Pegging the Right Outsourcing Strategy

By 2010, no business will remain competitive in its industry without outsourcing a significant portion of its IT activities and the business operations those systems support. Even companies with the financial resources to conduct every operation and information system in-house -- such as Dell, General Electric and Microsoft -- will have trouble competing unless they're off-loading substantial operations and IT to others. All three industry giants, in fact, outsource IT and business processes to China and India.

I'm not talking merely about outsourcing operations and systems that are easy to farm out, such as payroll, employee retirement accounts or the company's e-mail network. Depending on the business, I'm referring to major manufacturing operations, warehouse and distribution networks, and in some cases, R&D, as well as the ever-growing, ever-important IT behind those business processes.

IT outsourcing is here to stay, but not necessarily with its first-generation innovators, Computer Sciences Corp., Electronic Data Systems and Perot Systems. Even as demand is building, the provider landscape is shifting rapidly. Traditional domestic outsourcing vendors that have relied on the value proposition, "We'll take it off your hands and deliver you a little cost efficiency," will ring as hollow as a $1 rebate on a $1,000 purchase. They must get a lot better at their game and offer customers substantial value in the form of better business-process/IT performance. Otherwise, the windfall revenue will go to second-generation offshore-IT outsourcers, such as Infosys Technologies, Tata and Wipro Technologies, or third-generation business-process outsourcers, such as Affiliated Computer Services, Hewitt Associates and United Parcel Service of America.

Viewed unemotionally, the offshore outsourcing of IT and call-center work to India is merely the most recent step in a 100-year-old trend in which large corporations farm out pieces of their value chains, through which raw material becomes finished products to be marketed, sold and delivered. Before this, many of the biggest corporations -- such as Ford Motor Co. -- wanted to be independent of suppliers. As late as the 1930s, Ford still produced his own tires, steel, glass and even the wood with which its early cars were built.

But business-world complexity since then has rocketed. No automaker can keep up with the fast-evolving processes and materials used to build car components, whether it's tires, brakes, steel, glass, electronics, airbags or even paint --nor do they want to stray from their core business focus and competencies. As a result, employment among traditional auto OEMs has shrunk precipitously. In 1979, for every million cars that General Motors produced, it employed roughly 91,000 people. Today, that number is 24,000. Of the 67,000 jobs that were eliminated, 40,000 were through productivity improvements, and 19,000 shifted to on-shore, tier-1 component suppliers, such as ArvinMeritor, Johnson Controls and Lear Siegler; another 8,000 went to offshore suppliers. GM, like its competitors, has used outsourcing and offshoring to spread the burden of innovation and efficiency. Because of this, the company cut the cost and time for new-model development in half, and automotive innovation is accelerating.

While automotive companies were selectively outsourcing, other companies watched their IT spending soar in the 1980s and 1990s. IT budgets in some financial institutions reached billions of dollars, forcing managers to put on the brakes. One popular answer was to outsource IT activities -- software maintenance, data-center operations and sometimes information-systems implementation. Long-term contracts with first-generation IT-outsourcing companies, such as Accenture, CSC, EDS and Perot Systems appeared, at least on balance sheets, to rein in large corporations' burgeoning technology expenditures.

But cost cutting isn't the primary driver for outsourcing anymore -- or at least it shouldn't be. Growing complexity and the need to invest large sums in many parts of business operations to stay competitive are forcing managers to choose which operations to keep and which to farm out. All managers must decide how and where to invest their resources -- talent, time and money -- in business-process innovation.

Managers need to closely examine which operations enable the company to provide unique and attractive value to the customer -- that is, the bundle of benefits that differentiates a company and attracts customers to buy its product or service rather than someone else's. These processes need to be closely managed and typically aren't candidates for outsourcing. But everything else is up for grabs. After all, if a process merely contributes to competitive parity -- what I call threshold customer value -- in all the dimensions that don't differentiate that process, isn't it better to let someone else invest in maintaining that threshold position? Why consume resources that could be better applied to areas of differentiation? By "threshold," I mean the ability to meet average industry levels of performance, not superior performance, and to meet, but not exceed, customer expectations.

From my ongoing research of market-leading companies, I've found three basic ways of differentiating and providing value to customers: offer the lowest total cost (operational excellence); offer the best, most unique product (product leadership); and offer a solution that can be best tailored to the customer's need (customer intimacy). JetBlue Airways and Paychex, for example, have thrived on operational excellence, while 3M and Sony have competed on product leadership. Examples of customer-intimate champions are Nordstrom and GE Medical Services (see chart, below).

The business operations that are most important in operational-excellence companies typically contribute to the lowest net cost of operations or the highest standard of hassle-free service. JetBlue has the most efficient cost per seat-mile in the domestic-airline industry, created by copying and updating Southwest Airlines' playbook on how to run a point-to-point airline network. Paychex has built a hassle-free payroll-processing service, aimed at small employers that value their time as much as their money. Paychex's close-to-the-customer servicing processes are the core of what differentiates it from Automatic Data Processing and Ceridian, the closest competitors.

In customer-intimate companies, solving customers' broader problems is the differentiator. GE Medical sells imaging and diagnostic equipment to hospitals and medical practices, in competition with Siemens and others. It's unique among competitors because it developed substantial expertise in its clients' business and built a broad and deep set of consulting, application and systems-integration services around that. GE Medical not only delivers diagnostic and imaging equipment but also can tailor its clients' businesses and medical practices to meet their broader objectives of improved health-care outcomes and better financial performance.

Product leaders such as Sony, 3M and Pfizer have the best product-innovation processes in their industries. They can imagine innovative products beyond anything a customer can articulate and bring products through the commercialization process faster and with better results than their competitors. These companies have innovated the process of innovation, using advanced methodologies to improve the predictability of high-impact innovation.

What matters for all companies aspiring to be competitive in their markets is that they understand what parts of their businesses drive customer value. That insight, in turn, lets the best-run companies focus their innovation resources where innovations in business processes and IT can supercharge their performance. In all other areas, periodic innovation is used simply to maintain threshold levels of performance that meet, but don't exceed, customer expectations. Ford Motor at some point decided not to keep investing in making tires, steel and paint. Those weren't areas in which Ford would differentiate itself in the marketplace for automobiles.

Companies are making such decisions all the time. They also decide whether to: manufacture their core products -- Nike and The Gap, both product leaders, don't; serve customers after the sale -- Dell, an icon of operational excellence, farms out its break-fix services to NCR and others; or even conduct fundamental research and design on new products -- Administaff, a customer-intimate employee-management company, sources most of its product innovations through investments in acquisitions, not research labs. Such business-process outsourcing decisions can be life-and-death issues for a company when competition heats up. Bicycle maker Huffy Corp. decided too late that it had to keep product design in the United States, but outsource manufacturing to China. By the time the company got around to the decision in 1999, Chinese bike makers had waged price wars against Huffy and other companies. Huffy lost $33 million that year, and another $17 million between 2001 and 2003.

Over the past 30 years, IT has become a major component of business processes. Try running a manufacturing plant, warehouse, procurement operation or call center with the computers shut down and you'll prove the point. Moving forward, accelerating advancements in technologies will result in bigger and faster process innovation, and greater challenges in keeping business processes up-to-date. Outsourcing noncore business processes -- and their attendant IT complexities -- will be an increasingly attractive option. For example, running call centers has become a significant capital investment in buildings, computers and software that many large companies are trying to shed. Why should a company that doesn't compete on its customer service make such large investments in call centers? It shouldn't. Instead, it should seek a supplier that can keep it on a steady pace of improving customer service, and focus its own resources where innovation will allow it to maintain customer-value leadership.

The need to focus on the business operations that truly distinguish a business and the increasing dependence on IT will force companies to outsource business and IT operations that truly don't make a big difference to customers or company performance.

All of this represents huge opportunities for outsourcing vendors that can help companies maintain threshold levels of performance in their non-critical business and technology operations. The sophisticated companies of the future won't be concerned about outsourcing their data centers, network operations or software-maintenance capabilities. They'll instead focus their strategic energy on selectively outsourcing business processes and the IT that supports those noncritical business processes.

Traditional, domestic, first-generation IT outsourcing providers will have to demonstrate that they can turn their ships into the wind of business-process outsourcing if they're to survive and thrive in the third-generation market. They face formidable challenges from competitors that have built their business-process outsourcing skills for many years. In human-resource outsourcing, Hewitt and Exult have combined to form a multibillion-dollar business. In electronic payments, First Data Corp. and Affiliated Computer Services are 10 years ahead of IT outsourcers in developing business-process-centric IT-outsourcing platforms. In supply-chain outsourcing, UPS and Schneider Logistics have built strong offerings based on their own expertise.

First-generation providers also face low-cost competition from offshore IT outsourcers, such as Infosys, Tata and Wipro in India, and a growing cadre of Chinese clones.

Just how many of their most strategic business processes and systems companies will outsource remains to be seen. For example, Pfizer uses technology to develop new drugs, and Sony uses IT to design and develop new products.

There seems to be a limit because outsourcing companies would have to develop services that offer not just efficient and effective business processes, but superior performance. The chances of this happening will be low. And even if an outsourcer could develop that talent, it would probably be better rewarded as an industry competitor itself. Further, it's highly unlikely that any company would hand its crown jewels -- the set of business processes that delivers unique and substantial value to its target customers -- to outsiders.

But let's not say fourth-generation outsourcing, whatever its shape, will never develop. After all, the outsourcing of business processes looked equally unlikely just 10 years ago.

Michael Treacy is chief strategist at Gen3 Partners, a Boston- and St. Petersburg, Russia-based company that helps bring innovative products and processes to market.

Article originally appeared in Optimize and also appears in Outsourcing Pipeline