A lawyer-sourced view of the current outsourcing market.
 

By Chris Ford and Alistair Maughan 
 
 
Every year, Morrison & Foerster’s global sourcing group lawyers in Asia, Europe, and the United States are surveyed to create a snapshot of the current state of the world’s outsourcing market and to identify emerging trends that are likely to shape that market during the next 12 months. In this year’s update, the group of lawyers comment on the overall state of the outsourcing market, the importance of multisourcing, today’s interest in business transformation, the growing use of strategic global sourcing strategies, and trends affecting the market in specific geographic areas.
 
 
As the economic recovery slowly moves forward, outsourcing is taking a more prominent place on many agendas. Companies and outsourcing providers are adjusting to an environment where there is still significant uncertainty and where new approaches are being adopted to address new challenges.
 
 
Companies considering outsourcing face continued uncertainty on many fronts. Nevertheless, in recent months outsourcing activity has increased, up from the precipitous, recession-driven drop-off of the previous three years. The health of the economy—and outsourcing activity—varies from one place to another. But growth is expected to continue in many regions and sectors in 2012.
 
 
The uncertainty comes from various quarters. Many organizations are worried about the slow pace of economic recovery, or even the possibility of a double-dip recession. Added to that are the concerns about the European Union’s financial difficulties, fluctuating global stock markets, and political indecisiveness and election-year politics in the United States that often make it difficult for businesses to plan ahead.
 
 
But those concerns are just part of the story; a range of other factors are prompting companies to outsource. For one thing, corporate profits in many sectors are rebounding, giving companies more capital to work with than in recent years. For another, many parts of the outsourcing market are seeing pent-up demand. After several years of belt-tightening and holding off on large projects and capital investment, many companies need to catch up by improving systems and processes. This is especially true in industries such as financial services, where technological sophistication is key to the creation of new products. In general, companies are finding it is getting difficult to put off improvements any longer, and outsourcing often provides a vehicle for moving those improvements forward.
 
 
From our perspective, we have certainly seen an increased flow of outsourcing deals, with more emphasis on new deals and less on renegotiating existing deals to cut costs. Indeed, the number of outsourcing arrangements that we’ve worked on has grown throughout the year, and the past 12 months have been the most active of the previous four years. Our experience is shared by others. In the third quarter of 2011, ISG reported a 41 percent year-to-year increase in the global outsourcing market, and a 38 percent rise in the number of “new scope” deals.
 
 
However, the renewed interest in outsourcing is tempered by a definite sense of caution. Fewer megadeals are being done. Instead, companies are often engaging in smaller deals, focused on specific, carefully defined areas. Thus, where a large deal a few years ago might have been worth $1 billion or more, today’s larger transactions tend to be valued at $100 million and above. There are exceptions, of course, but in general, companies are showing a heightened aversion to risk and are not outsourcing anything more than necessary.
 
 
As a result, companies are tending to rely on several smaller providers to handle work, rather than one large provider responsible for a multifaceted engagement. Single “tower” projects are more prevalent. We continue to see greater use of multisourcing, with different towers of services handled separately by different providers, all under one framework managed by the client company. At the same time, providers are enabling this trend with a growing array of “as-a-service” offerings, designed to provide a menu of service offerings from which customers can choose.
 
 
Companies see the use of several providers as a way not only to cut costs, but also to have greater flexibility to tap the marketplace for different skills as needs evolve. In addition, companies often value the opportunity to have greater visibility with their provider, compared to what they might have with a large Tier 1 provider. This multisourcing approach lets companies take advantage of the cost-effectiveness related to the commoditization of some services, such as certain help-desk activities and PC break-fix, thus reducing the costs of the outsourced services.
 

In a related vein, we are also seeing the increased use of “outsourcing panels.” Here, companies assemble a group of providers to focus on a given task and establish a financial framework for working with each one. Then, as projects come up, the company can “bid” the work to the panel members. For example, a company might have a panel of three providers it uses for application­development work. When such work is needed, the company asks all three for a proposal and selects one. The vendors benefit from always being on the short list and not having to go through lengthy, repeated sales cycles; the company benefits from a shortened buying process and competition among vendors.
 
 
Extensive IT, Focused BPO
The current atmosphere of cautious optimism is also reflected in the types of activities being outsourced. For example, ITO is showing stronger growth than BPO, and we expect that to continue in the coming year. When a KPMG survey asked large companies what they see as effective ways to improve service delivery, “outsourcing more IT” ranked second, behind improving governance processes. “ITO is a mature operating model now, where executives believe that a big proportion of IT could and should be outsourced,” says Bill Thomas, CEO and senior partner at KPMG UK.
 
 
That is not to say that there are no BPO deals taking place. As a general rule, however, BPO tends to be used for specific activities or functions, compared to broad enterprise processes. Rather than all of finance or HR, a company might outsource accounts payable or benefits management. Overall, buyers are typically taking a careful, tactical approach to BPO.
 
 
Meanwhile, outsourcing arrangements that target business transformation appear to be coming back—and some are of significant size. This is a shift from the past several years, when companies were primarily interested in labor arbitrage and driving out costs. In part, this could be due to companies wanting to prepare themselves to weather the next economic storm and to use outsourcing as a tool for changing their businesses and strategically positioning themselves for the future.
 
 
Increased interest in transformation may also be the next natural step in the evolution of outsourcing markets. Many companies have now gone through several rounds of outsourcing—and internal cost-cutting—and have become more sophisticated in their understanding of the strategic benefits outsourcing can provide.
 
 
Shaping the Deal
In forging outsourcing contracts, costs have always been a central point of negotiation and concern. That will continue, and perhaps become more of an issue in the coming year, with buyers putting more pricing pressure on vendors. Having learned from recent recessions, customers will focus on pricing models with a high degree of flexibility, allowing the customer to shed costs and renegotiate terms in the event of future downturns.
 
 
At the same time, we are seeing more performance-based contracting, with companies moving away from headcount- or requirements-based contracts to agreements based on delivering desired outcomes. For example, instead of spelling out the number of technology personnel involved and the steps they will take to manage an IT infrastructure, an agreement might call for “keeping the system running well,” with the emphasis on achieving specific performance standards. How that will be done is left to the vendor. Ideally, this will help align the parties’ activities.
 
 
Sometimes, achieving such alignment can be more complicated. Companies often want to spell out what they will get and how they will get it. Vendors, on the other hand, want as much flexibility as possible, particularly in an uncertain and changing market. They want to be able to move operations to low-cost countries and to take advantage of new technologies, such as cloud computing, when appropriate. As a result, we find that vendors are increasingly interested in limiting their customers’ ability to dictate how the services are going to be provided.
 
 
As they were in 2011, data privacy and security remain key issues. Vendors continue to push hard to limit their obligations and exposure as they contend with burgeoning amounts of electronically stored personal information, growing regulatory requirements for data security, and customers demanding full accountability. To some extent, vendors are gaining ground, with agreements that cap vendor liability for data breaches and replace blanket guarantees of data security with the need to comply only with specific operational requirements. In 2011, however, we saw customers pushing back and pressuring vendors to assume more accountability. Customers have made clear that this is a C-level issue in their organizations. We routinely hear from companies that this is their biggest deal issue, and we have seen the issue elevated to the board level for resolution. We expect this to remain a critical issue in 2012.
 
 
The Cloud Expands
A great deal of discussion has been devoted to cloud computing in outsourcing, and in 2011, those discussions continued to be reflected in deal activity. Many companies have established plans for the cloud, and many have a clear grasp of the benefits that cloud-based delivery of services can provide, such as reduced costs and the flexibility to scale capacity up and down, quickly and easily—and they are ready to move forward. But they also need to understand that this differs from traditional outsourcing and brings with it some additional risks that need to be managed up front.
 
 
For example, companies need to take a planned approach that matches the right type of cloud—private, public, hybrid—to the processes that will be delivered so that critical processes aren’t being managed in an insufficiently robust environment. Business continuity and data security—and who is responsible for those items—also need to be clearly understood. When services are delivered via the cloud, companies typically lose a significant measure of control over various aspects of those services. Vendors are able to provide cost-effective cloud-based operations by having customers share servers and other infrastructure, as well as offering standard terms and conditions that customarily are not modified on a customer-by-customer basis. With greater competition among vendors, however, customers are starting to successfully negotiate several of the key terms of their agreements.
 
 
The move toward cloud computing also highlights the need for internal governance over how the organization uses and controls the services being delivered. Policies need to address a number of issues: Who can access which cloud­based services? How will provisioning, versioning, and upgrading of services be controlled? Does the cloud environment have adequate audit capabilities to comply with requests from regulators and litigants? Without clear answers to these types of questions, companies moving to cloud-based services may actually be increasing costs and risk.
 
 
It is clear that outsourcing customers and providers alike will face a complex and shifting landscape in the coming year. Finding the opportunities in that landscape will take insight and careful planning, but experience has shown that it will be worth it—and that the right approach to outsourcing can bring significant value.
 

The Road from Here
The U.S. outsourcing market is recovering, with the financial services segment leading the pack. For all industry sectors, however, 2011 activity was essentially at or above the five-year average, which we take as an indication of a broad-based increase in overall economic strength—and a rising tide that is lifting all boats.
 

Beyond the overall market statistics, we also see a change in attitude, with companies showing a greater willingness to switch providers when it is time to renew an outsourcing contract. Some companies may be interested in the favorable upfront terms offered by a new vendor, while others may feel that their incumbent vendor has squeezed out all the costs it can and it is time for a new approach. In addition, extensive experience with outsourcing has given more companies the confidence and sophistication to deal with change.
 

Looking ahead, we are likely to see evolving attitudes in the public-sector market as well. In a number of states, political considerations and some negative outsourcing experiences have created deep—and often vocal—opposition to the outsourcing of public-sector activities. Now, however, that opposition is running into the hard economic realities of revenue shortfalls and severe budget constraints. State governments need to reduce their expenses. But they also have to deal with IT infrastructure that is often rapidly becoming old and obsolete.
 
 
Outsourcing, which would enable states to access upgraded technology and processes without large upfront investments, offers a potential solution.
As a resuIt, the once resolute “no” attitude is shifting toward a subtle “maybe,” and we are seeing some states tentatively moving forward. Often, they are outsourcing smaller pieces to different providers—mainframe operations, perhaps, or the midrange environment.
 
 
As state governments increase their use of ITO, they may run into complications. For example, in a private-sector deal, a vendor would likely consolidate operations into its own data center. In a public-sector deal, that might be politically difficult if the center—and its jobs—is located out of state. Political concerns can make it difficult for states to use offshore operations, which are key to significant cost savings.
 
 
Overall, ITO is once again on the table. But if state governments are to meet the intense budget pressures they face in the coming year and beyond, they will need to find ways to balance political considerations with economic realities.
 
 
Chris Ford is the chair of Morrison & Foerster’s firm wide global sourcing group and Alistair Maughan is a partner in the firm’s London office. The preceding was excerpted from the white paper Global Sourcing Trends in 2012 from Morrison & Foerster.
 

Tags: Benefits, Contributors, Engaged Workforce, Multi-process HR, Sourcing

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