The current economic situation requires managers to come up with creative solutions to cope with short- and long-term effects on the organization. Faced with the unexpected severity of the downturn, many organizations tend to “freeze” strategic decisions and concentrate on the immediate operational problems. However, does this mean that organizations can put all initiatives aimed at the outsourcing of internal activities on ice?
Reducing costs by firing employees cannot be sustained indefinitely unless the corresponding activities are eliminated. By means of three questions, this article aims to give some insight into the possibilities that outsourcing (offshore) has to offer to relieve the pain in these difficult times.
Is the outsourcing of a shared service center a solution?
One of the effects that are the direct consequence of the financial turbulence is an increase of organizations that sell shared service centers (SSC) in other countries (so-called “captives”) to wealthy suppliers. This instrument for quickly improving the liquidity position is used by Citigroup. For example, at the end of 2008, Wipro took over an Indian software development part for $100 million, and Tata Consultancy Group (TCS) took over a SSC where several financial back office processes took place. This was a transaction of $505 million in exchange for a nine-year service contract with a value of $2.5 billion. Because only the wealthiest suppliers can finance this type of transaction, it is likely that the frequency will remain limited. Like other organizations, most suppliers are reliant on banks for financing such acquisitions. Other sales-limiting factors are the relatively low financial value of the transaction because of the low book value and low margins, and the low impact on the liquidity position (Citigroup: $605 million from the sale versus $4,000 million capital injection from the U.S. government to restore the ratios).
A related situation entails obtaining a captive as part of an acquisition. An example is the acquisition of Merrill Lynch by Bank of America, both of whom have a captive in India. Bank of America then had the option to merge both captives, to eliminate the acquired activities or to outsource. Suppliers regularly bid on SSC that are for sale, because it gives them the opportunity to obtain market share, customer knowledge and a long-term service contract. An example is the interest of India’s Wipro, Satyam and the much smaller Copal Partners in a captive of the beleaguered Lehman Brothers. However, all three missed the boat and a Japanese financial service provider eventually succeeded in buying the captive. In the Netherlands such scenarios are less likely, because captives are not frequently used, and Dutch companies were not hit as hard by the financial crisis as U.S. and British organizations.
The examples used so far are a direct result of the credit crisis and have little to do with a sound strategic choice. However, whether or not to sell an SSC or captive is a question that an organization, regardless of the economic situation, must occasionally ask itself. When creating an SSC the activities carried out can still be considered as strategic and/or risky, but this often changes when the organization continues to develop. Examples from a strategic standpoint are the sale by General Electric of a 60 percent share in GE Information Services to two investment firms, General Atlantic Partners and Oak Hill Capital Partners, for $500 million and the sale of Indian captives by the British insurer Aviva for $230 million to supplier WNS Global Services. In both cases, a sound decision-making and selection process preceded the sale. Dutch examples include the acquisition of KPN´s HR SSC by LogicaCMG, Philips’ sale of its financial SSC to the Indian Infosys, and the acquisition of the financial SSC of Unilever in South America by CapGemini.
Answer to the first question: Only sell a SSC/captive for the right reasons: the used intellectual property offers no longer has competitive advantage, and/or a supplier can further realize economies of scale and introduce new best-practices and innovations more quickly.
Do the advantages of outsourcing currently outweigh the disadvantages?
Current market conditions offer potential outsourcers both opportunities and threats. The U.S. remains the largest market for suppliers, measured in total contract value, but it is also the country hardest hit by the crisis. The huge drop in demand combined with a devaluating U.S. currency against emerging economies, causes major concerns in boardrooms of suppliers that operate from India, the Philippines, China or South Africa. Currency fluctuations can be covered in a contract, but the dependency of the U.S. asks for diversification of the business model. For this reason, many foreign suppliers currently are strongly driven to gain a foothold in continental Europe and other markets.
Dutch organizations that dare to outsource now can have positive consequences. In order to obtain the first customers, these suppliers will soon be inclined to “buy in” by offering favorable conditions. Later, they hope to catch up with the loss on the first assignments with new contracts. However, what may be an advantage for the outsourcer is unfavorable for the local European suppliers who will continue to see the price pressure increase. The local European players have the challenge of convincing the client of their innovative solutions and knowledge of the local market, rather than competing on price.
The possible threats come in the form of additional operational and political risks. One of the effects of an economic downturn is that fraudulent activities eventually come to the surface. While the whole world is under the cloud of a $50 billion pyramid game of Madoff, the Indian market is under the spell of the fraud at Satyam and a bribe scandal at Wipro. Although the fraud by Satyams CEO of $1 billion is nothing compared to Madoff, the effects in India are considerable. As with banks, trust is very important for suppliers, and the Indian government already has responded with proposals for additional regulation to limit reputational damage. However, cases of fraud by a CEO or by employees can never be completely prevented and are not a specific risk associated with outsourcing.
Large-scale fraud can lead to unexpected side effects. At Satyam, in just a few days 15,000 employees placed their resumes on the Internet, looking for another job. Such an “exodus” is a direct threat to the operational provision of services and one of the risks of outsourcing compared to an SSC or a captive. Another related risk is that suppliers completely specialize in services to one industry. Several suppliers that focus on certain niches in the financial sector are now in trouble, and already there is speculation over a number of bankruptcies among smaller players.
The only group of suppliers that is really profiting from the malaise in the short-term is active in Legal Process Outsourcing (LPO). These parties see a sharp increase of bankruptcies and acquisitions, especially from the U.S. For most suppliers, like Sasken, the short-term outlook is less rosy. Sasken saw its share fall by 16 percent on the stock exchange after one of its customers, the Canadian telecom manufacturer, applied for Chapter 11 (bankruptcy protection filing).
Another key point is political in nature. Although terrorism is not a new development, recent attacks in India (more than 600 deaths in the last six years), the Philippines (10 deaths in six attacks in July in 2008) and in China (several attacks in 2008 resulting in more than 25 deaths) have lead to, among other things risk surcharges by suppliers because of higher insurance premiums. The outsourcers themselves are often also confronted with higher costs because western employees sent to a risky country want to be paid higher compensation. Both effects are putting pressure on the business case, but it is not to be expected that countries like Vietnam will now suddenly become much more popular. Companies that dare to outsource in these uncertain times will opt for the familiar names among both countries and suppliers. As with fraud, exposure to conflicts can never be completely prevented, but it is good to be aware of this risk and to take it into account when preparing a business case.
Answer to the second question: Outsourcing has become an integral part of business and offers plenty of opportunities, even in these uncertain times. However, do not forget the impact of currency fluctuations, inflation adjustments and increased risk premiums when preparing a business case. Also, spend sufficient time choosing a suitable supplier and an exit strategy in case the supplier goes bankrupt or is taken over. While it is very tempting to completely squeeze the supplier in these times, remember: you get what you pay for. Eventually, every organization has to determine whether the potential advantages outweigh the disadvantages.
What’s to be done with ending and current outsourcing contracts?
Risk aversion and time pressure from more urgent problems in most organizations lead to maintaining the existing status quo with suppliers. Of course, this is an understandable reaction. However, be alert to the possible consequences of the economic crisis on suppliers. To reduce costs, their innovation budgets also are under pressure, which will lead to even more pressure on plans for “strategic partnership” and “adding value.” This may result in a situation where the owner of the contract expects the supplier to fulfill its innovative obligations, while the supplier expects that the economic situation will allow for postponement.
For the most important contracts, examine the clauses for possibilities for contract termination and who bears what costs at an exit, in case the supplier – for whatever reason – fails to fulfill its obligations. At the same time, think of possible alternatives to continue the service, like in-sourcing or another supplier.
For contracts that are ending an outsourcer has two options: continuing with the current supplier or taking a more risky approach by outsourcing again with the potential of a better end result. If the first option is chosen, it is recommended to at least benchmark against the market. If the second option is selected, it is advisable to take sufficient time to come to a contract, despite the financial pressure to show results quickly. The negative financial import of a bad impact is much greater in the long term than the positive effect on the result of the current year. Also, sign contracts with a relatively short duration and a limited contract value. Consider other risk mitigating measures such as a longer and gradual transition period for the transfer of activities to the supplier. Evidence that interesting deals can be closed is illustrated by an article in The Economic Times showing that Indian suppliers alone have given $300 million in discounts on new contracts.
Answer to the third question: Depending on the willingness of the organization to take on risk (”risk appetite”), determine the available time and the possibilities the supplier market offers for handling ending contracts. Schedule enough time in order to reach the desired end result and keep in mind that a price that is too low always comes at the cost of reduced quality. Also, do not hesitate to check whether it is possible to negotiate a better price or a lower compulsory purchase for current contracts.
Forecast for 2009
Despite growth in the number of signed contracts in 2008, it is reasonable to presume that the market will stabilize in 2009 and only improve going forward. The expected decline in the growth of contracts will impact the supplier market: On the one hand, a “shakeout” in which a number of rotten apples will be removed from the basket and on the other hand a consolidation of small and middle-sized suppliers to be able to face the economic malaise.
The recovery will depend on the moment when potential outsourcers will be to make time to take strategic decisions and are willing to accept the risk associated with outsourcing. For those who already dare to, there are enough opportunities for a beneficial agreement. However, besides a strong stomach, this demands patience and understanding of the market.