Make vs. Buy - Where Are You Going in Your Shared Services Journey?
As transaction processing has developed two types of models stand out as potential delivery structures for non-core support function services: insourcing/shared services (Make) and outsourcing/BPO (Buy). This article by Kathleen Brumme evaluates the pros and cons of each approach, and explains why the Buy option carries a great advantage.
Two types of models have emerged as the primary delivery structures for transaction processing and non-core support function services: insourcing/Shared Services (Make) and outsourcing/BPO (Buy).
In the Make delivery structure, companies typically establish centralized operations for transactional processing and delivery of non-core support functions in a captive Shared Services Center (SSC). Efficiencies are realized primarily through redundancy elimination, process standardization, scale effects, and in some cases wage arbitrage. Many companies also use the opportunity to reengineer their processes and implement technology improvements.
In the Buy delivery structure, management of transactional and non-core activities is transferred to a third-party BPO provider. The BPO provider delivers specific functions and processes to customers at agreed upon pricing and service levels, which are generally guaranteed for the life of the contract (typically seven to ten years). In addition to guaranteed savings and service levels, benefits include the ability to rapidly scale operations up or down as market conditions warrant, the conversion of fixed costs into variable costs, and the elimination of systems upgrade and maintenance requirements.
An interesting point to note here is the recent trend of companies moving from an insourced Shared Services model to an outsourced model. As the BPO market has matured and outsourcing has become a more viable option across industries and functions, many of the early adopters who initially chose insourcing and established their own Shared Services operations have since decided to either outsource those operations or spin them off as separate entities. Recent examples include Proctor and Gamble, International Paper, and General Electric.
Comparing Make and Buy
The primary differences between the two models can be segmented into three categories:
- operating model
- business focus
- risk and controls
Organizations that use insourcing do not generally charge market prices to the business units and are seldom able to reinvest their "profits" (assuming they are not run as a cost center) into the Shared Services operations. Scale efficiencies are realized through consolidation of processing activities and delivery centers but are limited by the size and transaction volume of the company. Governance tends to be less formal with many companies running Shared Services as a separate business unit.
BPO is a highly competitive market with aggressive market pricing. Providers typically leverage established multi-location delivery infrastructures and can support their pricing levels by achieving substantial efficiencies through multi-client scale, implementing best practices across clients, continuous investment in systems and process improvements, and labor arbitrage. BPO can reinvest their profits in their core business-optimizing business process operations. Formal governance structures are contractually established to manage the relationship between the customer and BPO supplier.
Insourced Shared Services are often considered "back office/overhead" functions and not the core business of the company. Decision-making is done in conjunction with corporate objectives, and profits are often returned to the business units rather than reinvested in the SSC operations. Corporate objective setting generally focuses on cost-reduction rather than service level improvement. The repetitive nature of the work and limited career pathing tends to result in higher employee turnover.
For BPO providers, on the other hand, back office functions are the core business. Therefore, they can focus their full attention and resources on delivering cost and service level improvements. Profits are reinvested in enabling technologies and best practices, allowing BPO providers to remain at the leading edge of process efficiency and service level delivery. Expanded career opportunities and incentive structures enable BPO providers to better attract and retain the most talented resources.
Risk and controls
One of the primary risks faced when insourcing operations, especially to an offshore location, is that there is often a lack of internal expertise on how to migrate processes without disrupting the business. In addition, companies tend to underestimate the complexity of operating centers in offshore locations such as India, China, and Eastern Europe where political and cultural issues can dramatically affect operations and increase the transition time. However, because the operations are still maintained in-house, there is a somewhat lower risk of intellectual property loss, and companies generally feel a greater sense of security around business controls.
In the case of BPO, there is often a perception of higher risk, although much of this is focused on the belief that through outsourcing, companies can lose control. Indeed, much of that risk can be mitigated through proper governance and business control structures. In fact, outsourcing can help lower risk. For example, one of the big risks companies fail to adequately plan for when building captive centers is cost overruns following incorrect assumptions about transition activities. Large BPO providers have extensive transition experience and are likely to be better able to budget, plan, and execute migrations. BPO providers also guarantee costs and performance levels so companies are not at the mercy of the assumptions built into their internal business cases as they would be for insourcing.
When the differences between the two models are understood, it is important to evaluate the strategic benefits of each. Companies must take into account their long-term objectives, along with their tolerance for risk, and weigh the relative benefits of each option:
- Maintain low risk of intellectual capital loss
- Retain high level of control
- Retain 100% of cost savings in-house because there are no profit margins or selling costs to cover
- Gain ability to leverage company wide scale advantages
- Relatively easier to attain support internally for insourcing than outsourcing
- Less dramatic cultural change
- Faster time to project start from lack of bidding, contracting, due diligence phases
- Less formal governance mechanisms required to manage Shared Services operations
- Free up resources to focus on the core business
- Guarantee significant cost reductions for the duration of the contract
- Guarantee performance levels based on service level agreements (SLAs)
- Lower upfront investment required
- Faster time to market/steady state than insourcing
- Gain increased access to new technology without major capital investment
- Maintain flexibility in tight labor markets
- Ability to leverage multi-client scale advantages
Beyond the strategic benefits, it is important to understand the financial impact of the Make/Buy decision.
Consider a business case, to evaluate key differences between the Make and Buy scenarios, which examines four areas:
- Investment required to start operations
- Annual savings from baseline costs after operations have achieved steady state
- Timing to reach steady state
- Overall payback
- Both insourcing and outsourcing require a substantial upfront investment to implement. The Buy scenario, however, generally has significantly lower investment requirements because of the ability to leverage exiting infrastructure. The key investment elements evaluated in the business case include severance, program setup, site selection, infrastructure, and IT application development (see also Figure 2).
- Severance: Severance is one of the largest investment costs associated with shared services or outsourcing. Severance costs should theoretically be the same for both scenarios.
- Program setup: The costs included in program setup are those associated with staffing the organization and migrating processes. These include: hiring/recruiting, training, and transition.
- Program setup costs for the Buy scenario are lower because of several factors:
A BPO provider has an established reputation as an employer in its delivery center locations. It has more career pathing opportunities and has been shown to have lower employee turnover than captive operations. It also knows the employment market and has established hiring mechanisms in place.
A BPO provider has established training procedures and existing staff and training facilities.
A BPO provider has experience and expertise in transition.
- Site selection: For the purposes of this business case, site selection costs apply only to the Make scenario. They are the costs associated with scouting a suitable location to establish a shared services center and the costs to establish a new legal entity. This paper assumes that the for the Buy scenario, there is an existing center, so these costs do not apply.
- Infrastructure: These costs include: setting up the PCs and applications for each employee, PC and phone equipment, building fit out (cubes, common areas, desks, and so on), and technology infrastructure. The BPO costs are lower because of the ability to leverage existing infrastructure such as canteen, meeting rooms, and technology infrastructure. In addition, the BPO provider typically has lower per-seat hardware and software licensing fees because of its scale.
- IT application development: It is assumed that in either scenario, the company requires some application development to achieve improved process efficiencies. In the Make scenario, the customer pays for 100% of their application development. In the Buy scenario, it is assumed that the BPO provider can leverage the development costs over multiple customers.
After operations achieve steady state, it is possible to compare run-rate savings for each scenario. Savings can be segmented into three categories: process, scale, and wage. For each category, the Buy scenario has some advantage.
Process: Buy has a slight advantage in achieving savings through process efficiencies because BPO providers can focus their full attention and resources on the core business of BPO. This is manifested through continuous investment in technology, process improvements, and best practices. Examples of this can be seen where BPO providers have taken over the management and execution of captive centers and have been able to achieve significant cost and service level improvements.
Scale: Scale is the area where the Buy scenario has the greatest advantage over Make. Scale advantages are achieved by spreading fixed costs such as building security, conference rooms, and common areas, over a greater volume of transactions and employees. BPO providers can leverage volume from multiple customers to achieve significantly greater scale advantages than captives. Captives can achieve some scale advantages from consolidating their operations in a single center, but those advantages are limited by the company's internal processing volume.
Wage rate: Wage arbitrage remains the single largest source of savings when offshoring operations. Both Make and Buy scenarios capture the majority of savings from the wage differential between onshore and offshore operations. Depending on the size of the captive operation and the company's existing presence and reputation in the region, wage rates for Make and Buy can be nearly equal.
However, large BPO providers tend to have a slight advantage as a result of several factors:
- BPO providers have an established reputation in their local markets and can be seen as a preferred provider of employment. New entrants to an area will often have to "hire away" employees at a premium.
- Attrition rates are generally higher for captives than pure BPO players (for example, in major outsourcing centers in India, industry average is nearly 40% per annum) primarily because pure BPO providers generally provide more opportunity for cross-training and career advancement and have more experience with local employee issues.
- BPO providers are focused on wage inflation and strictly manage increases, whereas captives often view wage increases in absolute terms (total dollars as opposed to %) relative to the domestic rates and are less stringent in keeping wage costs down. In addition, they also are better at aligning work complexity to pay rate and making better use of variable pay structures.
- BPO providers generally have a lower benefits burden than captive operations.
Experience has shown that it typically takes four to five years to reach steady state and begin seeing transformation level improvements when creating a captive shared services center. In contrast, in an outsourcing engagement, companies can readily leverage the outsourcer's existing operations and often achieve immediate cost and efficiency improvements. An outsourcing project typically reaches breakeven in two to three years.
Contracting and due diligence: Most companies that chose to outsource operations go through and extensive bid, contracting, and due diligence period before the project can begin. This is not required for insourced operations.
Transition: After the project is given the go-ahead and a BPO provider is selected, the lead time to set up a center is much shorter because of the existence of the provider's established infrastructure, as well as governmental relationships, local market knowledge, and an existing hiring network. A lack of local market knowledge is a common pitfall for which companies often fail to adequately budget. Knowing how to navigate the political, bureaucratic, and social landscape in a foreign market is one of the key, yet often undervalued advantages that outsourcers provide.
How to decide whether to make or buy – Applying the framework
Combining the economics of the business case with the Make/Buy decision framework (see below) helps to clarify the decision. Using this framework, you can evaluate a set of conditions to decide on your optimal strategy.
- The processes in scope are considered to be "core" to the business or are truly unique and therefore not leveragable.
- Current processes are at first quartile/world-class performance levels, leaving little room for process and scale efficiency improvement.
- Few constraints exist on capital spending, ensuring funds are available for establishing a captive center.
- Company has the ability and willingness to wait four to five years to achieve payback.
- The company has adequate volume from internal operations to achieve required scale efficiencies.
- Internal business units can and will adopt best practices and standardize operations without the formalized structure created in an outsourcing agreement.
- The company is willing to reinvest profits in shared services to maintain world-class capabilities.
- There is a lack a suitable BPO partners available, or in-scope processes are industry-specific and not currently offered in the BPO space.
- There is a lack of support for outsourcing among senior management.
- There is a high risk of intellectual property loss.
- The company has an existing disaster recovery network in place.
- There are regulatory constraints that prohibit the outsourcing of processes.
Given the economic and timing advantages of outsourcing, should a company not meet the majority of these conditions, they would be well advised to consider their outsourcing options.
What to outsource – In-depth assessment required
The Make/Buy decision is, of course, only the first-level, albeit most fundamental, decision that companies looking to transform their support functions must make.
After a decision has been made to make or buy, further in-depth analysis is required to determine the answers to many critical second-level questions, such as:
- Which processes and subprocesses should be included in either a shared services center or an outsourcing agreement? Which should remain decentralized?
- What is the best location to set up a shared services center or to move outsourced operations?
- What operating model and governance structure must be put in place to manage the realigned operations effectively?
Taking the time and effort to answer these questions upfront will help companies to more effectively and efficiently transform their operations.
Today, companies have more options than ever for achieving world-class performance in their support functions. Faced with increasing market and competitive pressures, leading companies are freeing valuable resources to focus on their core businesses.
Non-core operations and processes are being sequestered in captive shared services centers or outsourced to BPO providers. Executives must closely examine their strategic, operational, and growth objectives to make an informed decision about which structure will best meet their needs for the future.
Make/Buy decision framework
After examining the benefits, risks, and economics of both the insourcing and outsourcing delivery structures, it is important to analyze the options in a holistic manner to put this information in context and determine which structure will best meet the needs of a given company. The following six key questions help determine which delivery structure best meets a particular company's needs.
Strategic fit: Which structure will best help us meet our strategic and operational goals given our core competencies, competitive landscape, and growth objectives?
Economic impact: What are the required investments (time and money) versus the anticipated benefits (savings and service level improvements) of each option to our shareholders and stakeholders?
Required timing: What is the required timeframe to reach steady state and achieve payback on investment?
Operating model: Which structure will best enable us to achieve best-in-class performance in our required timeframe?
Cultural fit: Can we view an outsourcer as a partner and will an outsourcing partner offer best-in-class capabilities opposed to insourcing?
Risk management: What are the regulatory, operational, socioeconomic, and financial risks of each option and how can they be mitigated?