The Strategic Contribution of Business Process Outsourcing to Corporate Planning

TABLE OF CONTENTS

1. INTRODUCTION
1.1 THEORETICAL CONSIDERATIONS AND PROJECT METHODOLOGY
1.2.1 Literature review
1.2.2 Project methodology
1.3 A BRIEF HISTORY OF OUTSOURCING
1.4 THE FOUNDATION: THE CORE COMPETENCY PARADIGM
1.5 OUTSOURCING: INDUSTRY STRUCTURE
1.5.1 Service provision and cost structures
1.5.2 Outsourcing industry growth and trends

2. DISAGGREGATING THE VALUE CHAIN - BUSINESS PROCESS OUTSOURCING
2.1 OUTSOURCING OF BUSINESS FUNCTIONS
2.2 THE ROLE OF INFORMATION TECHNOLOGY
2.3 BUSINESS PROCESS OUTSOURCING AND CORPORATE TRANSFORMATION
2.4 MODES OF COLLABORATION AND CONTROL BETWEEN SERVICE PROVIDERS AND CORPORATIONS
2.5 LINKS BETWEEN COMPANY PERFORMANCE AND OUTSOURCING

3. OUTSOURCING STRATEGY: COSTS AND BENEFITS OF OUTSOURCING
3.1 GETTING STARTED: RESOURCES AND CAPABILITIES
3.2 EXPERIENCE CURVES IN MAKE-OR-BUY DECISIONS
3.3 DECISION CRITERIA
3.3.1 Financial considerations
3.3.2 Process and quality improvements
3.3.3 Business risks and risk management
3.4 STRATEGIC ISSUES
3.4.1 Monitoring strategic alignment
3.4.2 Maintaining strategic flexibility
3.4.3 Termination and continuation decisions
3.5 KEY SUCCESS FACTORS
3.5.1 Strategic alignment - option identification, selection and choice
3.5.2 Relationship management - value creation and learning
3.5.3 Performance management - operational excellence

4. OUTSOURCING STRATEGY IMPLEMENTATION
4.1 GOVERNANCE: STRUCTURE, SYSTEMS AND CONTROL
4.2 PRELIMINARY PHASE
4.2.1 Vendor selection
4.2.2 Contract design
4.3 OPERATIONAL PHASE
4.3.1 Service level management: measuring performance and managing scope
4.4 VALUE EXPECTATIONS AND LEVELS OF SATISFACTION

5. CONCLUSIONS AND RECOMMENDATIONS
5.1 CONCLUSIONS
5.2 RECOMMENDATIONS

BIBLIOGRAPHY

APPENDICES

LIST OF ABBREVIATIONS

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LIST OF TABLES AND FIGURES

Figure 1: A generic perspective on strategic sourcing models

Figure 2: Networked economy inter-firm relationships

Figure 3: Re-drawing firm boundaries - the functional perspective

Figure 4: Outsourcing services industry life-cycle

Figure 5: Relationship between business process management and backbone technologies

Figure 6: Major domains and sub-domains of BPO

Figure 7: Alternative approaches to corporate transformation

Figure 8: Types of outsourcing provider and buyer interaction

Figure 9: Outsourcing option space - competitive advantage versus strategic vulnerability

Figure 10: Outsourcing strategy - context, capabilities, performance and choice

Figure 11: Outsourcing outcome orientation and service delivery

Figure 12: Sources of outsourcing option value

Figure 13: Process performance and core competencies

Figure 14: Impact of economies of skill and scale on outsourcing risks and returns

Figure 15: The sourcing portfolio and implications for governance

Figure 16: Contractual relationships and the trade-off between flexibility and control

Figure 17: Make-or-buy revisited - a strategic decision model

Figure 18: Key success factors for business process outsourcing initiatives

Figure 19: Measuring performance in Business Process Outsourcing

Figure 20: The outsourcing management and learning cycle

Table 1: Financial comparison of make versus buy options

Table 2: Performance measurements and strategic implications for target setting

ABSTRACT

Focus strategies that seek to leverage company skills, capabilities and resources have become a dominant paradigm in business strategy planning and implementation. As a consequence, firms increasingly seek to reduce investments in non-core business processes and functions while freeing up resources and management attention for core competency development to achieve competitive advantage and provide unique value for customers. Activities for which companies do not have critical strategic needs or special capabilities are considered for external sourcing. Combining the two approaches can yield significant benefits. Outsourcing business processes can give access to provider economies of scale and learning thereby reducing operating costs and enhancing the quality of the activities outputs. The expected value of an outsourcing initiative is constituted by the aggregate projected benefits - both efficiency and effectiveness gains within the externalised process and strategic rewards - that flow from the exercise of the option. Strategic fit of the sourcing strategy with the current competency profile of the firm plays a key role in securing the success of vertical dis-integration policies and to obtain the highest value contribution from outsourcing initiatives. Corporate planners who are involved in firm boundary and competitive business policy decisions have to understand the market and service characteristics of outsourcing service provision, the relevant strategic linkages between non-core and core processes as well as the various types of interaction and governance models that are available to fulfil the needs of the organisation. Empirical evidence suggests that corporate planning procedures and externalisation strategies could be integrated more comprehensively.

KEYWORDS

Outsourcing, value contribution, corporate planning, core competencies, make-or-buy decision, interaction costs, business process re-engineering, interconnected value system, information technology, activity costs, standardisation, relative cost differentials, strategic sourcing, total cost of ownership

ACKNOWLEDGEMENTS

I am indebted to a significant number of people for assistance in the preparation of this report. This management project report would not have been possible without their support, guidance, discussions, insights and patience. I would like to thank Andreas Pfeifer, my project supervisor at Accenture, and his colleague Bernhard Holtschke for essential comments and insights. Susanne Theilig, Andre Waßmann, Elvira Rempt and Ulrich Wiedemann for helping me with the interviews; and Tomislav Groseta and Peter Post for their efforts and help in reading and commenting on the final draft. Furthermore, I would like to thank the senior executives who took the time to answer the survey and engage in intriguing conversations about the strategic value and trajectory of outsourcing as a contemporary management instrument. Above all I am heavily indebted to my NIMBAS project supervisor Professor Herbert Paul for invaluable guidance, discussions and help with the design and preparation of the report.

PREFACE

The current economic decline has accelerated the need to focus on cost performance and on the relative value contribution of individual business activities. Intense pressures on margins and from competitors lead to rigorous analysis and tough decisions regarding business value chain components. Despite shrinking budgets companies have to invest in their core competencies and processes to remain competitive.

Traditionally, the dilemma between operational excellence and cost conscious strategic management would have provoked a standard answer: re-structuring and process improvements. The necessary know how can be purchased in the open market by hiring consultants. But the traditional answer actually has proven to be a double-edged sword since consultants rarely implement and assume responsibility for their proposals. Therefore, root causes of substandard performance and costs often tend to persist.

Given these historic experiences companies are turning to an alternative method. Outsourcing information technology intensive parts of the business has become increasingly fashionable. Since the early 1990’s major corporations in the Anglo-Saxon world have started to outsource large parts of their IT infrastructure and operations, as well as significant parts of their value chains such as procurement, manufacturing, and component design.

In Germany the market for captive¹ and non-captive information technology related outsourcing services has reached a market volume of Euro 13 billion in 2002 and is forecasted to expand to Euro 21 billion in 2006². The comparably premature business process outsourcing market is projected to reach US$27.5 billion in Western Europe in 2003, growing close to 10 percent compounded annually³. The worldwide market for third-party outsourcing services had doubled from 1997 to 2000, when it had reached US$1 trillion⁴.

In parallel, a new breed of service providers has emerged. These service providers handle large parts of selected business processes of blue chip companies on a long-term contractual basis. This trend has extended beyond activities that were traditionally perceived as non-core - i.e. inventory and facility management - since companies have begun to outsource training and development, human resource management, finance and other core related business functions. This has led to a new role for the buyer companies’ corporate centres, which increasingly have become specialised functions that integrate and coordinate activities throughout the entire intra- and inter-firm value system.

Multi-billion outsourcing mega deals and breakthrough arrangements have a flipside. A recent survey of 200 German top managers reveals that 30 percent of the respondents judge their outsourcing initiatives as being “not successful”⁵. It should always be remembered that insourcing as a result of failed outsourcing initiatives is not uncommon.

Therefore, the key question is: How can managers reliably assess outsourcing options and structure decisions accordingly? Given the spectacular growth of the outsourcing services provider market and the importance of focused and cost conscious strategies for sustainable competitive advantage, the capability to make informed sourcing decisions can be regarded as a crucial management task of the future. The impact of effective outsourcing strategies on costs, service quality and competitive performance cannot be underestimated.

1. INTRODUCTION

This project analyses the role business process outsourcing initiatives play within and for the corporate planning function. Outsourcing, although sometimes regarded as a shortcut to dispose of routine and non- core operations, is by its very nature strategic, since it involves the re-definition of the firms’ boundaries. Outsourcing decisions have to be grounded in a clear understanding of strategic principles and tools and the relative merits of sourcing alternatives. This project seeks to develop an analytical framework for an assessment of the value contribution of outsourcing options, including the impact of relevant external and internal factors, respective decision criteria and analytical tools to evaluate optimal sourcing strategies.

Chapter 1 provides the background to this project from a theoretical and empirical perspective. It explores outsourcing market characteristics and strategic linkages between the core competency paradigm in business policy formulation and external sourcing. Chapter 2 gives a general overview of the nature of business process outsourcing relationships and the underlying factors that shape these long-term interactions. Chapter 3 analyses the specific issues and criteria that surround the selection, choice and implementation of an outsourcing strategy. The questions of operational implementation are addressed in chapter 4. Conclusions and recommendations of the project are laid out in chapter 5.

1.1 THEORETICAL CONSIDERATIONS AND PROJECT METHODOLOGY

1.2.1 Literature review

The majority of experts⁶ view outsourcing as a strategic management tool to restructure and re-organise current operations. The key rationale for outsourcing is a focus on core competencies and corresponding core processes. As such, outsourcing belongs to a family of affiliated concepts such as subcontracting or out tasking, shared corporate services, venturing and joint endeavours, and alliances and partnerships. These instruments help company management to concentrate on processes and capabilities that provide unique value to customers. The relevant differences between these tools are the relative degree of externalisation of resources and business risk, the decision rights retained or foregone and the respective cost versus revenue orientation⁷. Figure 1 below gives an overview of the various tools.

Figure 1: A generic perspective on strategic sourcing models⁸

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In definitional terms outsourcing can be characterised as:

The permanent movement of a business activity outside the firms ’ boundaries, whereby the firm incurs transaction costs ⁹ as a consequence of transferring decision rights to a third party responsible for managing the activity according to agreed specifications.

This definition remains neutral about the specific reasons for outsourcing. At a general level, outsourcing should be considered when the total costs of owning specific factors of production are consistently and significantly higher than the total costs of using the specific factors of production. The factor inputs can be both direct - i.e. to generate revenue by providing inputs to a product or service - or indirect, i.e. as input for a support process within a corporate function. In addition, there are strategic factors to be considered which cannot easily be quantified such as availability of skilled resources, costs of developing resources in-house, and projected capability gaps between current strategy and market trends, business model stability, and degrees of dependency on external inputs¹⁰.

Most writers¹¹ agree that the shift toward outsourcing and related flexible strategic sourcing models can be attributed to the following broad underlying business trends:

- Shortening of product, service and business model life-cycles
- Intensified international and domestic competition
- Industry economics are increasingly applied to the firms’ internal markets
- Dominance of the Core Competency Paradigm (CCP) in corporate strategy formulation
- Networked economy and increased collaboration across firm boundaries

The aforementioned trends can be summarised from a macro and a micro perspective. The macro perspective envisions the firm or SBU as a node in a network of collaborative inter-firm relationships (see Figure 2 below). Companies increasingly partner with suppliers, customers and other firms linked by electronic means of communication and commerce. Competitive pressures are forcing companies to form joint ventures, strategic alliances and other forms of collaborative agreements to enter new markets, overcome regulatory barriers and to expand scale and scope of operations. Higher speed, efficiency, global reach and process improvements in collaborative networks are all enabled by the comprehensive use of information technology¹².

Figure 2: Networked economy inter-firm relationships¹³

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This approach is markedly different from the logic of the vertically integrated stand-alone enterprise of previous decades. It signifies the natural consequence of disaggregation and focus strategies that require a careful management of a central set of corporate skills and of contracting out all activities that do not intimately relate to these skills¹⁴.

The micro perspective focuses on the traditional firm boundaries and the implications of the core competence paradigm on the organisation of internal business activities. In previous decades businesses were by and large organised internally around functional domains such as Finance and Accounting (F&A), procurement, marketing, Human Resources (HR), logistics and manufacturing. Although these domains still persist on paper and in company organisation charts, the dominant managerial logic behind them has lost its appeal¹⁵. Today, most firms concentrate on business processes that may be organised within a functional area or cut across different functions. For instance, an automotive component supplier may have special skills in sourcing high quality inputs cost-effectively, and in computer aided engineering, manufacturing and design. These functions constitute core capabilities that contribute to the competitive strength of the company. Warehousing, shipment and order management, invoicing and accounting, marketing, Human Resource management and training are contracted out to business service providers. Figure 3 below illustrates the example. The business service providers at the edge of the firms’ boundaries serve multiple clients and specialise in the management of the respective business processes or parts thereof.

Figure 3: Re-drawing firm boundaries - the functional perspective¹⁶

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The academic literature and its support of strategic sourcing models contrasts with current empirical research on the perceived effectiveness of outsourcing¹⁷. In fact, the positive evaluations of outsourcing as a strategic management instrument are largely based on case studies of companies that have incorporated outsourcing comprehensively into their business models. Nike, for instance, contracts out all activities except research and development, design and marketing, distribution and sales. The company manages its network of contract manufacturers closely and carefully to obtain high quality finished goods at competitive prices. But comparable pioneer companies that approach outsourcing consistently from a strategic angle are the exception and not the norm. There is considerable evidence that outsourcing initiatives are to a significant extent driven by tactical motives and are integrated into company-wide initiatives largely from the cost-cutting side¹⁸. Although companies assess process and activity costs associated within the function and also analyse historical and projected costs, a comprehensive integration with corporate planning procedures is carried out only incomprehensively. The results range from dissatisfaction with actual results, insourcing or outright failure of outsourcing initiatives.

1.2.2 Project methodology

Therefore, this project analyses and evaluates strategic planning models for outsourcing business processes from a theoretical and empirical perspective. The theory-based parts are based on the core competency paradigm and develop its implications for contemporary make-or-buy decisions.

The empirical part is primarily grounded in current market research, case studies and reports published in management journals, and the trade and business press. Projected outsourcing market and segment growth rates are based on industry analyst reports. The secondary research is supplemented by a questionnaire-based exploratory study of large German companies’ strategic outsourcing policies. Based on in-depth interviews and quantitative input from 11 high-level executives the effectiveness of outsourcing principles employed and the historical performance of outsourcing ventures vis-à-vis intended effects and benefits sought are evaluated¹⁹. Due to the restricted sample size the author’s research does not yield statistically valid results, but rather provides valuable anecdotal insights into the current outsourcing management practice in large German firms. Moreover, the exploratory research may serve as a basis for future surveys of the effectiveness of business process outsourcing.

The empirical evidence is used to quantify value expectations and levels of satisfaction with outsourcing projects. Given the guiding assumption that a focus on core competencies and “lean management” are key strategic guidelines for outsourcing, the empirical part of the project further examines, criticises and complements the current debate. Links between company performance and outsourcing are assessed based on strategic business policies and operational procedures such as service level and performance management. Special emphasis is given to key strategic decision criteria and performance expectations concerning cost reductions, quality improvements and value earned by various types of outsourcing agreements and their respective governance mechanisms. Furthermore, learning effects regarding outsourcing strategy planning, formulation, implementation and evaluation are considered to form valid judgements regarding key success factors.

The conclusion of the analysis defines key value propositions and outlines a promising market positioning for outsourcing service providers based on theoretical and empirical considerations.

1.3 A BRIEF HISTORY OF OUTSOURCING

The term “outsourcing” has been coined by the information systems trade press in the late 1980’s²⁰. The notion was used to describe the then prevalent and growing trend of large companies to transfer parts of their IT systems and infrastructure to service providers. Nevertheless, outsourcing is not new. It has emerged as a consequence of the disintegration of large companies’ value chains. In the late stages of the production era²¹ major companies reversed the previous trend to individually own as many factors of production as possible. The evolutionary view of the history of business concepts stresses the importance of strategic flexibility and lean thinking in the current “relationship” or “mass customisation” era. This is a major factor for the rigour with which companies analyse the value contribution of using versus owning factors of production. Lean management aided by information technology also occasioned a significant reduction of the relative degree of backward and forward vertical integration²² in the past decades. Despite a short-lived countervailing management inclination to conglomerate diversification in the late 1960’s and early 1970’s the general trend to focus on activities with the highest value contribution to the firm remains unbroken. Externally, the shift to more focussed strategies has gained support from financial theorists and investors who sought diversification of systematic or market risk without the assistance of corporate management acting as intermediaries²³.

Another historic driver for strategic outsourcing has been the “shareholder revolution” of the 1980’s²⁴. The distinctive focus on shareholder value within corporate strategy formulation and implementation that has come to dominate the Anglo-Saxon business world has also gained support in Continental Europe. This is a crucial factor that leads to a continuous redrawing of the boundaries of the individual enterprise and confirms the observation that companies are redesigning and re-shaping their business models at an unprecedented pace. In this context outsourcing has evolved as a major tool to focus management attention on activities that create economic value.

Outsourcing has progressed in three stages:

- Stage 1 Peripheral non-value adding activities

(Food and janitorial services, security, facility management, office supplies)

- Stage 2 Core related support activities

(Information technology infrastructure, contract component manufacturing, business services)

- Stage 3 Core related business functions or processes

(IT application management, finished goods contract manufacturing, customer care and invoicing, F&A, complete logistics management, HR)

The third wave of outsourcing is currently underway. What is new is that previously outsourcing of entire business processes has not been prevalent²⁵. Historically, the most significant outsourcing in terms of strategic impact involved component parts manufacturing and information systems. Today, fast changing technical staff functions (such as F&A, HR, and customer care and logistics management) that require substantial systems investment, support and expertise are increasingly considered for outsourcing. Organisations are growing reluctant to invest in and maintain state-of-the-art technology and expertise internally, when necessary economies of learning, scope and scale are only accessible at substantial costs. More importantly, in the service provider market these assets exist externally and have been developed with others’ investment and risk. Moreover, the service providers’ core competencies are the processes and technologies the buyer organisation considers peripheral.

1.4 THE FOUNDATION: THE CORE COMPETENCY PARADIGM

The basic rationale for contemporary strategic make or buy decisions is built on the conviction that - all other things being equal - companies that focus on their core competences tend to perform better than companies that get distracted by activities that do not embody special skills or capabilities²⁶. Successful firms have managed to build competitive advantage by developing specific resources into distinct capabilities or competencies. Core competencies are organisational skills or knowledge sets²⁷ that are path-dependent, scarce, embedded in organisational behaviour, cannot be easily replicated and sources of rent-earning potential. There are various theoretical arguments and empirical hints that effective capabilities contribute to above average business performance²⁸. The prescriptive content of the CCP states that capabilities that contribute to competitive advantage require on-going substantial investment and management attention.

In the context of actual outsourcing decision-making a recent survey among 200 German top-level executives found that capability-based considerations play a dominant role. 70 percent of the respondents claim that access to specialised resources in the areas of professional and IT skills is the second most important factor in outsourcing initiatives; 62 percent of the respondents say that outsourcing helps them to clearly concentrate on their firms’ core business²⁹. This dual aspect - outsourcing offers rights to use competencies the company does not possess and outsourcing contributes to focussing management attention on what the firm does best - constitutes the empirical and theoretical link to the core competency paradigm³⁰.

1.5 OUTSOURCING: INDUSTRY STRUCTURE

With the growth of a knowledge-based service economy on top of the industrial economy in the past decades, the number of specialist business service providers has grown as well as the array of knowledge- intensive services they provide³¹. Examples include the advertising, accounting, business consulting, IT services and professional training industries. According to projections³² about 30 percent of corporate spending related to corporate centre functions in Western Europe today is paid to external service providers, while the other 70 percent is spent on internal staff and resources used to manage corporate functions in-house³³. In each business process area there are examples of companies that have been able to grow a successful business out of managing corporate functions that are regarded as non-core by others such as Danzas, TNT Logistics and Stinnes in logistics management, Vertex, Convergys, and ClientLogic in customer care management and ADP and Exult in human resources management.

Compared to the relatively mature IT outsourcing market where leading companies attract contracts in the billion Dollar range, business process outsourcing is not a homogeneous market but an amalgamation of many different markets, each with unique characteristics³⁴. Moreover, providers in the same market segments often offer different types of services in terms of scope and customisation³⁵. In the past decade BPO has grown steadily and an increasing number of suppliers - especially traditional IT services firms - have recognized the potential of the market opportunity and have begun to develop and offer BPO capabilities³⁶. In terms of competitive dynamics the provider market is in the early stages of the industry life-cycle³⁷. Providers compete on price, service delivery capabilities, relevant experience and credentials as well as brand reputation. The barriers to entry are comparably low and the attractiveness of the market - measured by the number of entrants and active players - can be estimated to be high.

Figure 4 below gives an overview of the various types of outsourcing and their respective stages in the industry life-cycle. The most established and mature offering is IT infrastructure outsourcing, followed by software application development and management. In the infrastructure business large asset-rich companies compete for high value multi-year contracts. In the application management segment the integrated IT services companies are joined by systems integrators and software vendors. Increasingly, systems integration project services are offered with an outsourcing component, which gives buying organizations the option to transfer the responsibility for the business application management to the project service provider. Business process outsourcing is a relatively new, emerging service with early corporate adopters primarily located in the US. Transformational outsourcing takes the BPO concept a step further by introducing an explicit business process re-engineering component. Moreover, in addition to activity measures transformational outsourcing is partly tied to cross-functional performance metrics.

Figure 4: Outsourcing services industry life-cycle³⁸

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1.5.1 Service provision and cost structures

The ability of business infraservices providers to create value and achieve commercial success varies considerably. Buyers of BPO services have to be clear about the fact that providers only flourish if they can capture value in performing the former in-house activity that eludes the purchasing organisation³⁹. Providers usually achieve this value gain in creating economies of scale and learning. Economies of scale are especially important in asset-intensive activities such as data centre management; call centre operations, and logistics management⁴⁰. Prospective buyers of such commodity services should pay attention to the asset base the provider controls, otherwise the purchaser might experience unpredicted rising costs if the supplier has neither the capacity nor the customer support to spread fixed operating costs effectively over a sufficient number of client organisations⁴¹.

A broad customer base is also central for economies of skill and learning. The ability to create value for customers and capture a sufficient share of the surplus is to a large degree dependant on capabilities to cut inefficiencies in the customers’ current operations. This requires skills in customising offerings for multiple clients at reasonable cost, exploiting insights gained in other engagements and transferring successful practices across different accounts. Since innovative techniques and competencies are valued highly by customers⁴² an open-minded stance towards innovation and partnering is a key success factor on both sides.

Another important factor is the delivery or engagement mode. Various outsourcing service provider business models have emerged where, for instance, the vendor serves a single client, or the provider offers his services as shared service centre to many clients, or a consortium of many suppliers serves one client. The respective strengths and weaknesses of these models have to be carefully evaluated in individual outsourcing decisions⁴³.

The vendor pricing models mainly employed are:

- Fixed price
- Cost plus (or time and materials)
- Cost plus with a performance related incentive scheme, and
- Gain / risk sharing

With fixed price contracts the buyer effectively hedges against price increases by setting an agreed price- level for the duration of the contract. The main problem with these contracts, as with other hedging instruments, is that the insurance mechanism works in favour of the buyer if prices are rising but in the opposite direction if prices are decreasing. Cost plus (or time and materials) is the traditional consultant compensation scheme where the provider is paid his expenses and receives a margin on top of those costs. Some agreements add an incentive or bonus system which is normally grounded in performance against agreed service levels⁴⁴. The critical issue with cost plus is that the cost developments are hardly calculable. With gain sharing contracts the provider receives baseline compensation and, in addition, improvement targets are set. The parties then agree on a distribution mechanism for any realised gains⁴⁵. Although an innovative concept, gain sharing is a seldom utilised in practice because of the causal ambiguity of realised performance improvements that give rise to disputes between provider and buyer. Clearly, an enlightened partnership perspective is needed to make gain / risk sharing work.

Concerning pricing a clear preference in current practice⁴⁶ and from a theoretical standpoint⁴⁷ for fixed price agreements has become apparent. Fixed price arrangements offer a predictable cost basis for the outsourced process and allow for the negation of bands below and above the contractually specified service level. Within these bands the provider must not accept less than the fixed amount if the volume of the activity drops beyond, for instance 10 percent, of the agreed amount. On the other hand the buyer can demand more of the activity - within the 10 percent range - without having to pay anything extra. The valuable characteristic of fixed price contracts is that they provide incentives that are effective and easy to understand. Moreover, they allow for a clear borderline between the service and any additional project services that might arise in the course of the contract duration⁴⁸.

1.5.2 Outsourcing industry growth and trends

Reliable estimates and growth projections of the total market for outsourcing and the respective market segments are difficult to obtain. On a country basis the market researchers mostly infer the national market value from the money contract value of known deals and from the turnover growth of suppliers. In the domain of ITO this method is comparably accurate because most of the information about contract values and duration is publicly available. Concerning BAO and Business Process Outsourcing the methodological assumptions and the accuracy of input data vary enormously; this leads to significant discrepancies in the forecasted market sizes and - to a minor extent - the forecasted growth rates. There are three major problems associated with the calculations:

- Market and market segment definition. Some analysts do not include business application management in their outsourcing definition⁴⁹. Since BAO is a significant spending category, and most of the contracts do not neatly fit the project services or outsourcing description, market assessment differ. The same holds for segments in the respective BPO definitions.
- Market demarcation. There is a continuum between outsourcing and simple sourcing. At some point in time services recently transferred outside the firms’ boundaries such as logistics management may justifiably be regarded as outsourcing while others - such as contract manufacturing - might better be viewed as sub-contracting. Given that contract manufacturing accounts for nearly half of the BPO market there is large room for error⁵⁰.
- Market transparency. According to projections between 30 and 50 percent of all outsourcing agreements are captive⁵¹. Depending on the degree of monopoly power the captive supplier can exercise over the parent company it can be problematic to use the term outsourcing for these relationships⁵².

With these caveats in mind, the estimated value of US$1 trillion⁵³ of the total worldwide market for third- party outsourcing services might serve as a very rough approximation. The share of IT related outsourcing is estimated between 20 and 50 percent⁵⁴. The worldwide market for BPO services excluding contract manufacturing, purchased R&D and processing services was valued US$121.6 billion in 2003, up 10.5 percent from US$110 billion in the previous year. In the period to 2007 the market is expected to grow with a CAGR of 9.5 percent to US$173 billion. Equity and market analysts predict a steep growth of 15 percent in 2004 and 2005 compared to the minor growth in the IT services segment of only 5 percent annually⁵⁵.

These growth projections are especially significant given that most of today’s external business services spending are related to services provided on a consulting, project or hourly billing basis. According to estimates currently about 5 percent of total spending in Europe on corporate functions can be identified as BPO spending and this percentage is forecast to grow to 7 percent by 2010 and to 11 percent in 2025⁵⁶. Not only will a growing portion of services be provided via long-term business process outsourcing engagements, significant effort within initiatives will go into supplier induced performance improvements. In ITO, for instance, typical cost savings are in the region of 5 to a maximum of 15 percent. Business Process Outsourcing in conjunction with a re-engineering component offers buyer organisation opportunities to cut between 40 and 60 percent of their costs of running the process⁵⁷.

2. DISAGGREGATING THE VALUE CHAIN - BUSINESS PROCESS OUTSOURCING

It has been established that outsourcing is a process of vertical disintegration were external suppliers take over value chain activities (either primary or support activities) previously performed in-house⁵⁸. Generally, the purchase of various types of external business services depends on the scope and duration of the project, and the responsibility that the external business service firm assumes. The three main engagement types for business services⁵⁹ are:

- Business consulting and support services
- Contract labour and capacity
- Business outsourcing

These different engagement types can relate to business services around any corporate function. For instance, suppliers can provide business consulting as well as education or business outsourcing services around the corporate HR, logistics or procurement functions. A business outsourcing engagement transfers responsibility for ongoing management and execution of a business activity, process, or functional area to an external service provider in order to gain efficiencies and improve performance. Outsourcing contracts may involve the transfer of fixed assets and personnel from the customer to the service provider. Business outsourcing engagements are ongoing, and contract terms may range anywhere from 1 to more than 10 years. A business outsourcing engagement can include an entire value chain component such as HR, logistics or procurement, or discrete parts within business functions, such as benefits administration, warehousing, or strategic sourcing.

2.1 OUTSOURCING OF BUSINESS FUNCTIONS

The majority of business processes has dual characteristics: On the one hand the management and coordination of the process at the activity level and on the other hand the management of supporting infrastructure and systems. In complete business process outsourcing⁶⁰ the provider assumes responsibility for management and execution at the activity level and therefore becomes part of a wider decision-making system surrounding the outsourced process or functional area. This system is primarily geared toward customer service and strategic business value. Strategic business value is recognized through results such as increased productivity, new business opportunities and revenue generation, cost reduction, business transformation, and the realisation of shareholder value⁶¹.

The underlying support component might be called a backbone process⁶². These are activities or a single business process that mostly tend to be IT enabled, high-volume and automated such as customer invoicing, payroll processing, claims management, etc. Performance indicators for these backbone processes are primarily tied to accuracy, timeliness, and efficiency. Backbone processes are typically standardized and involve little or no customization and are often considered as natural candidates for outsourcing⁶³. Data processed in backbone operations may or may not be used by multiple users and cut across business process boundaries⁶⁴ (see Figure 5 below for a general overview of business process management and the support structure). Moreover, backbone operations may also be embedded in a core competence or process of the firm. For a BPO initiative to succeed, corporate planners must therefore not only evaluate the linkages of the process considered for outsourcing to core competencies of the firm but also the connections of backbone processes to secondary user groups and other interfaces that might impact on strategic skills⁶⁵.

Figure 5: Relationship between business process management and backbone technologies⁶⁶

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Besides a detailed knowledge of what can be identified as a business process and what as a support or processing service⁶⁷, it is necessary to have up-to-date and reliable cost information at the activity level. Empirical evidence suggests that a significant number of companies do not have appropriate systems in place to adequately cost their internal business processes or activities⁶⁸. It is still quite common to allocate corporate overhead costs to other firm units on a largely arbitrary basis. The lack of knowledge of individual costs of carrying out specific activities conceals the true value contribution of the business process or function measured by internal supply and the willingness of users to pay for the service. There are also demand-side implications. The quasi monopoly status of the internal supplier to the captive market often leads to managerial complacency and furthermore reduces the inclination to innovate⁶⁹. This is especially apparent in traditional cost centre operations such as marketing, procurement, information technology and human resource management. Although the availability of benchmarking data regarding business processes across industries has led to more enlightened views on performance and in some instances to the adoption of ABC systems, the market opportunity for business process outsourcing is to a significant part based on the fact that neither scale of operations nor incentives of many cost centres can match those of external suppliers.

Although the key drivers⁷⁰ of BPO - focusing on core competencies, improving service levels and reducing costs - are common for most business processes and industries, the characteristics of the drivers vary from process to process, and industry to industry. Instead of moving straight to a fully outsourced environment for a business process, enterprises increasingly use selective sourcing strategies⁷¹. These opportunities for selective outsourcing can be conceptualised at the primary and secondary domain of activity level by a generic value chain model (see Figure 6 below). Within or across these sub-domains the activities are supported by backbone processes and systems such as CRM, SCM, logistics planning and scheduling systems, personnel data administration, etc.

Figure 6: Major domains and sub-domains of BPO⁷²

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¹ “Captive outsourcing” denotes a preferred supplier - mostly a former internal department - that provides services to the parent firm. In most cases, the supplier and the parent are linked by equity stakeholdings. Captive arrangements tend to be budget rather than balance sheet-based and therefore have only limited potential for sustainable business improvements.

² PAC (2003).

³ Gartner (2003b).

⁴ Dun & Bradstreet, quoted in: Auguste, Hao, Singer and Wiegand (2002). For a methodological discussion of the market value assessments and projections see section 1.5.2.

⁵ IMCS (2002); cf. Doig, Ritter, Speckhals and Woolson (2001) who refer to international and US-based surveys with similar results and Gartner research quoted in: Computerwoche , March 26, 2003.

⁶ Cf. Quinn and Hilmer (1995), Lacity, Willcocks and Feeny (1995), Hagel (2002), Greaver (1999).

⁷ Chandler (1992).

⁸ Author’s analysis.

⁹ Williamson (1979, 1985), Chandler (1992).

¹⁰ These issues are further discussed in section 3.3.

¹¹ Cf. the literature mentioned in footnote 10. The respective force and scope of the trends is subject of major debates. For the purposes of this paper it is sufficient that these factors can be invoked to explain the shift toward an externalisation of business activities.

¹² Hagel (2002), Hagel and Singer (1999). Chesbrough and Teece (1996) provide a critical assessment of the networked economy model.

¹³ Author’s analysis based on Hagel and Singer (1999), Hagel (2002) and Hamel (2001).

¹⁴ Quinn and Hilmer (1995).

¹⁵ Hammer (1993, 2001).

¹⁶ Author’s analysis based on IDC (2002).

¹⁷ IMCS (2002).

¹⁸ IMCS (2002), Doig, Ritter, Speckhals and Woolson (2002), Quinn and Hilmer (1995).

¹⁹ See Appendix C for the questionnaire and Appendix D for a summary of the key findings.

²⁰ Greaver (1999).

²¹ Dibb, Simkin, Pride and Ferrell (2001).

²² Lynch (2003), Grant (2002).

²³ Quinn and Hilmer (1995).

²⁴ Rappaport (1981, 1992), Copeland, Koller and Murrin (1995).

²⁵ IDC (2002), PAC (2003), Greaver (1999), Auguste, Hao, Singer and Wiegand (2002).

²⁶ Quinn and Hilmer (1995), Hamel and Prahalad (1994), Grant (2002), Lynch (2003).

²⁷ Quinn and Hilmer (1995).

²⁸ Grant (2002), Lynch (2003), Johnson and Scholes (2002), Stalk, Evans and Shulman (1992), Hamel and Prahalad (1990).

²⁹ IMCS (2002). A concentration on core competencies is cited by 67.3 percent of US-based Financial Executives as dominant reason for outsourcing; CFO Magazine, October 1, 2001.

³⁰ Chapter 3 gives a detailed discussion of the nature and current practice of strategic core capability management in the context of outsourcing decisions.

³¹ Bleicher and Berthel (2002).

³² IDC (2002).

³³ The aforementioned IDC research foresees an increase in the proportion of spending with external business service providers to about 36 percent in 2010 and 45 percent in 2025. Auguste, Hao, Singer and Wiegand (2002) estimate the market opportunity for these third-party ‘infraservices’ at 30 to 40 percent of the overall corporate business service spending.

³⁴ Buying organisations often view this perceived market opacity as a major inhibitor to large-scale outsourcing.

³⁵ Auguste, Hao, Singer and Wiegand (2002).

³⁶ Currently, there are several established and potential players in the BPO space: IT service providers, multinational accounting and consulting firms, telecommunications and IT infrastructure companies, technologically sophisticated business process service providers, and management consulting firms that are involved in deal shaping and advisory services. To effectively compete in the BPO area suppliers need deep skills in technology, process and people management and have long-term capital and stability. Therefore, consortia bidding, alliances, and mergers and acquisitions will be dominant trends on the supply-side.

³⁷ The outsourcing industry life-cycle discussion is partly based on research by IMCS (2002).

³⁸ Adapted from IMCS (2002).

³⁹ Auguste, Hao, Singer and Wiegand (2002).

⁴⁰ In this context offshore facilities provide access to lower sourcing costs in both human resource and capital intensive operations.

⁴¹ Auguste, Hao, Singer and Wiegand (2002).

⁴² According to the IMCS research (2002) 53 percent of the respondents state that: “access to innovative technologies and methods is an important factor in outsourcing initiatives”.

⁴³ Gartner (2003a).

⁴⁴ If the provider exceeds the performance requirements he receives a bonus payment; if he fails to meet these he is obliged to pay the buyer a penalty fee.

⁴⁵ Greaver (1999).

⁴⁶ Author’s research; Lacity and Willcocks (2003).

⁴⁷ Lacity and Willcocks (2003), Greaver (1999), Auguste, Hao, Singer and Wang (2002).

⁴⁸ In business practice mixed contract forms are common - cf. Lacity and Willcocks (2003) -, nevertheless, decision- makers should always keep in mind that contract complexity adds transaction costs for supervision, conflict resolution and interpretation. These interaction costs limit the initial value gain of the outsourcing initiative.

⁴⁹ Some of the aforementioned analysts, for instance PAC, treat application management as a project service.

⁵⁰ The transfer criterion does not solve the ambiguity: If an activity is brought outside the firms’ boundaries it is per definition outsourcing. After the contract expires - and the company does not explicitly address the make-or-buy option - the activity is simply sourced from the incumbent or a new supplier.

⁵¹ PAC (2003) reckons that currently 33 percent of IT related outsourcing contracts in Germany are captive. The proportion of captive suppliers is decreasing since most of these large company subsidiaries did not succeed in the external market.

⁵² Consider the example of Germany’s largest public transportation provider Deutsche Bahn AG. Catering, food services and logistics are exclusively provided by the fully-owned subsidiary Mitropa AG. The relationship is budget- based and the subsidiary charges monopoly prices within the captive market. It is questionable whether such relationships provide access to sustainable strategic benefits be they efficiency gains, performance improvements or business innovations.

⁵³ Cf. Footnote 4.

⁵⁴ Lacity and Willcocks (2003) estimate the market size of the ITO market between US$200 and 500 billion; an error margin of 300 billion.

⁵⁵ Gartner (2003b), SG Cowen Securities research quoted in CNET News.com, January 14, 2003.

⁵⁶ IDC (2002). These projections do not include cross-selling revenues of providers which offer IT or project services in conjunction with BPO.

⁵⁷ CNET News.com, January 14, 2003.

⁵⁸ Mahnke (2002).

⁵⁹ Adapted from IDC research (2002).

⁶⁰ Complete BPO refers to the management responsibility for the business process in its entirety. This contrasts with the application or system management which currently prevails.

⁶¹ Greaver (1999), IMCS (2002).

⁶² Some analysts refer to these backbone processes as ‘processing services’, see IDC (2002).

⁶³ This assumption is confirmed by the fact that backbone processes are to a large extent IT enabled and the relative degree of outsourcing in areas such as payroll administration, billing and invoicing is high.

⁶⁴ Hammer (1993).

⁶⁵ Mahnke (2002) issues a word of caution regarding the obvious non-strategic nature of backbone technologies: “The IT outsourcing bandwagon is littered with examples where companies thought to outsource commodity services just to discover that the have compromised their strategic capabilities only few years later”.

⁶⁶ Author’s analysis.

⁶⁷ Problems of identifying the relevant processes and their linkages to core competencies are further discussed in section 3.1.

⁶⁸ Stoi (1999) provides empirical evidence that less than 25 percent of corporations within the sample of his survey of German firms have adopted company-wide ABC, in some functional areas such as procurement and logistics the adoption rate can reach up to two thirds. According to the author’s research the majority of the respondents initially measured activity costs shortly before or during the outsourcing initiative.

⁶⁹ The lack of innovative capabilities is a major explanatory factor for the external market failure of captive outsourcing providers.

⁷⁰ For an overview of perceived drivers and inhibitors to BPO see IMCS (2002).

⁷¹ Lacity and Willcocks (1995, 2003); author’s research. Selective sourcing combines the use of in-house applications with outsourced approaches, whether they are hosted solutions, out tasking some of the steps in a process, or full BPO solutions. Out tasking is often a pragmatic way of exploring the potential benefits of BPO without fully committing to it.

⁷² Partially based on Gartner (2003b).