Outsourcing Turns 20

Two decades of experimenting with routinized independent contracting has brought us to a new inflection point.

By Kevin Campbell

 

As revolutionary moments go, the day in early October 1989, when Eastman Kodak Co. CIO Katherine Hudson struck a deal to outsource the bulk of the company’s IT functions undoubtedly ranks among the least noted. But in business history, it was a seminal event—one followed soon thereafter by major and even innovative outsourcing deals made by such industry leaders as DuPont, BP, the London Stock Exchange, and the Dow Chemical Co. These companies legitimized a sourcing strategy that had been tentative and experimental until that point. Since then, the growth of outsourcing has been extraordinary. Today, it is a global market estimated to be worth more than $300 billion—a number that could top the $400 billion mark sometime in 2011. The practice has evolved dramatically since its “Kodak moment” 20 years ago.

 

What will outsourcing look like during its third decade, and what will it mean to the competitive nature of organizations around the world?

 

Outsourcing has not altered the fundamentals of business. But it has changed the way companies create and distribute optimal value from and around those fundamentals. From its origins as a hardware operations play, outsourcing has moved with a kind of relentless logic up the value chain—first to applications and software, and then to higher level business processes and services. The next wave of change will take companies to unexplored territory: strategic value and innovation.

 

Old Rules, New Rules
Catching that wave, however, requires an understanding of the trajectory of outsourcing to date and the insight to see where the trajectory of value redistribution will lead. It also requires an improved ability to manage those evolving value streams. In the late 1980s, after years of stagnation, the world’s economy was booming again. For global businesses, fundamental changes in the nature of competition were at hand. Value redistribution had begun.

 

For example, companies such as Microsoft and Intel were about to transform the technology world by breaking up, or “disaggregating,” the PC industry. Instead of relying on a single provider for most of a computing solution, customers could go with the best provider for each part of the value chain. In this context, outsourcing can be seen as a disaggregation, not of an industry or market, but of the enterprise itself. This was the period when business strategy was beginning to be driven by the conviction that companies should focus on their core competencies and get out of markets or functions in which they could not compete at the highest level. So why shouldn’t the company continue to run the parts of the disaggregated business that remained core to value creation, but let an external expert run the parts that did not?

 

According to this model, value is initially built up over time for any kind of product, technology, or service. Eventually, however, that value levels out and then begins to diminish.

The first part of the enterprise to experience the diminishing value of running a function internally was the hardware side of IT. As a result, many early outsourcing contracts, including those initiated by Eastman Kodak and General Dynamics Corp., focused primarily on IT infrastructure—taking over hardware operations and running a client’s data center. The value from such an arrangement was measured primarily in cost reduction. These were also financial arrangements. The outsourcing provider would write a big check to the client for its hardware— which, in theory, could then be used to serve multiple clients as a data center provider. It was a play to establish economies of scale, and, to an extent, it worked.

 

One major drawback loomed over outsourcing hardware alone, however. It was summed up at the time by the phrase “my mess for less”—that is, some companies had IT operations that were costly, redundant, and inefficient, so in effect the client was asking a provider to “fix” that situation for them while also saving them money.

 

As IT hardware outsourcing entered a period of commoditization and price pressure, it didn’t take long for the value redistributed to the outsourcing provider to level out and begin to decline. By the early 1990s, the central question for both companies and their providers had become: Where else can value be created by disaggregating the functions and processes of the enterprise?

 

Moving Up the Stack
In outsourcing, the key to delivering ongoing value to both parties was now to “move up the stack”—higher up the ladder of business value. For their part, providers had to rethink their role if they were to maintain an adequate level of value for themselves. They had to move beyond commoditization and build a business case that didn’t rely only on the cost side of the equation. A new generation of outsourcing arrangements would also need to be about quality, efficiency, and effectiveness—measured and visible via spreadsheet.

 

One innovative example of how both client and provider could hold on to some of that value came in 1992 at the London Stock Exchange (LSE). At the time, the exchange’s trading and information systems were showing signs of age. But while the exchange and its provider were able to develop a transformation program to dramatically upgrade systems, the LSE was short of capital. So the two parties worked out an innovative “gainsharing” mechanism between client and provider. The plan worked extraordinary well, and some £50 million of savings were redirected into the implementation of new systems.

 

People, Not Machines
The next rung on the business value ladder: managing a company’s software—the business applications that, various studies show, can constitute as much as 75 percent of a typical company’s IT budget. Running a company’s applications well would prove to redistribute value in a manner that was less fleeting than a hardware play alone because it requires higher order skills. This was really about running people, not running machines.

Canada Post was one of the first major organizations to leverage an application management outsourcing relationship at scale. By the early 1990s, companies were beginning to migrate from mainframes to the world of client/server and distributed computing. Canada Post executives felt that its organization lacked the skills internally to accomplish that difficult migration alone. By using an outsourcing provider, Canada Post could reduce both risks and costs, and was able to focus its resources on its core business and customer obligations.

 

Delicate Balance
Another milestone was reached in the mid-1990s with chemicals giant DuPont’s decision to outsource both IT infrastructure and applications (both considered cutting edge) in what the company called an “alliance partnership” with two providers. At $4 billion over 10 years, it was then one of the biggest deals ever.

 

The deal focused on cost reduction and efficiency, but also on other important business metrics: improving productivity, the speed of delivery, and the value of IT investments. Value redistribution from outsourcing had entered a new phase. DuPont and others were learning to discriminate between what could be commoditized—redistributing value by driving down costs and giving work to the lowest bidder—and higher level work, where the goal was to deliver more business value through improved efficiencies and the ability to focus more on business strategy and performance. DuPont itself achieved several important goals: increased variability in spending, greater flexibility in responding to business needs, and access to diversified, state-of-the-art business solutions, methods, skills, and techniques.

 

Application outsourcing evolved still further with Dow Chemical’s decision to outsource its application development and maintenance activities in an arrangement known as “co-sourcing.” Dow retained responsibility for some aspects of the IT function while outsourcing most of the application work.

 

One of the distinctive aspects of Dow’s arrangement was the rigorous measurement of results. In addition to the traditional commitments of on-time and on-budget delivery of the project, the ability to meet defined response and resolution times on issues, and support, higher level metrics—such as development and maintenance productivity, quality measures in terms of defect rates, and business measures such as speed-to-value—were also tracked. This work marked a turning point in value redistribution and in effective management: Measuring the value given back to the business units and functions at Dow was built into the deal.

 

DuPont’s decision to form an alliance partnership, and Dow’s co-sourcing tactic revealed a more complex approach to governance, with both client and supplier working to improve the ways they managed the arrangement. The notion had arrived of what Professor Mary Lacity, international business fellow and professor of information systems at the University of Missouri-St. Louis, calls “relational governance.”

 

Process Pioneer
If managing applications was actually about managing projects and people, why couldn’t the skills and experience from application outsourcing be transferred to the external management of business processes and the people performing them? The beginnings of this marketplace were already present with payroll outsourcers; improvement, not just performance, was the need now.

 

Global resources giant BP got this message very early. Until 1987, the company had been partly government-owned, and analysis had shown that the organization was still too bureaucratic and costly to succeed in a rapidly changing industry. In 1991, the CEO of the BP Exploration business unit took an important first step in what would be a thorough transformation of the company by outsourcing all of the division’s accounting operations for Europe.

 

The 1991 agreement consolidated all of BP’s accounting centers throughout the U.K. in a single accounting system and at a single site. Five years later, BP outsourced the accounting functions for its U.S. upstream, downstream, and chemicals businesses. And in 1999, following its merger with Amoco, BP outsourced its upstream business to one outsourcing provider, its downstream businesses to another.

BP’s success became a model for other companies looking to improve the efficiency and effectiveness of their business processes. Telecommunications giant BT became one of the first enterprises to outsource its HR function; U.S. high-tech company Avaya pioneered end-to-end outsourcing for the enterprise learning function; and Deutsche Bank found that it could make wiser procurement decisions and better control its procurement expenses through an outsourcing relationship.

 

A second reason why BP stands out in the history of outsourcing is that its agreements made it clear that economies of scale would be an important part of the value redistribution caused by outsourcing. After its shared services center was established to provide finance and accounting services, it began to attract other companies in the oil industry.

 

Industrial Strength
This kind of “one-to-many” delivery capability was a significant step in the industrialization of the outsourcing industry. Providers were demonstrating that, at scale, they could not only transition hundreds of employees into new organizations and manage them more effectively; they could also redeploy them where necessary to work with other clients on similar work. This approach boosted productivity and, because it rationalized the functions being performed, also drove down costs.

 

Notable in these early examples of business process outsourcing was the realization of how critical effective transition management is to realizing the full value of the deal. At BP, for example, as part of the initial agreement, European legislation dictated that a large group of BP employees (about 200) would have to be transferred to the provider.

 

Yet such a transfer was really more than a regulatory requirement; it was a key part of BP’s strategy to move core players to the outsourcer, because of the importance of those employees’ knowledge, skills, and experience with the company. At a higher level, companies were beginning to recognize that business process outsourcing could be a vehicle for radical change. For example, BP’s decision to outsource its finance and accounting functions came as a shock—and was actually intended to have that effect.

 

New Century, New Goals
The next challenge for outsourcing came from an unlikely source: the looming Y2K emergency, requiring the massive rewrite code to prevent applications from recognizing “00” in date fields as 1900 instead of 2000. Given the enormity of the task, the answer was to take the work around the world.

 

This was when sourcing work to areas such as India and the Philippines took off. All the pieces were now in place—industrialized and standardized methods, transition planning, more effective relationships, and now, deep experience with global sourcing—to move outsourcing in a more transformational direction.

 

A 2001 Accenture study found that conventional outsourcing was reaching its limits in terms of generating incremental savings. Rigorous service-level agreements, and even establishing penalties for failure to meet performance targets, could not by themselves improve the business value provided by the kinds of outsourcing arrangements then in place.

 

The answer would be to pursue more collaborative relationships capable of driving both cost savings and innovations, in the same way that successful companies use a combination of internal resources and strategic partners for product development. Sometimes that meant sharing ownership for results—an insight adopted by many outsourcing pioneers.

 

In 2002, for example, when BP renewed its finance and accounting outsourcing agreement, two things happened. First, the company and its provider agreed to an enhanced risk-reward arrangement that set annual cost and service-level targets. The provider would receive additional financial rewards based on achieving those targets. Second, the contract set aside a number of days for BP to consult with the provider about innovation—new ideas, applications, and technologies. In effect, an annual commitment to spend time thinking about new and better ways of doing things was written into the agreement.

 

The most recent research from Leslie Willcocks of the London School of Economics and Political Science stresses the importance of such collaborative relationships in taking outsourcing to the next logical phase of value redistribution: to innovation itself. According to Willcocks, both sides must strive for a deeper level of collaboration, “if outsourcing is to reach its next level of value creation.”

 

Bundled Up
The move toward transformational outsourcing has led companies and academics alike to reconsider the merits of sourcing to multiple providers versus a single provider. The issue is complex, requiring careful balance. Independent research has found that a combination of outsourcing and insourcing—rather than a total outsourcing approach—has historically achieved expected cost savings with a higher relative frequency. Yet this fact, perfectly applicable in a cost takeout environment, becomes problematic if the future of outsourcing is seen as a collaborative relationship focused on innovation and strategic value creation.

 

More recently, companies have begun to realize that the hidden costs of managing multiple providers are eating substantially into the value of the deals—and into the effectiveness of the overall collaboration. A 2009 research report from industry analyst IDC looks at the issue in dollars-and-cents terms, estimating that the governance costs in a multisourcing arrangement “can range from approximately 5 percent to 8 percent of the contract value.” In addition, the report notes that shorter deals, which must be renegotiated every three years on average, add to procurement costs. “In some cases,” cautions IDC, “these hidden costs have actually nullified the additional price benefits.”

 

Similarly, another 2009 study, from the Everest Research Institute, crunches more detailed numbers when analyzing this phenomenon. The savings from using fewer suppliers for application development and maintenance can be as much as 22 percent to 28 percent of multisourcing costs on an annualized basis, including a 35 percent to 40 percent annualized reduction in one-time setup costs and a 20 percent to 25 percent reduction in recurring costs. Key drivers of these savings include reduced governance costs to manage supplier relationships and delivery, as well as optimized resourcing from suppliers.

 

By combining or “bundling” functions and processes to a single provider, companies can generate significant synergies resulting in both greater cost savings and a bigger impact on the business, especially because of the ability to create a deeper collaborative relationship.

 

Bundled approaches can vary considerably from company to company. They can involve only the IT function—combining both infrastructure and applications—or they can bundle the management of multiple business processes. Or they can combine IT and business processes under a single arrangement, reflecting the increasing centrality of technology platforms in the enactment of business processes.

Several groundbreaking bundled programs stand out in recent years. Unilever has gained from bundling the management of its applications and its HR functionality. A comprehensive bundling arrangement at Bristol-Myers Squibb—application development and maintenance, finance, and R&D—has helped the company adjust to regulatory and industry challenges, and has helped the company in its productivity and transformation initiatives.

Companies can implement a bundled approach in “big bang” fashion, though more often than not, the approach is sequential. BT, for example, decided to expand its business process outsourcing strategy over time—beginning with HR, then moving to learning and then to finance and accounting.

 

Redistributing Knowledge
What’s next? As always, outsourcing will continue to be driven by customer needs, and that will result in market-driven innovations and new types of value redistribution. Basic outsourcing is already being extended into other innovative applications, such as product lifecycle management. Who would have expected, for example, that aerospace and defense firms would outsource the detailed specifications needed to build aircraft through “engineering services”?

As the global economy has become knowledge-based, so too has the outsourcing industry, and the next stage in value redistribution will involve nothing less than knowledge itself. The modern enterprise now has the ability to source not only hardware, applications, and services but also knowledge and skills, anywhere in the world. Some of the knowledge needed to achieve competitive advantage in the future will remain internal to a company—distinctive intellectual property that drives new products and services. Other forms of knowledge will be sourced externally, opening up the walls of collaborative innovation to drive better ways of doing business.

 

Companies will likely increase their reliance on universities and private research labs, and on their suppliers. Outsourcing providers are already retooling themselves as providers of differentiated products and innovative processes. As these capabilities grow, co-sourcing with such providers to drive innovation will become increasingly important. It also seems likely that companies will take equity positions in organizations focused on emerging markets and new ideas.

 

Committing to exciting, shared goals will be critical to winning in outsourcing’s next phase. So will a model through which both client and provider benefit from the partnership, with creative deal structures reflecting value creation that exceeds initial targets. The time is coming soon when even the very word outsourcing will be obsolete. No one in the industrialized world thinks of grocery shopping, for example, as outsourcing their family’s food production, though that of course is exactly what it is. We simply procure food from reliable sources at the quality and price we desire. That is where business strategy is now moving—inexorably. It’s an exciting time.

 

Kevin Campbell is chief executive of Accenture’s outsourcing business. He can be reached at kevin.campbell@accenture.com.