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There are new ways to divvy up the outsourcing pie, and new players are lining up for a piece.
Scott Leibs, CFO Magazine
February 1, 2001
Who was Tenzig Norkay? If you said "One of the 20th century's most famous outsource providers," you're correct, although badly in need of a vacation. Norkay helped Sir Edmund Hillary get to the top of Mount Everest, yet the anonymity of this Sherpa guide towers over his achievement. So too the growing legion of outsource providers, who play an increasingly important role in many corporate missions, yet enjoy none of the buzz lavished on sexy new technologies or managerial trends du jour.
What attention they do receive usually stems from the size of a few noteworthy contracts. This was true in 1989, when Rochester, New York-based Eastman Kodak Co. put outsourcing on the map by announcing a 10-year agreement with IBM Corp., and it remains true today — last December both Exult Inc. and EDS Corp. put out breathless press releases announcing deals worth more than $1 billion.
But huge contracts tell only a small part of the story. Over the past decade, the dominant players in outsourcing, which include IBM, EDS, Computer Sciences Corp., Arthur Andersen (now renamed Accenture), and a few others, have been joined by hundreds of new, smaller players. They may specialize in a business process (Exult offers a wide range of human resources services, for example) or in E-commerce, or offer software applications in an ASP (applications service provider) model, or network, storage, security, and a vast number of other services that can be lumped together as "XSPs."
Indeed, despite the fact that the outsourcing market declined last year after a Y2K-fueled boom in 1999, it is poised to gain significant ground over the next half-decade. Market research firm Input says the total market, encompassing traditional IT outsourcing, business process outsourcing (BPO), and processing services, will grow at a 19 percent annual clip from now until 2005, eventually topping $260 billion.
The advent of so many new players means that companies can outsource almost anything; they can quite literally become virtual. But tapping a growing number of partners for services both mundane and cutting-edge poses a new set of challenges: How will companies choose wisely and make sure that all those partners can not only hold up their individual ends of the bargain, but also work together to make sure a client's needs are met?
For answers, one need only revisit that historic Kodak deal, which proved remarkably prescient. "People tend to forget that we didn't do just one deal at the time," says current CIO John Chiazza, "but three." IBM got the bulk of the assignment, and all the press, but Digital Equipment Corp. (DEC) provided some network services, and Businessland addressed key elements of desktop computing.
Parceling out critical parts of its IT infrastructure to three different companies, each of which was as new to outsourcing as Kodak itself, was not without risk, and Chiazza readily admits that some "battle scars" resulted. The most critical lesson, that a company, in Chiazza's words, "can't manage technology by parts, but by how the parts come together," is instructive for the many companies today that suddenly find themselves in possession of an entire portfolio of outsourcing agreements, often stitched together with little thought given to overall strategy.
Kodak may have made some mistakes — its arrangement with DEC, for example, proved highly unsatisfactory, and that business was transferred to IBM as soon as contractual terms allowed — but it also did several things right. For one, it established at the start what Chiazza describes as a "relationship management group" to foster good communication between Kodak and its outsourcers. That has since matured into a multifaceted approach in which a dedicated group within Chiazza's IT organization researches potential outsourcers, negotiates terms, and addresses other matters of policy, while individual relationship managers interact with the outsourcing providers on a day-to-day basis.
Sounds simple enough, but, unfortunately, few companies follow this model. "There is a big difference between procurement and strategic sourcing," says Linda Cohen, a managing vice president at Stamford, Connecticut-based research firm Gartner. "Procurement is the tactical, one-off purchase of a product or service. Strategic sourcing results from developing a sourcing strategy that enables the business strategy."
Cohen and others at Gartner believe that we are entering an era in which "outsourcing" should be rechristened "strategic sourcing." The key difference lies in how companies integrate a range of sourcing contracts within their overall objectives, and how they manage those relationships. Outsourcing got its start when companies went looking for someone else to handle the complexity and expense of their data-center operations. In fact, outsourcing was virtually synonymous with back-office infrastructure, but that's not the case today. "Companies now make three distinct types of deals," argues Cohen. Some are what she dubs "utility" deals, and boil down to simple economics: How can a given service be acquired most cheaply? Others are "enhancement" deals, in which price matters, but so does "speed to functionality." And on the high end, "frontier" deals have little or nothing to do with price, and are created instead to move a company into a new line of business, or to navigate a complicated merger, or to acquire E-business capabilities.
That was the case last year when Houston-based Enron Corp., regarded by many as the embodiment of everything innovative and admirable in American business, created The New Power Co. Launched in May and based in Purchase, New York, TNPC aims to be the first nationwide energy provider for residential and small-business customers, and last fall it began offering services in several states. Enron had tried to get into the consumer space once before and had failed. This time, the company decided that a new company, aided by new and powerful partners, was the way to go. TNPC has signed exclusive marketing and service agreements with Enron, IBM, and America Online Inc. (AOL). The contribution made by IBM, in fact, is so significant that Tony Wyatt, TNPC's managing director of operations and technology, says that "this relationship really can't be considered outsourcing at all."
Certainly not in the traditional sense. Like AOL, IBM has an equity stake in TNPC. And it is providing not just data-center services, but also so much of the company's IT needs that Wyatt says simply, "IBM is my CIO. And [it works] so closely with us that there really is no boundary between IT and operations." Formerly CIO at AT&T's consumer division, as well as at other companies, Wyatt is now responsible for both IT and operations, an arrangement that would seem to guarantee substantial integration between the two. Bill Jacobs, CFO at TNPC, says that one key to the arrangement is that "Tony and his team are in minute-by-minute contact with IBM. They've worked out a shared vision that is essential to making the deal work."
Managing the Relationships
Despite TNPC's reliance on IBM for the bulk of its technology needs (as well as call center and other customer-service functions), Wyatt agrees that in today's environment, no single supplier can do it all — not even IBM. "It's really a network of relationships we have," he says, "with IBM dominating but others playing important roles." For example, the company uses E-Online to host its SAP software in an ASP model, while ExoLink provides messaging capabilities between TNPC and local utilities — a key bit of infrastructure in this deregulated age — and SCT provides the billing "engine."
"We never contemplated building something like that ourselves," says Wyatt. "That would have been suicide." As with many newly formed companies, TNPC wants to contract for as much technological capability as it can. That's one of the current drivers in the outsourcing market. "We wanted to outsource as many business functions as we could," says Doug Paustenbach, former head of IT at Branders.com, in San Mateo, California. "To grow quickly, you have to devote your staff to core business issues. You lose some control and some reaction time, but the pluses outweigh the minuses."
This approach, however, places a different burden on client companies — they may not have to build it themselves, but they must learn how to manage it. "It changes things," admits Wyatt. "Your status no longer comes from managing an army of internal staff, but from managing a successful relationship."
Or many relationships. As outsourcing metamorphoses into strategic sourcing, companies are creating senior-level positions for the employees who select outsourcing providers and manage the ensuing relationships. This allows companies to create what Barry Wiegler, managing director of Sourcing Interests Group, a Bell Canyon, California-based consortium of outsourcing clients and providers, describes as a "knowledge center where benchmarks, processes, and insights into how to develop and refine relationships" can be gathered and accessed by those in the company who might have a need for outsourcing expertise.
Centralized knowledge centers are likely to be invaluable as more employees get involved in outsourcing decisions. While most outsourcing arrangements still encompass some IT component, the fastest-growing segment is in BPO, where the key decision maker is often a line manager, not a CIO or IT staffer. And BPO vendors as well as ASPs routinely market themselves to various "process owners," from the vice president of sales to the head of accounting.
Who's the Boss?
This creates plenty of room for miscommunication and disagreements about which party should take the lead — internally as well as among the retinue of companies providing services. Gartner's Cohen believes that, because such services are, at bottom, about technology, IT should dominate. "There is the potential for some organizations to be duped by the claims of ASPs," she says, "especially if the CIO is left out of the loop." She argues that because IT organizations usually have deep experience in selecting technologies and negotiating terms, they should, in essence, shop on behalf of the business units they serve.
But James C. Madden, president and CEO of Irvine, California-based Exult, sees things differently. "In large companies," he argues, "IT is one stovepipe, and business processes such as human resources are another. The process is more important than the technology that underlies it, so we sell to the people who own the process. Functional expertise trumps technology."
As a former CFO (of MCI), Madden believes that by creating the role of sourcing expert, companies can maintain control over what could become a management nightmare. "At two clients, we have situations where the CIO has tapped one outsourcer, the head of HR another, and the CFO a third. But it can all be made to work together."
At least one consulting organization, in fact, has begun to offer "relationship management" training as part of its services. Jack Benton, vice president of marketing for Technology Partners International Inc. (TPI), in Houston, says the need is great for several reasons: companies are using more outsourcing providers, the providers themselves now subcontract to others more than before, and often the people who choose the providers "go off and do something else, leaving someone else to manage a relationship they know nothing about." Wiegler of Sourcing Interests Group adds that, "with the rush toward E-commerce, companies often go around the discipline that IT and procurement organizations have put in place. Outsourcing becomes very ad hoc."
Benton estimates that only about 10 percent of large companies have a relationship manager or department in place, but many more are currently establishing the position. Finding the right people can be difficult. "We've put some people in that role who haven't worked out," says Kodak's Chiazza. "It's easy to get into finger-pointing between the client and the vendor. You need people who have a good background in IT, but who may not be experts. They have to be good at negotiation and communication."
Other experts suggest that project-management skills are also essential. Opinions differ, however, on just how a sourcing expert or relationship manager should interact with the service provider. Chiazza believes that "there is always day-to-day traffic that requires a point person who can make sure service is being delivered." Exult's Madden counters that "if the job is just managing the vendor day-to-day, that's not much of a value-add. Once you pick the vendor, the process owner should own the relationship."
It may be that IT outsourcing and BPO are fundamentally different in that regard, but even if companies can work out their own internal politics, there is still the tricky matter of making sure outsourcers can work together. In some cases, such as that of TNPC, it is clear that one company is the top dog — the general contractor that will set the direction for the other service providers. Wyatt wouldn't have it any other way. "If I had to tap five lesser companies for all the things that IBM can do," he says, "I would have to work harder on those relationships, and I'd get less strategic value."
But in many cases, no single partner dominates, and often each one wants to deal directly with the client, not be subordinated in a subcontractor role. "We need direct communication," says Heather Shively, CEO of CapitalThinking Inc., a New Yorkbased ASP that provides E-finance software to the mortgage industry, "because even when you work hard at it, expectations and deliverables may not match."
One Slice per Customer
Often, outsourcers want not only direct contact, but also a bigger slice of the pie. "There is a tendency for third parties to want 'umbrella deals,'" says Kodak's Chiazza. "But I think comprehensive agreements can make it hard to evaluate performance, and to disentangle yourself from unsatisfactory relationships." It's not that Chiazza is averse to using a vendor for more than one service, but he recommends addressing each area of functionality in a separate contract.
As partners multiply, of course, so do contracts, the original form of "relationship management." Chiazza and others believe that companies have become much smarter about how to structure various outsourcing deals, but he cautions against "management by contract." In Kodak's earliest experiences, he says, the company wrote contracts vaguely, which led to disagreements about expected service levels. The company overcompensated by writing very detailed contracts, which created an inflexible bureaucracy. "Now," he says, "we've gone back to more general contracts that provide a framework but that count on a proper attitude by both parties. That's the key to making it work."
A certain amount of proper attitude can be captured in a good contract. "Someone has to take the lead on certain issues," suggests Dave Hudson, head of marketing for Getronics USA, a Boston-based outsourcer, "on matters such as anticipating a client's requirements for storage, network capacity, and so on. So companies that spread their business among many different suppliers should make sure the contracts stipulate which providers will monitor those issues and sound a proper alarm."
Jacobs of TNPC draws an analogy befitting a CFO: "A contract is like a balance sheet — a snapshot of where things are at a given point. The relationship is like an income statement — a broader view of the entire picture." And those relationships will shape the bottom line like never before.
Scott Leibs is technology editor at CFO.
Name Your Price?
As the number of outsourcing providers increases, so too do the pricing models being offered. Traditional terms have included either flat-fee or volume-based pricing (based on transactions, for example). But increasingly, various forms of "value pricing" are becoming more popular. These typically focus on the quality or business impact of a service, and represent a certain risk/reward sharing between client and vendor. At The New Power Co., for example, IBM was guaranteed $1.5 billion over 10 years. That means it can save on selling costs, since TNPC has little incentive to open every new process to competitive bidding, but TNPC has flexibility to tap non-IBM vendors when it sees fit, as long as it reaches the spending threshold within the stated time period. In other models, vendors are paid based on how much they save the client, or how much new business they facilitate. But some remain bearish on the economic benefits of outsourcing, no matter what form the contract takes. "We did an exhaustive study of outsourcing our data center," says Jim Hatch, CIO of $3 billion packaging giant Pactiv Corp., in Lake Forest, Illinois. "In every single case, it would have cost us more to outsource than to do it ourselves. Add to that the loss of control over what should be regarded as a strategic asset, and it doesn't make sense." That is, Hatch adds, if one is comparing an outsourcer to a well-run internal operation. "But two-thirds of the IT organizations out there are badly run, so it's not surprising the outsourcers are finding a fertile market." Pactiv did sign a three-year deal with Exult last year, however, suggesting that even hard-line companies have their soft spots. —S.L