The New Age of Outsourcing

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The New Age of Outsourcing

By Edward Gardner and Joe Hogan

The biggest business driver of outsourcing has always been cost savings. And while cost continues to influence decision-making in the IT and business process outsourcing markets, increasing and expanding demands on IT organizations are compelling them to seek more from their service providers.

As mature enterprises enter into the next generation of outsourcing deals, they are embracing new—and sometimes risky—models to achieve more than the old-fashioned "your mess for less" value proposition.

"Certainly, there is an evolution under way," says Arno Franz, a partner with outsourcing consultancy Information Services Group (ISG). "Buyers have matured to such an extent that they are looking for something quite different in the marketplace."

To get an industry-wide perspective on how practices continue to evolve, we spoke with five of the outsourcing industry's most respected consultants. We asked them about emerging trends they're seeing and the impact these changes will have on both buyers and service providers. Here’s what we learned from these conversations.

1. The Rise of Managed Services

Mature buyers of IT services are opting for managed services deals over staff augmentation arrangements, thus moving from input-based to output-based pricing. But while the potential benefits of the model, such as increased value and flexibility, are clear, the approach requires significant behavior changes from both the provider and the customer.

"In a staff augmentation deal, the client knows the people and they're used to working that way," says Ralph Schonenbach, CEO of Trestle Group. "When you take that away, it's a big cultural change. It requires a higher degree of trust, because you are allowing the supplier to take over operations to run as they see fit.” Suppliers likewise may not be used to taking such a proactive role. "They need to be much more innovative in reorganizing the way people work," he says.

These managed services deals are significant in size, ranging from $100 million to $500 million, according to Schonenbach, and the customers that pursue them are looking to cut costs by at least 20 percent to 30 percent. "It's an easy number to communicate to the market, but what comes with that is risk because you don't own the process anymore," Schonenbach says.

Clients who pursue the managed services model must spend more time upfront, mapping out the scope of the deal and the desired outcomes in the contract. Some "are going through them too fast, which creates a lot of ambiguity," says Schonenbach. "You need to spend enough time together to create a mutual understanding."

The biggest risk, however, is that the client will continue to treat a managed services arrangement like a staff augmentation project, failing to give the supplier the flexibility required to deliver the promised savings. These relationships also require strong senior management support in the initial phases. "It can't be a bottom-up type of engagement, because there’s too much resistance to this kind of change," says Schonenbach.

Managed services make most sense in operational areas, like application maintenance. Application development, however, may not be a good fit, because these are often one-off projects rather than ongoing processes.

While still in the early days, there have been a number of large deals in this space in Europe, says Schonenbach. "Everyone is looking to see how effective managed services will be for both parties."

2. Betting on Business Outcomes

When it comes to outcome-based pricing, outsourcing customers are increasingly interested in business—rather than basic technology—results. "It gives everyone a chance to benefit from that linkage of the value of what's paid to the vendor to the value that the client receives," says Ben Trowbridge, the founder and chairman of outsourcing consultancy Alsbridge. "If you can get those two to sync up, it's just wonderful."

It's a challenge for both the buyer and seller to define what those outcomes are prior to signing the contract, but early adopters and business process outsourcing (BPO) providers are hard at work in this area.

Providers who already have a business processing auto claims, for example, have a distinct measure of what it takes to process an insurance claim. "They've got a situation where they control the outcomes and it's easier for them to control the prices," says Trowbridge. "And everyone understands the metrics and pricing structures."

The New Age of Outsourcing

However, that's not often the case. In an environment where clients want to move the procurement process along as fast as possible, some are reluctant to give bidding vendors the time to figure out individual business outcome-based pricing. And a vendor with 100 customers may not want to take the time to develop distinct outcome-based pricing for each business.

"It takes a sophisticated seller and buyer to understand the outcomes," says Trowbridge. "Both have to want to do it, and both have to want to devote the time to do it." The client needs to take the time to make sure it wants to move in this direction; the provider needs time to get the metrics and pricing right. "Sometimes the desire is there, but the metrics just aren’t available," says Trowbridge. Other times, business-outcome-based pricing doesn't make sense if, say, you're buying 100 images of server capacity.

3. Turning the RFP on Its Head

Historically, the outsourcing request-for-proposal (RFP) process was a highly prescriptive affair. Buyers would describe, in great detail, what they wanted and how they wanted it. The similarly detailed service provider responses enabled buyers to make a clear apples-to-apples comparison, based largely on cost. It was a fairly risk-averse approach, says ISG's Franz, with the solution determined from the start by the buyers—for better or for worse.

But what if it was the wrong solution? Time and again, buyers found that "they got the solution they asked for, but it may not have been right for the environment," says Franz.

That's beginning to change. While outsourcing clients are still looking to control costs, they are also interested in taking advantage of the latest and greatest technology advancements like mobility, cloud computing and big data analytics. Also, they don’t know what they don't know. Therefore, some are turning to a much less prescriptive RFP process. "Clients are looking for something, but they're not quite sure what the answer is," says Franz. "So they are better off describing their environment and the problem and asking suppliers for their solutions."

It's a welcome change for service providers. With the traditional approach, "they end up having to artificially construct a solution that's not differentiating for them and ultimately costs them and the buyer more," says Franz. "The less prescriptive approach enables them to do something in their sweet spot."

For clients, it's quicker and less costly than the customary process. They spend a week or two drafting an engagement document versus three months on an RFP. The approach also narrows the field of competing vendors significantly, says Franz.

It requires a more mature and trusting client, he says. "[Buyer and supplier] are going on a journey together versus buying a bunch of widgets." Governance, likewise, has to be taken up a notch. "It's much more evolved and really requires strong engagement on both the service provider's and the buyer's behalf," says Franz. While there are still traditional KPIs, everything from the procurement process through delivery is much more collaborative. That change requires more frequent meetings to test the solution and make changes as needed, says Franz. And the governance process must be stipulated in the contract, including who is involved, what the guiding principles are and the methods of escalation. "All of those have to be front and center," Franz says. While it's unlikely to take hold in the government sector, this less prescriptive procurement process could become the norm in industry. "There's so much new technology available," says Franz. "And clients want to adopt and adapt to that technology in their sourcing."

4. Commercialization to Fund Innovation

Cost containment is still top of mind for CIOs, so some are getting creative about how they fund their transformational work. One option is the commercialization of the outsourcing relationship. That is, they are bundling and marketing systems and processes that an IT service provider initially develops for one client. Some clients see an opportunity in selling their assets to their service provider in order to finance other projects in the near term and potentially generate a revenue stream in the long term.

A bank, for example, may outsource the development of its reconciliation system to an IT service provider. The service provider develops a system for the bank, buys the rights to the system from that customer, and then modifies or enhances the system for marketing to other companies. If those companies sign on, both the outsourcing provider and the original customer share in the profit.

The New Age of Outsourcing

The key word is "if": There have yet to be any high-profile examples of vendors able to take these commercialized systems to market in a meaningful way, says Trestle Group's Schonenbach. "The model itself is a nice idea, but commercialization is not the core competency of either party," he says. "That's where it runs into challenges."

Customers also need to consider what the exit strategy might be if the arrangement doesn't work. "If you're not able to take it to market successfully, then what happens?" asks Schonenbach. "Do you have an agreement to bring it back in-house? What about your loss of key resources?"

But there are benefits beyond additional revenue to outsourcing customers' taking a chance on commercialization. They rid themselves of the legacy system burden, which presumably has been upgraded and is now managed by a third party. And, as other clients come on to the system, they benefit from the larger investment in system enhancements over the long haul.

"People within IT find it exciting—developing an application and selling it to the market," says Schonenbach. "The go-to-market strategy doesn't happen in your typical outsourcing arrangement." It requires customers to be much more involved and visible in the marketing and sales of the product. And the IT service provider needs the sales capabilities to succeed.

Initially, tier two providers were most likely to enter into such commercialization arrangements, but interest has been increasing among big players as well. "There needs to be an appetite to do it," Schonenbach says. "The more entrepreneurial suppliers are moving faster in this direction."

5. The Increased Significance of Service Integration

The single-sourced mega-outsourcing deal—the shifting of the majority of an organization's IT or business process work to a single provider—is dead. In recent years, the market has seen a significant move toward multisourcing, which can provide the flexibility, cost competition and access to skills that enterprises need. "If you get the right service providers with overlapping capabilities, it creates a natural tension and competition," says Lee Ayling, head of KPMG's technology sourcing practice in the U.K. If there's a service failure, the customer can take that percentage of their wallet share and give it to another provider. Service providers are getting used to that fact. "They don't have a choice," says Ayling. "If it's a global [customer], the deals are so big anyway, it’s in the service providers' best interest."

For buyers, the effective management of that multiprovider environment has become increasingly important—and increasingly complex. "If you have three providers looking after your IT, there's quite a lot that the buyer needs to do to integrate those services," Ayling says. "The more strategic parts of service integration are being brought in-house."

The goal of service integration is to manage providers in a way that accommodates business demands. Third parties—from consultants to the service providers themselves—have offered this service to clients. But, says Ayling, "historically that hasn't worked," and increasingly, organizations see the benefit in doing it themselves.

Setting up a service integration shop from scratch isn't easy. Buyers have to find the 20 or 30 professionals with the right skills and often must work in conjunction with their service providers to develop the appropriate capabilities.

6. Re-examining the Big Picture

Over the years, clients have outsourced various components of organizations to various vendors in various countries for various reasons. This silo-by-silo approach to building up a sourcing portfolio did not necessarily translate to the best delivery strategy. Today "clients want to take a look at all the different pieces," says J. Marc Mancher, the head of Deloitte Consulting's insourcing and outsourcing advisory services in the U.S. "They've got four vendors in three locations and then another five locations where they do the work themselves, and they want to figure out whether or not they put the pieces together right."

The New Age of Outsourcing

Buyers on their second- or third-generation deals want to figure out if the Philippines was the best source for that call center, whether they should narrow their vendor portfolio from four down to two, or if they should bring some towers back in-house. "That initial gap of labor arbitrage has been captured, and now they want to look at the overall operating model and do a global reset before heading into the next generation," says Mancher. "We stop, look at all the pieces within the operating model for IT and business processes, and see if it makes sense." Those pieces include not just IT work but also business process outsourcing and shared services operations. "It has to be a holistic look," Mancher says.

Sometimes that reassessment leads to big changes; other times, it may make more sense to stay the course. A customer might find that achieving more efficiency in a certain area would cost more money and take two years that they don’t have. "It all depends on the case for change," says Mancher.

However, the case for exploring new outsourcing models—whether introducing managed services or service integration, managing by business outcomes, rethinking the RFP, inventing new ways to fund innovation, or taking a more holistic approach—is clear. IT services customers who want more from their next-generation outsourcing relationships should step out of their comfort zones and explore new approaches.

About the Authors

Edward Gardner is senior director, Global Advisory Services, and Joe Hogan is vice president, Global Advisory Services, at HCL Technologies.

This article was originally published on 12-16-2013