Shifting Sands

31 March 2009 Allie Young

The outsourcing market, though not immune to economic volatility, will continue to grow in 2009. However, as Allie Young, research vice-president at Gartner, tells CEO, providers and buyers of outsourcing services will need to develop relationships that factor in longer-term performance improvements.

In the last few months, uncertainty over the global economic downturn has become so widespread, and the path to economic recovery so obscured, that ‘cautiously optimistic’ is the most positive position most organisations can muster.

In this uncertain and rapidly changing environment, the outsourcing market represents something of a dichotomy. On the downside, organisations’ outsourcing strategies may negatively affect market growth, while the upside is that cost-focused outsourcing accelerates as more companies seek the benefits of outsourcing to help them work through financial and competitive challenges, thus driving market growth.

"Executive scrutiny of IT budgets and internal cost controls will lead many to focus on outsourcing as a means to reduce labour costs."

The potential for outsourcing to address immediate cost pressures as well as long-term recovery goals will be unprecedented in the coming years. However, only organisations that are diligent about understanding the pitfalls of cost-focused outsourcing and applying business-outcome-focused outsourcing will be successful.

Looking back at the contracts that have been signed in 2008, there has been a continuation of past trends, though admittedly there was some softness in large signings. In part, this continuation is because external forces do not change the basic drivers of outsourcing. Organisations still outsource for cost benefits, increased efficiency, access to skills, focus on core business, innovation, modernisation and even business transformation.

While the situation will become less volatile, one thing that is clear is that, for the next year at the least, organisations will be under extreme pressure to cut IT costs. Most buyers will focus on cost cutting or driving predictability of costs through outsourcing. Some organisations will renegotiate existing outsourcing contracts, and others will sign contracts focused on reducing costs and getting cash for adjustments.

Unfortunately, because of this focus on low-priced IT services provisioning, some bad deals that lack provision for enhancement or innovation when recovery begins will also be signed. More first-time outsourcers will fall into the trap of signing long-term cost-cutting deals that will turn bad for both parties within two years. Shortcuts in sourcing strategy development and provider selection will be common. In order to counter these trends and avoid unsatisfactory outsourcing relationships, organisations of all sizes must develop sourcing and vendor management competencies and invest accordingly.

Another feature of the market is that proposal requests will focus on price comparisons and competition for deals, particularly for standardised IT outsourcing services, will be intense. Best practices in sourcing strategy and management may be given short shrift and buyers could be lured by ‘lowball’ pricing from providers trying to make quarterly revenue goals or build market share.

In other cases, providers will be pressured to accept low margins for revenue growth and buyers will make decisions based on who promises the lowest cost. The scenario could turn grim if, several years into the deal, the provider’s delivery cost increases or exceeds revenue, degrading service quality. Providers and buyers must work together to apply sourcing discipline and craft relationships that address near-term cost objectives and longer-term scalability and enhancement.

Executive scrutiny of IT budgets and internal cost controls will lead many to focus on outsourcing as a means to reduce labour costs. However, risk avoidance will inhibit some companies from outsourcing, even though they could gain from managed services and performance-based contracts with an external provider.

Some areas of the outsourcing market will naturally fare better than others. Gartner predicts that outsourcing of infrastructure, applications and business processes will all increase. However, in the application sector, key areas such as critical application modernisation and portfolio rationalisation may be overlooked to avoid near-term cost with longer-term payback. Similarly, pressure to standardise, virtualise and automate to gain cost-benefits and variable pricing will subtly shift the market away from highly customised environments.

Green IT issues are likely to grow in importance and will no longer be considered discretionary, but green IT initiatives will be fully embraced only if costs are reduced. Alternative delivery and acquisition models (ADAMs) will see a net boost in adoption as a direct result of economic conditions in 2009. ADAMs will increasingly deliver IT services through approaches such as software as a service, business process utility, infrastructure utility, remote management services and web platform/cloud computing.

Competitive environment

Bucking the trend of recent years, where a proliferation of service providers has defined the competitive landscape, only the strong will survive in 2009. Providers that have recurring revenue from outsourcing relationships will have the staying power and competitive edge.

As a consequence of heightened competition, merger and acquisition activity will increase; targets will be other service providers, captive centres of organisations, and Tier 2 and Tier 3 offshore providers struggling to achieve revenue growth.

"Overall, the demand for strategic business value from outsourcing will rise as the economic downturn is prolonged."

Cash-rich providers will become well-positioned to make strategic acquisitions for technical, vertical or geographic competencies, leading to the potential for India-based companies to take leadership positions among the top-five global service providers.

Indeed, the current environment will establish cost as the necessary competitive condition, regardless of other service characteristics such as scale, provided by global players, or differentiation, provided by local players. The combination of the restrictive economic scenario and the growing maturity of business process service providers will accelerate the adoption of outsourcing services on a worldwide basis.

As a result, 2009 looks like a good year for outsourcing providers in many developing economies. ‘Chindia’ may well be work in progress and the outcomes are far from determined, but early signs indicate continued positive movements; both China and India are growing at the same time that they are developing relationships between the countries.

Similarly, 2009 will be the year that the Latin American countries join the offshore services race in earnest. Mexico will continue to be an attractive near shore services destination for US organisations although the Mexican economy, being strongly tied to that of the US, will undoubtedly suffer more than other Latin American countries.

Conversely, the strong Brazilian internal economy and its broad portfolio of international trade partners will lessen the impact of the economic downturn, making it one of the least affected countries. Nearshore outsourcing from Eastern Europe will continue to grow and increased investment is expected in areas such as North Africa.

Overall, the demand for strategic business value from outsourcing will rise as the economic downturn is prolonged. Flexibility is the operative word for outsourcing strategies and contracts because ultimately, outsourcing can never be separated from business goals.

To drive the desired results, outsourcing must constantly evolve. Organisations with successful outsourcing relationships will understand where they are in the business cycle and make necessary adjustments.

In downward economic cycles, cost will be paramount, but when growth returns, organisations and their service providers must be prepared to adjust their sourcing goals.