the need for managers who understand how to operate with providers as well as who can own the finance, accounting, marketing, legal, or human resource functions.

Balance Sheet Impact:

The basic premise is that companies must look beyond the cost. While cost remains a primary focus, organizations must negotiate for a flexible variable cost structure to sustain growth requirements. They must increasingly pursue other strategic goals such as increasing shareholder value by freeing capital for internal investments in core business, reducing workforce and exploiting the provider’s expertise.

Conclusion – Complexity and Low Provider Margins Require Change

Clearly the provider margins are operating at a level that is not sustainable. Achieving low cost in an outsourcing transaction is a norm, not an achievement. True measurement of success will be in finding relationship structures and pricing models that align client expectation with provider capability in a structured, yet non-prescriptive way that links and aligns.

While some areas of outsourcing, namely ITO, have matured to the point where a number of the larger corporations can rely on their own expertise, new avenues continue to open up requiring experienced, knowledgeable consultants to reduce risk and find aligned structures that go beyond pure commodity pricing of complex outsourcing services. That is a key way that complex relationships should be valued. Expect more. Demand more. Find the value. Tomorrow’s BPO and KPO expand the opportunities for outsourcing and build upon the mature industry that is outsourcing.

It is imperative that the current industry find new ways to structure for value. Currently, no steep change is on the horizon for onshore provider costs. If the industry fails to offer a new structure, the companies that replace today’s providers will.

About Alsbridge

Alsbridge is the award winning global advisory firm, providing unbiased advice and assistance on outsourcing, shared services and offshoring. Alsbridge consultants bring extensive vertical industry expertise and a practical knowledge of all areas within information technology and business process outsourcing. The firm's proven methodology incorporates proprietary collaborative sessions, bringing together executive teams from both the client and the provider in an environment that fosters collaboration. Alsbridge supports its recommendations and assistance through significant investments in proprietary benchmarking and ongoing research within the industry.