Is Outsourcing dying on its feet or merely adapting to undemanding clients?

Is Outsourcing dying on its feet or merely adapting to undemanding clients?

[Part 1 – A multi-part investigation and commentary]

What is going on with the outsourcing industry? Large or mega deals have all but disappeared, the deals being signed are small, shorter and less complex than three to five years ago. Yet when viewing the service providers published annual or interim results, turnover ranges from mediocre, which given the state of the world’s economy is not bad, to the rip-roaringly excellent results of the Indian providers. This despite their own expectations and massive currency fluctuations, state led xenophobia, huge double digit wage inflation and unacceptable staff attrition. Stranger still, solid gross margins are still being achieved – a typical example would be Infosys, which achieved year on year growth of only 15.7% (most analysts predicted and expected 20%+ growth), but a gross profit margin of 41.29%.

What about the performance of the more traditional service providers? IBM’s 4th quarter and year-end 2010 results show a gross margin of 49%, and current gross margins are 46.54%. Accenture reported strong financial results for the fourth quarter, ended 31st August 2011, with an operating margin of 33.1%. Clients have grown used to single digit profits from traditional service providers. Even a sleepy under-capitalised provider like Unisys has experienced coming “back from the dead results” with reported a third-quarter 2011 gross profit margin of 27.9% – this truly illustrates why clients need to understand the causes of and why outsourcing is changing.

Outsourcing has and continues to adapt and morph as it responds to client and economic demands. A lot of these changes are lost on even seasoned commentators and analysts. For example, our industry is counter-cyclical to the economy, so when recession hits we experience a mini boom for greater levels of new signings as corporations seek to contain and reduce costs, right – wrong! The industry ceased being counter-cyclical at least five years ago. Why? Simply put, the market’s previous momentum and success meant that most corporations have previously outsourced to a reasonable degree. Therefore the “black-art skills of how to do outsourcing deals” shifted, from the exec and very senior management, down into the gene-pool of middle management and, importantly, procurement departments. Procurement had previously been dismissed for not understanding how service provision, and therefore business risk, are not best bedfellows with accepting lowest pricing. So after ten years of wandering in the corporate desert, procurement is back with at least seven or eight of the ten tablets off Mount Sinai.

Extending, amending or undertaking new deals no longer needs executive signoff, it sits squarely within middle management control. At the same time the use of multiple specialist suppliers to handle only those areas of their specific expertise has largely eliminated the automatic inclusion of the large tier one players like IBM, CSC and HP. Indeed the approaches of the tier one suppliers often intimidates the empowered management team, who have grown used to having control and see loss of control as a direct consequence of using bigger global players.

Niche or Indian players accept shorter contracts with ease, whilst global players generally demand a longer tenure as a pre-requisite of bidding. Today’s shorter contracts seldom contain major CAPEX requirements, previously a major reason to use players with deep pockets. However, even tier one’s adapt fast and they have learned that in a bidding situation they do not need to fully compensate for their scale and leverage advantages in the cut-throat way that mega deal procurements usually drive out best and cheapest “everything” – that is a nice way of saying that higher margins, up to double, are back.

The cost of sale for smaller deals is of course much higher proportionally, but this is now easily affordable. But surely sourcing services from the market is all about lower cost? Few clients would fail to agree with this sentiment, however this is one of several realities a canny buyer needs to face up to in the new world of convenience sourcing, as opposed to the strategic sourcing where decisions had to last 5, 7 or even 10 years. Face facts – you will not get best pricing for small parcels of work. You will not get real risk carrying for smaller parcels, nor innovation beyond technical wiz-bangs.

What are the other consequences of today’s appetite for convenience sourcing? Firstly and most importantly poorer contracts, most are done without specialist legal or other advice, leading to reduced, unenforceable or non-existent contractual obligations and supplier liabilities. Typical examples from the market today:

• lack of measures and remedies for poor performance

• reputational damage (for example, prolonged outage of an IBM run ATM network in Singapore – this resulted not in a regulatory fine, but the bank being ordered to carry additional liquidity effectively locking up hundreds of millions of dollars)

• data protection – often given secondary consideration but it is critical to prevent potential litigation and even reputational damage if not handled badly

• poorly defined ‘exit’ responsibilities and costings, especially around the transfer of undertakings associated with deployed staff (their pension entitlements, etc). This is a time-bomb of hidden costs and major future managerial distraction

Apart from not achieving the keenest of pricing due to the lack of strategic commitment and accepting sub-standard contractual contracts, clients have fallen into other “traps” of their own making, such as not being able to address balance sheet issues on their books. Previously strategic outsourcing removed assets and people from the balance sheet and shifted the costs to expenditure. As outsourcing matured the tier one suppliers in particular, no longer wanted yet more people and assets which severely affect the supplier’s own balance sheets, and the performance and earnings per employee ratios that drive service providers share price and investors sentiment.

For middle management, convenience sourcing absolutely solves very real and impactful issues by providing expert services under the client’s control, with only a minimum commitment. The short-term nature of convenvience allows for “plug and play” replacement services where necessary. This convenience represents a double success for the larger suppliers too. They achieve higher margins, and deals with little or no impact on their balance sheet as they do not take on people, assets or risk profiles – no wonder the lack of large deals is not worrying them. So are today’s outsourced clients capable of securing a good flexible deal, yes. Will they secure the best commercial deal, with a risk bearing and innovative partner? The evidence suggests otherwise.

In conclusion – the service provision market has adapted to the client’s convenience sourcing model rather well and is significantly reaping the rewards of the new model. But it does not end there, in part two we will cover the knock on effect to the fractured independent sourcing support eco-system of the intermediaries, analysts, lawyers and benchmarking companies.

Posted in Outsourcing Comments: 2 comments


2 Responses to Is Outsourcing dying on its feet or merely adapting to undemanding clients?

  1. GrAy says:

    This is a good post. Neal Gray

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