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short lines

Outsourcing - into 2006 and beyond

January 2006

Market analyses indicate we'll see a greater use of outsourcing in 2006 than ever, but individual deal values will continue to fall, customers will commit to their suppliers for shorter periods, and existing longer term deals will be restructured (i.e. renegotiated). Customers will increasingly multi- or selectively-source, the offshore service markets (China, India, South Africa, etc.) will grow faster than other service provision centres, the growth of BPO (business process outsourcing) and particularly HR outsourcing, will outstrip other sectors, (e.g. IT outsourcing), and business transformation outsourcing (BTO) will become increasingly common.

This continuing evolution of global outsourcing markets will not fundamentally reshape how projects are negotiated and documented, but legal and commercial teams will undoubtedly need to finesse existing contractual models to accommodate some of the new demands that will arise, if successful projects are to be delivered. In this Short Lines we suggest our half dozen golden rules for the next 12 months.

Redefining deal structures

Outsourced services deals are getting shorter and cheaper for several closely connected reasons. Competition has driven down the cost of many services, particularly where the services can be offshored (see below). For certain services (e.g. IT), the underlying production costs of non-people resources have also fallen dramatically in recent years, meaning customers don't need to lock themselves into very long term deals to balance affordability with supplier return on massive front-end investment. The increasing trend to multi-source is also markedly reducing individual deal values, with previously 'one stop shop' services now being divided amonst a number of suppliers.

Rule 1 - Pay attention: As deals get smaller, there is an inevitable temptation to give them less strategic attention, but this should be resisted. Individual deals may be getting smaller, but simply because it is now cheaper to outsource business functions does not necessarily mean it is otherwise less risky. If the service falls over the customer may have wasted less money, but the impact on its business will otherwise be no less significant. That said, negotiators do still need to be realistic about risk apportionment. A supplier will usually earn less from a lower value deal (though the key is the margins, not the service charges) and the customer should therefore expect lower aggregate financial risk assumption. However, in all other respects, unless the deal value is wholly disproportionate, robustly contracting for risk does still make a great deal of sense for anyone wishing to avoid protracted expensive litigation.

Rule 2 - Multi-source for quality: Multi-sourcing can potentially significantly reduce the impact of failure, simply because only a part of a service has been outsourced to each supplier. However in practice, multi-sourcing creates new risks, through integration and inter-reliance, and the real possibility that one supplier may cause others to fail, and worse still, no supplier may be responsible for failure at all, if none has assumed the integration risks. The reality is, therefore, that multi-sourcing fundamentally requires substantially greater project governance, whether retained by the customer, or itself outsourced to one supplier assuming responsibility for end-to-end service delivery, (the 'single point of failure'). In either case, envisaged costs savings from multi-sourcing can easily be eliminated through internal resource allocation or supplier integration risk premiums, and if the governance models are actually still inadequate, the risk of failure is probably only slightly lower than single-sourcing.

Rule 3 - Contract for flexibility and exit: Several very large project restructurings were announced in 2005, as customers' business strategies and services requirements proved markedly different from those originally envisaged. Whilst it may be somewhat inevitable that requirements change in the often lengthy period from project inception to implementation, if customers wish to avoid the often phenomenal costs of deal restructuring, greater pre-signature consideration must be given to contract flexibility and exit management. If contracts inherently permit service flexibility they're less likely to require restructuring. Whilst there will probably be some additional premium to pay for contract flexibility (particularly down-scaling), it is likely to pay off, particularly for longer term deals. If the changes required are so fundamental as to be outside the supplier's scope of competence, or cannot be provided on reasonably attractive terms for both parties, the mechanisms must be in place to permit a shift and painless insourcing or supplier replacement. It pays to remember that negotiating exit is substantially less difficult in advance, than when it's needed.

Offshoring

Indian service providers are now firmly establishing themselves as global IT and BPO service providers with TCS winning two major European contracts in 2005 with a combined value of over £600 million, and Infosys appearing in one industry report ranked third in the worldwide rankings of IT suppliers by value, behind IBM and Accenture[i]. However, some commentators are predicting that India may struggle to keep its currently estimated 85% share of the global BPO market[ii], as costs pressures, poor infrastructure and lack of available quality talent cause customers to look increasingly to other shores, such as China, Vietnam, South Africa and Eastern Europe.

Rule 4 - Be selective: The single most important commercial rule for offshoring is to outsource only those services that cannot be adversely affected simply by the particular location. Many customers have learnt this lesson the hard way and have lost substantial business, often far exceeding services costs savings, by offshoring customer-facing services, only to discover that the old adage 'you get what you pay for' is most definitely true. 2006 will likely see a further refinement of offshore services locations, with destinations such as the Philippines and South Africa increasingly taking the lead for customer-facing (e.g. call centre) services, and India and China undertaking more programming and back office processing.

Rule 5 - Take advice: Having identified the most commercially viable location, do not underestimate the potential legal and accountancy issues, and take local advice. The issues will vary from location to location, but it is vital to understand local tax regimes, intellectual property laws, the local corporate and regulatory requirements, the inevitable impact of the EU data protection rules and local mandatory laws (e.g. around employment terms and protections and commercial contracts laws), and for regulated businesses (e.g. banks and insurers), any particular regulatory requirements imposed by home state regulators (e.g. the FSA's SYSC3A and in time, MiFID[iii]). These many factors can potentially have a significant impact on the commercial viability of offshored deals so it's vitally important that projects are structured appropriately. Remember too, to account for local enviromental issues. It is an unfortunate reality that our ever-advancing industrialisation is affecting our climate, and many potential offshoring locations do more frequently suffer from environmental disasters than European states. Adequate business continuity provision is a must, and needs to be properly interfaced with contractual release mechanisms (e.g. force majeure).

Growth of BPO and BTO

Over the next 2 to 3 years, the global BPO market is predicted to grow at a compound annual rate (CAR) of 17.1%[iv], to be worth around £13.5 billion per annum by 2007[v]. By contrast, the IT outsourcing market is predicted to grow over the same period at a relatively modest CAR of 4.6%[vi], but there is really no cause for alarm amongst ITO service providers. The primary reason for these contrasting growth predictions is the relative maturity of each market, in consequence of which ITO will naturally grow less than BPO over the coming years, and likely far less than the BTO market, which is currently still relatively conceptual.

Rule 6 - Appropriately measure performance: Service level matrices are less appropriate when measuring BPO, and are inappropriate when measuring BTO performance. SLAs measure only supplier performance, which can work well for input-driven ITO, but for BPO, and more so for BTO, project success is actually about improved customer performance in consequence of supplier performance, not good supplier performance of itself. In other words, if customer performance is not also measured, a project may succeed contractually, but not strategically, in which case it has failed. Therefore, for BPO and BTO, identify the strategic project objectives and how best to measure their realisation, and consider appropriate benefit-sharing to map onto each party's investment into the project. Being predominantly output-driven, BPO and BTO projects tend towards partnership rather than supplier-customer relationships, and performance measurements and payment triggers need to be devised accordingly. Typically supplier margins will be on risk of project success, though there may be (not always) some minimum baseline charges to cover supplier costs. In turn, customers should expect related dependency obligations on themselves, although it is surprising how often this simple quid pro quo is not predicted.

David Meredith

[1] source: Everest Group

[2] source: Garner Inc.

[3] The Markets in Financial Instruments Directive (2004/39/EC)

[4] source: TPI

[5] source: Gartner

[6] source: TPI