@The_Whole_Outsourcing_Industry: Labor arbitrage built your house of cards. #Bubble What’s next?

The outsourcing industry is a labor arbitrage bubble waiting to burst.  And today’s smartest buyers and service providers are poised to fatally pop it and build a better future.

We know that buyers were accomplices in the run up. After failing to invest in their operations, buyers saw limited value in their business functions.  Accounts payable teams were overwhelmed with paper, finance teams struggled with creating process rigor, and human resources teams bungled global resource management.

Struggling with recent macroeconomic issues, buyers simply didn’t have the time or resources to reengineer for greater value.  So, they threw in the towel and asked service providers to manage their processes for them at a lower cost.  To them, reducing the monetary size of their cost centers was success.

IT was no different and they were the biggest buyers of expensive labor.  Their internal customers furiously revolted against swelling technology wai$tline$ and the lack of an “application development factory” mentality.  So, in the midst of economic haircuts, CIOs surrendered by outsourcing their staff to offshore companies that brought CMM and ITIL process rigor.  Yet, these efforts did little to simplify underlying application and infrastructure platforms that drove their high costs.

Have no doubt – labor arbitrage provided everyone immense value.  Yet, at its best, labor arbitrage is a funding mechanism for true best practice adoption.  At its worst, it is a circus sideshow absorbing management focus.   And we know that most buyers adopted to lift and shift, rather than rushing to adopt best practices at the outset of their deals…

Never before has the future of our industry been more clear: Today’s wiser buyers know that the value of accounts payable, procurement, or customer service shouldn’t be equated to its cost per invoice, PO, or call.  They want value.  Accounts payable should improve working capital and enforce contract compliance.  Procurement should generate hard savings and source best in class suppliers.  Customer service should eliminate the sources of customer frustration and create loyal relationships.

Still, the road to our future is unclear.  As buyers begin to line up for higher value services, their shift in demand will dramatically affect the marketplace.  Service providers that cannot develop IT-enabled BPO platforms, provide insightful analytics, or drive high value business outcomes will lose market share and be relegated to second tier “tactical” supplier status.  Service providers that can help extract greater value will dominate and their customers will benefit.   Billions of dollars are on the line and buyers need to make bold decisions – many of which involve justifying switching costs of changing service providers on improved business outcomes.

The Bottom-line: Today’s Buyers Face Three Challenges

1) The foremost challenge facing buyers is the immaturity of service providers to provide more than labor arbitrage.  In every segment of the outsourcing marketplace, leading service providers are urgently developing solutions.  Like Accenture’s acquisition of Duck Creek to provide value to property and casualty technology.  Or IBM’s development of Watson and its application in the healthcare industry.  Or Genpact’s acquisition of Akritiv to support account receivable departments.   Surprisingly, most service providers are non-committal and prefer “dating” through arms length partnerships, but their maze of third party partnerships are hard for buyers to understand.  Other service providers are hesitant to invest at all and instead try to talk their customers into co-investing in developing improved capabilities

2) The second challenge facing buyers is determining a fair fee structure of a value-based arrangement.  Because buyers have a mindset and past experience based on FTE-based economics, they find it difficult to compensate service providers for the value they will create.  Especially when comparing a value-based bid to lower cost labor arbitrage-based bids.  Buyers are notoriously cheap.  Buyers figure they can start “phase 1” with a low cost FTE-based structure, but rely on the service provider’s unplanned “innovations” that may provide more value.  But they are unlikely to be satisfied with the results.  The foundation of any outsourcing relationship should be making changes that maximize a process’s business value.  Service providers who create better outcomes should be entitled to better margins, which buyers should be willing to pay – if the outcomes are assured and proven.

Tony Filippone

Tony Filippone is Executive VP for Research (click for bio)

3) The third challenge facing buyers is managing transitions to new service providers that can provide value.  If their business cases are not sound, internal pundits will hamper transitions and long-term value.  Risk adverse buyers with limited experience with switching service providers will need to manage large transition efforts. Most importantly of all, if buyers fail to establish the right governance leadership, they will fail to achieve their ultimate goals.

Much of what lies ahead is unclear.  As the economist Adam Smith said, “On the road from the City of Skepticism, I had to pass through the Valley of Ambiguity.”  To this end, HfS Research will continue its aggressive research agenda focused on providing unbridled, industry-leading research to organizations seeking improved clarity.

Tony Filippone is EVP, Research at HfS Research.  He can be reached at tony dot filippone @hfsresearch.com

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7 Comments

  1. Posted December 13, 2011 at 11:35 pm | Permalink

    I totally agree that the outsourcing industry is a labor arbitrage bubble that is ready to burst. Companies have certainly become dependent upon outsourcing key responsibilities–and this practice does certainly unlock value for the company. That said, the outsourcers do have their underlying profit motives and need to get themselves paid.

    As you point out, outsourcing key responsibilities like accounts payable should not be judged solely on cost reduction metrics, like cost-per-invoice, but also be be judged by how they support other key outcomes, like improving cash management.

    Outsourcing will obviously never go away, but expect it to change. As we have seen, software has simplified the means for scaling tasks. For example, automating accounts payable processing not only provides the cost benefits of outsourcing accounts payable, but it allows internal teams to remain in control and get external benefits outsourcing has trouble delivering–visibility to improve cash flow, simplifying audits, faster reporting, etc….

    In short, outsourcing is certainly a bubble that will burst. Expect outsourcing services to adapt and find ways to unlock more value than cost savings alone. I expect much of this value-add to come from automation of key processes and varies software.
    , providing them the insights and access needed to improve cash management and

  2. Alain Schaeffer
    Posted December 14, 2011 at 9:39 am | Permalink

    Tony,

    Love this post. However, this seems more appropriate for offshore outsourcing than onshore?

    Alain

  3. Paul Cantante
    Posted December 14, 2011 at 12:51 pm | Permalink

    Tony,

    Your analysis is spot on! Sounds like the winners will be those who can find and acquire companies that fill vertical niches

    Then their challenge will be integrating those companies to harness real value, drive costs down and increase automation.

  4. Russell
    Posted December 19, 2011 at 4:24 pm | Permalink

    Tony, great insight. Extracting the value from outsourcing is a 2 way street. Sure labour arbitrage has been the basis of the industry for some time, but that has also meant that the buyer has been able to extract the value without thinking to hard about changing their processes, culture and organisation. The next wave of value extraction (think about the mining industry have to work lower yield mines !) must address both sides of the street; for the buyer how do I change my processes, organisation, operating models to more effectively leverage the capabilities of my supplier, for the supplier – as you have suggested – how do I change my delivery model to align around the value drivers of my clients be that platform, process improvement, transformation and new commercial models. This means change on both sides, working together closely on joint value creation. And you can’t do that in a commodity buy/sell environment !

  5. Posted December 20, 2011 at 6:11 am | Permalink

    Our customers and prospective clients are looking for us to provide higher value but are not in a position to invest in the time to determine what that value might be for them in the long term. They’re operating with such short time frames with executives moving in and out of the company in a 24 to 36 month time frame that it makes it hard to stick to one plan.

    There’s no continuity, one day the value they want is “X” and 6 months down the road it’s “Y”.

  6. Anil
    Posted December 29, 2011 at 4:26 am | Permalink

    Tony and others,

    I am afraid that I do not agree with the bubble part for the simple fact that this is known to both the buyer as well as the seller. Therefore, this is a simple transaction between two willing parties.

    On the other hand, the bubble perhaps lies in the way the value is articulated as this is difficult to measure and more difficult to govern both contractually and otherwise. The buyer would be happy to have all the value to be delivered by the provider included in the cost or FTE cost so that they can make simple apple-to-apple comparison.

    I firmly believe that buyers are no novice and have capability to derive what benefit / value they would get provided service provider delivers on certain metrics.

  7. Posted January 17, 2012 at 5:16 pm | Permalink

    With due respect, the thought process behind this article is defensive and reflects a “cost center” mentality. Most P and L owners realize instinctively that to even sustain a margin (much less increase it) in any business, they need to be more cost/operationally efficient than the prior year. If your pricing is not going up (it is not in many industries because of competition), even to fund a “merit increase” of 3% for your staff, you need to be 3% more efficient than prior year for the same workload. Unfortunately, cost centers are often headed by executives who don’t get this basic facet of capitalism. It is a delight for an organization to find a head of customer service who gets the cost/call down every year AND increases first call resolution or customer satisfaction simultaneously. Not one vs. the other. Or a CIO who brings down the cost of application maintenance AND brings time to resolution down simultaneously. That is the bar unfortunately, those cost center managers who don’t “get it”, do so at the peril of their careers. Articles such as this one don’t help – they reinforce a bad mentality.

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