As revolutionary moments go, the day in early October 1989, when Eastman Kodak Co. CIO Katherine Hudson inked 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 2010. 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? These are important questions for companies as they emerge from the current economic downturn.
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.
As Adrian Slywotzky writes in his book Value Migration, at the time many large, successful companies were sensing that the old rules of success, driven by market share and scale, were no longer working: “They were beginning to see the emergence of new competitors that, although starting small, were winning away their most valuable customers.”
Put another way, value redistribution had begun. For example, companies like 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 where they could not compete at the highest level. If that was true, the thinking went, 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?
The hardware play
According to the value redistribution 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 the IT shop.
As a result, many of the 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.
There was one major drawback to 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, in the vernacular of the industry, 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—the ability to point to a spreadsheet to say, “Here’s how your company is performing better, serving customers more effectively or getting products to market faster because of this outsourcing arrangement.”
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. At the time, the exchange’s trading and information systems—which had been put together rapidly in the early 1980s in anticipation of the sweeping deregulation of the UK financial markets—were showing signs of age. But while the exchange and its provider were able to develop a transformation program to dramatically upgrade the exchange’s systems, the LSE did not have the available capital to adequately fund the initiative.
So the two parties worked out an arrangement whereby funding for systems development would come from savings derived from outsourcing, through the use of an innovative gainsharing mechanism between client and provider. The plan worked extraordinarily 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 their 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 in what the company called an “alliance partnership” with two providers.
Value redistribution from outsourcing had entered a new phase. At $4 billion over 10 years, it was then one of the biggest deals ever. And it was especially influential because DuPont was recognized as a leader in IT cost efficiency and viewed as a model of best practices in IT management. 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 the company’s IT investments. Value redistribution from outsourcing had entered a new phase. DuPont and others were learning to discriminate between the parts of their IT departments that could be commoditized—where they could redistribute 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 at about the same time 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 at the heart of the deal. In addition to the traditional commitments—on-time and on-budget delivery of the project, the ability to meet defined response and resolution times on issues and support—the arrangement included such higher-level metrics as development and maintenance productivity, quality measures in terms of defect rates and business measures such as speed to value.
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.
Both DuPont’s decision to form an alliance partnership and Dow’s co-sourcing approach are indicators that approaches to governance were evolving to support a more complex environment, and that client and supplier were both working to improve the ways they managed the outsourcing arrangement.
Mary Lacity, international business fellow and professor of information systems at the University of Missouri-St. Louis, who has written extensively on outsourcing, notes: “At the beginning of the outsourcing movement, companies saw their goal as being primarily concerned with the effective management of a contract. They soon realized, however, that the contract is not the best form of governance in the long term.” Outsourcing engagements require “relational governance,” Lacity points out, “in which both parties are committed to fairly adapting the engagement to changes in technologies and business needs, and to search for new ways to innovate. As the domain of outsourcing expanded, so, too, did the need to manage in a way to create long-term, sustainable ways of operating.”
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? In fact, the beginnings of this marketplace were already present with companies that performed transactions like payroll on behalf of clients; what needed to happen next was to improve those processes, not just perform them.
Global resources giant BP got this message very early and became a pioneer in business process outsourcing. 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 United Kingdom in a single accounting system and at a single site located about five miles from the company’s exploration office in Aberdeen, Scotland. Five years later, BP outsourced the accounting functions for its US 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.
As with DuPont and Eastman Kodak in the IT space, 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; US 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 the Aberdeen shared services center was established to provide finance and accounting services to BP, it began to attract other companies in the oil industry, including Britannia Operator and the UK operations of Talisman Energy and Conoco.
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 to work in new ways for a new organization 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. In a 2002 Outsourcing Journal article, Alan Eilles, who was a key member of the BP team at the time of the landmark deal, recalled that if the transition of the work hadn’t happened “soundly and peacefully,” with no awareness of any change, “the relationship and deal [would have gotten] off to a really, really bad start from which [it would have been] tough to recover.”
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. “It was a radical signal to the employees,” confirmed Eilles, “that the world had changed and our corporate culture was also changing.”
New century, new goals
The next challenge for outsourcing came from an unlikely source: the looming Y2K emergency. Massive efforts were under way by the late 1990s to rewrite millions of lines of code to prevent applications from recognizing “00” in date fields as 1900 instead of 2000.
It was all too much for any single company or even nation to handle, so 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—demonstrating that, with adequate management techniques and methods, companies and outsourcing providers could source work wherever qualified people at the lowest cost could be found.
All the pieces were 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 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. “Our research,” says Willcocks, “is finding that relatively few clients have really wakened to the fact that outsourcing to this point has only rarely driven significant innovation. Making that happen needs to be the responsibility of both sides—client and supplier alike. Both parties need to create a different working environment, a different type of collaboration with the supplier, 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 a complex one requiring careful balance, to be sure.
On the one hand, 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 more 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 that organizations managed to extract from their suppliers during the first phase of negotiations.”
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 (offshore delivery mix, leverage of onsite relationship management and so forth).
By combining or “bundling” functions and processes to a single provider, companies can generate significant synergies resulting in both better cost savings and a greater 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, for example, 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.
Another recent study from Everest underscores the importance of thinking clearly about an organization’s long-term aims and vision prior to outsourcing, because the initial choice of provider is critical. If a company plans to outsource additional business processes or functions in the future, then careful consideration of the breadth of services offered by competing providers is especially important.
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 drawings and specifications needed to build their aircraft—a recent outsourcing development in an area called engineering services.
Industry-specific outsourcing is also an important part of the future because it leverages the power of the one-to-many platform mentioned earlier. Navitaire, for example, provides a comprehensive package of integrated, outsourced services to the airline industry—from reservations capabilities to resource planning and distribution, to back-office functions and revenue accounting.
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. We also foresee developments where companies 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 where 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.
For further reading
“A bold new look for global sourcing,” Outlook, September 2007.
“Jobs, profits and patriotism,” Outlook, September 2007. “
"A matter of control,” Outlook, February 2004."
About the author
Before being named head of Accenture’s new Technology group (which includes applications and infrastructure outsourcing, as well as systems integration and technology), Kevin Campbell was chief executive of the company’s outsourcing business. In that role, he oversaw the development and delivery of application, infrastructure and business process services to more than 650 clients globally. Mr. Campbell helped pioneer Accenture’s BPO activities in the 1990s and is widely recognized as a leading figure in the outsourcing industry. In 2007, he was elected to the Outsourcing Hall of Fame by the International Association of Outsourcing Professionals. Mr. Campbell, who is based in Atlanta, is a member of Accenture’s Executive Leadership team.
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