Last Year's Outsourcing Trends are Accelerating

Look for accelerated growth this year of the outsourcing trends that predominated in 2006: Expansion of business process outsourcing (BPO), the maturing of the offshore market and more multi-sourcing at the expense of single, one-off "mega-deals."

That's the word from a survey of lawyers at the lawyers in Morrison Foerster's Global Sourcing Group. Their view is based not only on their own experience on sourcing projects but also on the opinion of clients, service providers and outsourcing consultants, the company says.

Each of the trends cited will continue this year but at an accelerated pace, Morrison Foerster says. Not only has the mega-deal suffered, for example, but most deals are now shorter in duration and smaller in value than two years ago. Businesses remain committed to outsourcing but are less prepared than in the recent past to lock into long-term deals. Flexibility has become the outsourcing mantra.

Predictions for the outsourcing market in 2007 include:

* A continued trend towards smaller, shorter deals as businesses focus on individual processes instead of large, complex institutional transactions;
* Increased reliance on global service delivery models;
* More importance for data privacy and data security issues;
* Increased offshoring to China;
* A revival of anti-outsourcing sentiment with 2006 U.S. mid-term elections;
* Adoption of recognizable elements of IT outsourcing and BPO into traditional Japanese contract partnering operation.

In the meantime, outsourcing remains a buyer's market. Increased competition from service providers allows customers to pick and choose. Rather than risking whole business lines with a single service provider, shorter duration and smaller value transactions allow businesses to spread operational risk and develop new relationships. The trend complicates governance, a burden that businesses appear willing to shoulder. Besides, assigning a broad set of service requirements to a single service did not always work well in the past.

Niche players are winning more deals at the expense of both the Tier 1 service providers and the sub-Tier 1 mid-range providers. While the outsourcing market continues to expand rapidly enough that the larger service providers can protect their earnings even with a reducing market share, the potential losers are likely to be mid-level service providers who have not come up with a strategy to overcome the shift. In 2007, many of the traditional big service providers may change their focus and try to wind more of the smaller deals.

Multi-sourcing has become the favored strategy. One service provider cannot be good at everything--and concentrating on "best of breed" is likely to deliver value. That strategy comes with a cost because businesses need to spend more time and money managing service providers. We find that our clients are more focused on governance than they were even two years ago. They build on-going governance and retained organization costs of 8% to 15% into their business cases. However, many customers struggle to manage deals properly, and project management needs to improve if multi-sourcing is to achieve its goals.

Exceptions occur. Big deals are still signed by the Tier 1 service providers. The difference is that the large deals are now concentrated in fewer sectors, and many larger deals are broken up when they come up for renewal. Outsourcing consultancy TPI predicts fewer than eight deals in 2007 with a value in excess of $1 billion, down from 15 in 2005 and 25 in 2004.

As deals become smaller and customers focus on governance, deals are taking longer to close. There is a difference between offshore-origin service providers (who remain fleet-of-foot and prepared to meet customers' expectations to close deals quickly) and larger (especially Tier 1) providers. The big providers have increasingly protracted and convoluted sign-off procedures and are reluctant to move away from predetermined policy positions. Big service providers need to ensure they have factored their increased cost of sales into bids and that they set realistic expectations about projected revenue.

Still, business process outsourcing (BPO) will remain the fastest growing sector in 2007. More processes are now in-scope, both front and back office. HRO has not grown as much in 2006 as predicted, as service providers have struggled to deliver the savings and performance. Hewitt and Convergys have revealed less-than-expected performance data in 2006, which has slowed HRO Other areas, however, continue to grow.

Finance and accounting should be a growth area in 2007 as CFOs have moved on from Sarbanes-Oxley compliance issues to examine internal processes. Many of our insurance clients outsource claims administration services to cut costs and improve performance. The insurance sector should clearly remain a key buyer of outsourcing services, as companies are driven to reduce their costs further. Shortages of skills prompt insurance companies to outsource the support for the roll-out of new products.

In another trend, 2006 saw the convergence of onshore and offshore. More deals involve an element of offshore delivery, and key offshore service providers are coming onshore to win business. In March 2006, for example, Pearl Insurance outsourced payment execution services to TCS, which came onshore to win that work. Many of the Indian-origin service providers now have delivery centers in all key geographic areas. That has helped them win more deals from the Tier 1 service providers and move beyond their typical strengths in applications development and maintenance (ADM).

Increasingly, service providers will be distinguished from each other -- and selected by customers -- based on the robustness of the global service delivery model--in other words, by their ability to source services delivery from the right place at the best price.

Last year also saw more work done in China, a trend that will continue. Although India retains a cost and language advantage, China closes the gap year-by-year and is making strides to close the significant skills gap for many types of outsourcing. Analysts have recently claimed that between 5% and 10% of U.S. and European IT software outsourcing will be diverted from India to China in a few years. Certainly most of the major Indian service providers are established in at least one major center in China, as are some of the U.S. service providers.

Businesses are looking to China for ADM work. Despite a Chinese regulatory regime that remains less friendly to business interests than the system in India, the Philippines and other popular sourcing destinations, more companies are sending ADM work to China where the cost advantages are greatest.

Deals are won by Indian service providers and are then performed in China, and we believe that trend will continue. India will remain the largest offshore center for the immediate future, and more complex work will be performed there for the moment. China will begin to attract more lower-value work, especially ADM. Businesses also set up their own development centers in China, usually as a joint venture with a Chinese partner. That is done for traditional off-shoring work as well as to position companies for the Chinese domestic market. Operating in China remains complex.

Data privacy and security are now established as major concerns in outsourcing, too. Global companies have become concerned that their outsourcing contracts do not protect them from security breaches, and consumers are also alive to the issue after media exposes. Research by the UK's National Outsourcing Association demonstrated how data protection concerns loom large in the minds of companies contemplating outsourcing.

That trend will continue in 2007, and much more effort will be put into ensuring data security requirements are met and that customers are informed of security breaches by service providers. Meanwhile, global companies will continue to permit cross-border data transfers.