Business Book Review

Monday, October 30, 2006

Offshore Outsourcing - Business Models, ROI and Best Practices - by Marcia Robinson and Ravi Kalakota - PART I: OFFSHORE OUTSOURCING—AN OVERVIEW

Reading Suggestions & CONTENTS
About the Authors

“Strategic and often gut-wrenching changes are taking place in corporations as offshore outsourcing becomes a viable alternative. Smart companies realize that if they don’t keep hunting for breakthrough cost innovations, some other organization will.”
“A crucial issue … is selecting the appropriate business model. Offshore business processes have a variety of organizational forms. … [And] the distribution of activities … may vary from one project to another depending on the effort involved, speed of execution, level of interaction, and the cultural and time zone differences.”

Because of continuous cost pressures on U.S. and European firms, offshore outsourcing, which Robinson and Kalakota define as “the delegation of administrative, engineering, research, development, or technical support processes to a third-party vendor in a lower-cost location,” is slowly but surely becoming an entrenched part of modern management. Transactions costs associated with finding vendors, sending work overseas, and monitoring this work are steadily plummeting, driven by: rapid declines in the expenses associated with communications and computing; dramatic improvements in Internet reliability and functionality: an increase in available offshore suppliers with better capabilities: an increase in high-quality onshore suppliers offering offshore services; better access to low cost, high quality workers, especially for labor-intensive tasks; and an offshoring business model that has been proven by such successful pioneers as GE and American Express.

The authors note that the Global 1000 (i.e., the big manufacturing multinationals) have been implementing offshore outsourcing for two decades, seeing rising productivity as a result and also realizing that the same advantages could be garnered from offshoring business-process outsourcing (BPO). Thus, the cost advantages realized by the Global 1000 have put tremendous pressure on competitors and suppliers, causing offshore outsourcing to surface rapidly as both a strategic and a tactical method of meeting new business demands. A successful strategy typically moves through the three broad phases of offshore entry, offshore development, and offshore integration. However, because most firms presently find themselves at the entry phase, Robinson and Kalakota focus their discussion on issues relevant to that stage. Those issues are concerned with determining the business model, selecting the location, defining expected results, and establishing a presence.

Every business model has two dimensions—ownership (or relationship structure) and geographic location of the work. And, within each dimension, varied and complex configurations are available. For example, three different general relationship arrangements exist for outsourcing engagements: pure contract offshore outsourcing (buy or third-party), joint ventures (partnership agreements), or fully owned captive subsidiaries (build it or insource).

Pure outsourcing is a make-versus-buy decision. With it, a company relinquishes control of a function to an external service provider in a foreign country, who takes over the function and does much of the work, using cheaper offshore labor. It is an approach that can lead to three different models. The first is selective outsourcing in which companies only send out a small subset of their business process activities. The second is transitional outsourcing, which occurs when a company temporarily hands over a function to a third-party vendor, but brings it back in-house later. With the third, total outsourcing, external vendors take over the business process and do whatever the original organization was doing, but for 20-30 percent less. In each case, the chief advantages include limited operational risk, a potential for cost savings, and rapid execution.

In a joint venture (JV), two or more companies pool their combined resources (thus, sharing expenses and workload) to create a new entity that implements a specific business project for a set period of time. However, as a business evolves, companies discover that it is better to build their own subsidiaries (i.e., captive offshore subsidiaries or foreign subsidiaries) to complete all the BPO work. This ownership model provides lower prices on a long-term basis, and provides more control and flexibility.

In terms of work location, there are three choices: onsite outsourcing, offsite outsourcing, and nearshore or offshore outsourcing. The onsite location model mandates that the third-party vendor utilize its own workforce to carry out all processes, from information gathering to implementation, at the client’s premises. Because this approach gives the client a greater degree of control, it is suitable for projects that are mission-critical, location sensitive, and that require constant attention. The offsite model is dependent upon the service provider having an office onshore so that, even if work is done offsite, it is still in the same country as the client. Thus, the offsite center may be used to provide support to an onsite team as a means of ensuring timely, quality service.

With nearshore or offshore outsourcing, the project-related activity is done at the vendor’s premises (For U.S.-based companies, nearshore is Canada or Mexico, while offshore would be such counties as India or the Philippines.), and offshore team members interact with the client via telephone, fax or email. This is model is high-risk (because of the communications problems inherent in the approach) and, thus, best suited for situations in which the project plan is well-defined and the development team has a clear understanding of client requirements.

From each combination of location and ownership structure, distinct business models and/or delivery mechanisms can be created in which the relationship between the client and provider is uniquely and appropriately structured for different levels of organizational maturity and complexity. These different structures include: the internal delivery (department-based) model; offsite onshore shared services; offshore captive shared services; cosourcing; offshore development centers; staff augmentation, contracting, or temporary, services; pure IT or BPO; and first-generation offshore outsourcing. In addition (as customer needs evolve), second-generation business models are emerging that tend to be more sophisticated and to span multiple models of the first generation. These combination models include the global delivery or blended outsourcing approach, hybrid delivery, the global shared services center, build-operate-transfer (BOT), and offshore multi-outsourcing (implemented by large global vendors, midsize and large offshore vendors, large multinationals, risk-averse corporations, and experienced multinationals, respectively).

In addition to understanding and choosing the right business model/mechanism, managers must also pay attention to the underlying revenue model. Robinson and Kalakota note that offshore outsourcing comes in two flavors: piecemeal task-oriented or comprehensive process-oriented. Whereas task-oriented BPO contracts tend to gravitate towards time and material (T&M) billing and fixed price, process-oriented contracts range from cost-plus to the more ambiguous examples.

T&M billing is the simplest pricing model and an attractive option when the scope, specification, and implementation plans of a project are difficult to define at the outset. Its challenge lies in adhering to very strict project management and reporting practices—any lax in oversight can make this approach very expensive.

The fixed-price (or fixed-time) option is suitable for customers with clear requirements and project schedules. Under this model, the customer pays a previously negotiated price, linked to well-defined deliverables, for the completed project. Moreover, changes in scope are subject to a predefined, fixed hourly rate, and must follow a prearranged change-request procedure. Thus, customers with clear requirements and project schedules are attracted to this approach because of the upfront commitment to a fixed time and because the risk is shared if cost or time overruns occur.

The cost-plus revenue model is typically used in combination with BOT, for complex, multiyear, multi-element arrangements, or with the dedicated development center (an extension of a company’s software engineering facility). These contracts, principally structured on a fee-for-service basis, stipulate that the vendor receives a fee that is no greater than the client’s historical operating costs. After vendors have recovered their costs, or achieved a negotiated minimum cost reduction, they may be required to share further savings with the client. Thus, the cost-plus revenue model is popular among large companies that seek long-term gains from their offshoring initiatives.

Because the goal of outsourcing is to help clients become more effective in their business operations, vendors that enter multiyear contracts favor risk-reward (or gain-sharing) performance-based models that tie payments to business performance. This approach is also known as value pricing, or “pay as you save,” in that the vendor builds first and is paid as savings materialize. Of course, the drawbacks are that revenue recognition becomes a critical accounting issue for the vendor.


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