Although HRO is the biggest of the two markets, FAO buyers and providers have reason to be upbeat about their corner of the outsourcing world. A market value of $100 billion is not out of the question in the future.
In the first of this two-part series, we closely examined the development of the broad HRO and FAO markets and contrasted the two different outsourcing approaches. In the second part is an explanation of why the FAO market appears to be on a much stronger growth path than its HR counterpart and the drivers behind its explosion.
REASONS FOR OPTMISM
FAO is a $2 billion market, growing at more than 30 percent with lots of legroom. Cumulative annual contract value of full-service FAO contracts—a useful measure of FAO market size—is currently around $1.8 billion, with a consistent growth rate of about 30 percent (CAGR of 30 percent from 2001 to 2006).
The number of known, “live” FAO contracts—another useful measure of growth—has more than doubled in the past 18 months, from 70 to 160. Further optimism stems from specific data points that show demand is increasingly driven by customer pull and not just vendor push.
Multiple factors support continuous and sustainable growth of the full-service FAO market at this high-40-percent growth rate:
- Ample room for growth. Current penetration rates are still very low and provide ample room for growth. For large-cap companies, multiplying an assumed average spend of 2.1 percent of revenues on F&A by the aggregate S&P500 revenues of $7.8 trillion and assuming only 25 percent of F&A can be outsourced, the large-cap FAO market is more than $40 billion1. For mid-market companies, FAO opportunities could reach $100 billion during the long-term. Even if the current FAO market continues to grow at a 30-percent rate during the next 10 years, the resulting $27 billion is
- Mid-market enterprises are the new Wild West! While the FAO market was pioneered by Global 100 companies, it has quickly expanded to Global 500 and more recently to even smaller organizations, with employee sizes as low as 5,000. While enterprises with more than $5 billion of revenues still represent approximately 80 percent of total FAO contract value, about half of new FAO deals were signed, with customers reporting $5 billion or less in 2005 revenues, up from one-third of the deals in 2003 (see Fig. 1). The mid-market presents an exceptionally attractive opportunity, due to both size (number of mid-market companies) and the attractive one-to-many economics achievable with smaller customers (who are less prone to require customization).
- Compliance and transparency are king. Increased regulation (e.g., Sarbanes-Oxley) and shareholder demand for transparency are strong drivers for both public and private enterprises to standardize their finance and accounting activities, provide third-party management of those activities, and allow for best practices in financial management and reporting. While initial compliance requirements kept CFOs busy and unable to focus on F&A outsourcing, now that the regulatory environment has stabilized, compliance and transparency have turned into a driver for FAO adoption.
- Added value is available. As processes and technology mature, BPO vendors increasingly are able to offer value beyond just cost cutting. In addition to compliance and reporting, adoption of standard tools, processes, and best practices can offer additional demand-driving benefits such as reduced working capital (through better management of cash and receivables) and reduced operational and financial risk. For example, by making order-to-cash outsourcing more efficient, customers cut the number of day sales outstanding and shorten the cash-flow cycle and reduce revenue leakage.
PROFITABILITY OF FAO
Several factors stand to allow FAO to be significantly more profitable for well-positioned service providers than HRO. These factors include:
- BPO is more likely to enjoy one-to-many economics, especially in the expanding mid-market segment. Many finance and accounting standards and practices are more common than are HR standards and practices (beyond payroll) across customers. This enables FAO vendors to deploy a common platform across multiple customers, provide less customization work than HRO, and enjoy the resulting one-to-many economics. In addition, many F&A functions are based on standard ERP products (more than 75 percent of FAO contracts have packaged ERP systems as the underlying technology, with one ERP vendor—SAP—leading with nearly a 40-percent market share). This fact further reduces the amount of customization workload. Moreover, F&A functions are naturally easier to integrate (e.g., an accounts payable transaction is easily translated into the required accompanying entry in the general ledger), much more so than HR-related functions.
- FAO deals are based on relationships between an outsourcing vendor and the finance department of a buyer. In FAO relationships, the interaction is typically between the service provider and the personnel within the finance department and, in some instances, procurement. Overall, it is less complex for service-level agreements and accountability metrics to be built into contracts. The outcome measurements are easier to quantify, and the overall governance of the contract is simpler to administer than typical HRO contracts. HRO usually affects the entire staff within an organization, and many of those deals are challenged from the onset as a result.
- FAO economics are driven more by labor arbitrage. FAO profitability will continue to be more attractive than HRO as its economics are driven more by labor arbitrage, as opposed to being driven by technology and automation; this simple fact provides more room for vendors to enjoy attractive margins (financial transactions rarely have intense or intimate customer interaction that HR processes have, making them easier to send offshore). Of all FAO contracts, 73 percent have a significant offshore component. Technology transformation is becoming increasingly crucial with FAO deals, but this is more from a perspective of vendors developing “tie-and-run” capabilities to enable the smooth transition of F&A processes to the service provider through wrap-around technology that builds on existing ERP.
KEY LESSONS FOR THE HRO INDUSTRY
There is no doubting the fact that most HRO engagements are considerably more complex and sensitive than those in FAO. However, there are some simple lessons HRO buyers and suppliers can learn from the current success of FAO to set expectations for buyers.
- Keep it simple from the outset. HRO has been positioned as a major strategic game-changer for companies. Focus on the transactional processes first—namely payroll and benefits administration—where buyers can take advantage of cost savings through labor arbitrage. And there are technology platforms available that can facilitate an HRO engagement without enormous complexity. Once the first transitional phases of HRO have been accomplished, the buyer can focus more heavily on aligning its retained HR organization with the corporate goals. FAO is positioned primarily as a cost-reduction play, with the issue of achieving quality service a differentiator between suppliers.
- Define stakeholders effectively and execute early transition phases with extreme diligence. HRO can negatively impact an entire organization if the relationships between the service provider and the buyer’s governance team are not well-defined. This is particularly the case during the early transition phases post-transaction. Areas of impact such as the introduction of self-service tools and high-touch offshore employee care representatives need to be managed and communicated extremely diligently. HRO service providers need to work harder with their clients to help them through these early transition issues of HRO. Third-party advisors can help, but the service provider should expect to invest more attention and resources in ensuring the early transitional excellence.
- Get the economics right. The industry has seen close to 140 multi-process HRO deals to date, yet we are still witnessing many leading suppliers struggle to achieve positive returns from HRO contracts, coupled with the poor publicity of trying to manage highly complex operational issues. There have been enough test cases out there for suppliers to start getting the balance right. The FAO industry has experienced a similar number of contracts, but has got its act together much more quickly, largely as a result of the contracts being smaller, and less complex. That said, there are enough benchmarks to get the economic fundamentals of HRO correctly balanced. That leading providers are taking a more cautious approach to taking on new business is an encouraging sign. Let’s hope the industry has turned the corner.
I would like to thank Bernstein Research for its contribution to the financial outlook in this article.
1 FAO Source: Everest Research Institute and Bernstein Research