2009 ORN Service Provider Survey Report, Part II
Click here to view the first part of this survey
This second part of a three part series on the results of the 2009 ORN Service Provider Survey, builds on the findings outlined in Part One, that offshoring service providers face increased competition, by discussing the challenges providers face and their efforts to overcome them.
The primary challenge faced by large providers is the pressure on their margins as new entrants create price competition. As a result, providers seek to achieve economies of scale by enhancing volume and growing through the acquisition of competitors. Service offerings, meanwhile, are increasing rapidly in high margin areas like Legal Process Outsourcing and the outsourcing of Innovation. As competition increases, providers are also focusing on renewing their current contracts, with larger companies being more successful than smaller companies, and those that provide Business Process Outsourcing and Information Technology Outsourcing services maintaining longer relationships than those providers involved in Knowledge Process Outsourcing. Finally, the increase in demand for nearshore services has led many companies to seek to achieve economies of scale, though survey results show that increasing scale leads to decreasing margins stemming from overhead and transaction costs arising from coordinating and managing multiple locations. Likewise, companies attempting to diversify their service offerings have encountered a similar phenomenon in which an increase in scope is met with decreasing profit margins as well.
Since its inception in 2004, Duke University's Offshoring Research Network (ORN) project has tracked and reported on the growth of global sourcing for business and IT services. Central to these studies has been the observation of aggressive growth of outsourcing and offshoring demand and the shift from the dominant labor arbitrage tactic to a game-changing global sourcing strategy. The ORN 2007/08 annual buy-side survey report, Offshoring Reaches the C-Suite, documented the importance of a global sourcing strategy for companies accessing capabilities and talent outside their home country. On the supply side of outsourcing service, the ORN 2009 Service Provider Survey documents the transformation taking place on the provider side. The outsourcing industry is being transformed as new entrants around the world rapidly emerge, as countries reshape their national policy to obtain a share of its value, and as incumbent providers attempt to defend their existing market and expand into new markets in order to keep up with the increasing demand and intensified competition.
The ORN Service Provider Survey, initiated in 2007, aims to track service providers along the key dimensions of service offerings, offshore destinations, contract and client relationships, economics, and growth strategies. This survey complements the ORN global corporate client surveys on outsourcing and offshoring and covers large multinational, midsize, and small entrepreneurial service providers.
Increasing pressure on profit margins
In the current economic climate, service providers are focusing on accommodating their client demands while defending their market position from new competitors by offering price concessions, intensifying their focus on internal operational efficiencies, and adopting new operating models. Survey findings indicate that pressure on margins is the most important threat (see Figure 1) to service providers, especially for large and midsize providers, followed by the challenge of retaining talent and achieving quality expectation. More than 65 percent of large and midsize service providers rate pressure on margin among their most important risks compared with 46 percent for small service providers. This is partially explained by the fact that large providers have a much bigger share of large BPO, information technology outsourcing (ITO), and contact center contracts, while the more nimble, smaller providers are able to realize higher margins because of their focus on KPO and innovation services and lower overhead. As a result of the economic crisis, more service providers are entering the market, often with indirect support from their governments. As this phenomenon fuels price competition, large service providers seek volume to achieve economies of scale. Rather than a pure organic growth approach, alternatives include acquiring their competition or their clients' captive operations. The market recently has seen significant examples of both strategies.
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Service offering margins are shown in Figure 2. LPO has only recently emerged as a new opportunity for outsourcing offshore and, perhaps not surprisingly, realizes the highest profit margins for service providers as well as the highest cost savings for companies. The attractive economic benefit of LPO may explain the high number of service providers entering the market and of companies exploring opportunities to outsource their most routine legal activities over the past few years. In the United States, legal services outsourcing also has been stimulated by two important events. The Federal Rules of Civil Procedure concerning Electronic Discovery in 2006 has changed the relationship between law firms and their corporate clients. Later, in September 2008, the American Bar Association issued an ethical opinion endorsing the outsourcing of legal services: US attorneys are responsible for the supervision of offshoring services and for making sure that offshored work meets the US standard. In India alone, the LPO industry is growing faster than 40 percent per annum with more than 110 LPO service providers as of 2008. Interestingly, the presence of a rapidly growing number of LPO providers has not yet unleashed price competition as economic theory would predict. Together, an emergence of outsourced legal services and the recent economic events have set profound changes in companies' perception of the legal industry, once regarded as a sensitive and privileged activity that needed to be kept in-house.
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Outsourcing of innovation processes generates similarly high margins for service providers and very significant cost savings for companies. Due to a high degree of required customization and context-specific characteristic of innovation projects, service providers are able to realize higher margins. However, in a mature, commoditized service market, such as contact center or application development, intense price competition and declining profit margins are unavoidable. For instance, participating service providers report an average margin of 23 percent for contact center, 24 percent for IT services, and 21 percent for finance and accounting (while companies realize savings of 35 percent).
Building enduring outsourcing relationships
Apart from revenue growth driven by securing new clients, service providers are also focused on renewing their existing contracts. The results from the 2009 survey show that, on average, 70 percent of deals were renewed at the expiration of the first contract compared with 72 percent in the 2007 survey, reflecting many clients' reluctance to go through the pain of transitioning to a new provider. According to the 2009 survey respondents, the failure to meet clients' expectations is a key reason when contracts are terminated (see Figure 3): More than 40 percent of service providers indicate clients' unrealistic expectations and lack of clear outsourcing strategy as one of the most important reasons for contract termination. Increasing M&A activity during the past year also helps to explain why we observe a slight decline in contract renewal rates: Post-M&A reorganization and integration efforts often result in rationalizing the number of service providers leading to some contract terminations.
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Generally, BPO and ITO deals, which often involve a high degree of standardization and large investment, are at an advantage when it comes to contract longevity in comparison with KPO deals, which involve shorter duration, project-based work carried out by highly skilled staff (e.g., research and development, product design, and engineering services). Interestingly, the analysis of renewal rates by service provider size reveals that large service providers tend to have a higher renewal rate compared with smaller-size providers (see Figure 4): 81 percent of large service providers' contracts are renewed compared with 66 percent of small providers,' supporting the view that transition costs can be an important consideration in contract termination. The survey also reveals that smaller service providers have a 58 percent renewal rate for their KPO contracts while the KPO deals of large providers, which are likely to incur higher transition costs, have a significantly higher contract renewal rate of 84 percent.
The tension between satisfying demand for near-shore delivery centers and declining margins
Among the recent trends in outsourcing and offshoring, near-shoring has gained momentum among companies currently offshoring and those considering it. Media reports point to a substantial number of companies making changes or planning to bring their offshoring closer to their home country. The emergence of new service providers in near-shore locations and the toll of time zone differences and geographical distance in offshoring likely have influenced this trend. Incumbent service providers are under pressure to establish delivery centers in multiple locations in order to serve an increasing demand for near-shore location.
Unfortunately for service providers, the 2009 survey findings indicate that average profit margins generally decline as service providers expand their scale - defined as the number of a provider's delivery centers in different locations (see Figure 5). This suggests an inherent conflict between clients' demand for near-shore delivery centers and large, global providers' overall efficiency. Setting up an operation in multiple locations helps providers distribute their risk of relying on one major operating location and accommodates their clients' near-shore demand. However, it requires a large investment and a focus on capacity management and utilization, especially for asset-intensive services requiring technology infrastructure, such as contact center and IT services. Overhead and transaction costs arising from coordinating and managing multiple locations also add to operating costs and drive down profit margins. This suggests that large global providers will experience underexploited economies to scale. However, the exception is North American-based providers, which achieve high margins and deliver the highest cost savings. Through in-depth experience and a large international footprint, these providers have developed superior client account management models and superior organizational capabilities to exploit the benefits of custom software development projects (see Figure 6).
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Many service providers are also looking into expanding the scope of their service offerings, hoping to realize gains from economies of scope, to broaden their client relationships, and to diversify. Surprisingly, our survey results show that the number of service offerings and profit margins have an inverted U-shaped relationship (see Figure 7. In fact, economies of scope, or the positive effect of synergy among different service offerings, tend to level off and, consequently, decline as providers continue to increase the scope of their services beyond an optimal point.
The diseconomies of scale and scope of service offerings found in our survey results lead us to conclude that most large service providers have neglected to invest in organizational capabilities, such as client account management or coordination capabilities that match their build-up of scale and scope. In fact, we believe that full service providers are at advantage for realizing synergy among their service offerings but, more importantly, they need to develop organizational capability to synchronously manage, rationalize the portfolio, and coordinate among diverse services.
Click here to view the final part of this survey
1 Source: Heijiman, T., Lewin, A., Manning, S., Perm-Ajchariyawong, N. & Russel, J. (2008) Off shoring Reaches the C-Suite. Duke University & The Conference Board.
2 Source: EFY News Network
3 Source: Prism Legal "Outsourced Legal Services – Introduction and Explanation"
4 Business Process Outsourcing (BPO) includes contact center, human resources, fi nance & accounting,
marketing & sales and procurement. ITO includes information technology service.