Going beyond commodity outsourcing.

Talk to enough people in the outsourcing business, and you will hear the same message over and over: Don't outsource to cut costs. That certainly sounds counter-intuitive--isn't outsourcing mainly about cost-cutting, after all?

Not necessarily. That was true in the early days of outsourcing, especially for IT. But the word most heard in contemporary outsourcing circles is not cost-cutting but transformation. As outsourcing has moved beyond IT to include a broader range of business processes, it has evolved from a short-term tactic into a long-term strategic play. "It's a classic make-or buy decision," says Bob Pryor, a vice president at Cap Gemini Ernst & Young. "Is it a core competency? Can you do it better than anyone else in the world? If not, outsource."

Outsourcing used to be a simple concept. Now, it can mean a multitude of things. At its most basic level, derisively referred to as "body shopping" or "your mess for less," an outsourcing firm merely takes on responsibility for an existing function, offering to do it cheaper. This is commodity outsourcing. All of the major outsourcing service providers do it, but since commodities are by definition undifferentiated, few want to be trapped at this end of the scale.

The industry leaders are pushing not only low costs but also the opportunity to differentiate by redefining and improving business processes. They offer innovative financial and risk-sharing arrangements. They put skin in the game, tying their compensation to their ability to deliver both top- and bottom-line results. Outsourcing at this level offers much more than cost reduction.

Strategy Play

The history of outsourcing has been to a large extent a history of redrawing the line between core and noncore business processes. A study published in 2000 by Stern Stewart & Co., the economic value added (EVA) consulting firm, found that outsourcing can boost effectiveness by eliminating distractions, allowing management to focus on critical strategic issues. Stern Stewart's research examined 27 major outsourcing announcements and compared the stock performance of the outsourcing companies with the market at large to determine whether the decision to outsource affected investors' views.

The conclusion: on average, outsourcing companies outperformed the market by 5.7 percent. The median equity capitalization of the outsourcing firms was $7 billion, so the decision to outsource put an additional $400 million in share holders' pockets.

BP plc (the former British Petroleum) was one of the first global firms to commit aggressively to outsourcing non-core business processes. The oil giant made Andersen Consulting (now Accenture) responsible for finance and accounting for its North Sea operations in 1991, and later expanded F&A outsourcing to other regions, dividing the work between Accenture and IBM Corp. In 1999, BP went further and outsourced most of its human resources work to Exult.

"We tend to be very clear about what is our core activity," says Tom Macartney, Western Hemisphere HR performance and assurance manager with BP. "If we don't believe we have a competitive advantage for doing it sourcing is so extensive that the firm has a global outsource." BP's outsourcing is so extensive that the firm has a global outsourcing network to allow outsource-relationship managers to trade information. "They're such a large piece of the business, there's a lot to learn about measurement, delivery, new technologies and so forth," Macartney says.

For example, in the past, the transactional side of human resources--payroll, benefits, recruiting etc.--used to be dispersed and unfocused throughout the corporation. "Outsourcing has brought a completely different level of transparency, visibility, level of perform-information that never existed before. It has brought a new sense of business process that was lacking before, when we had no centralized view on how we were delivering. It has moved from subjective to objective, " Macarthey enthuses, adding, almost as an afterthought, "It saved money."

James Madden, Chairman and CEO of Exult, says that BP was the company's first big client. Founded in 1998, it signed a $600 million outsourcing agreement with BP in 1999. Subsequently, Bank of America, Prudential Financial, BMO Financial Group, International Paper, Universal Entertainment Group and Unisys have joined the client list. Madden boasts that Exult was the first firm able to take full, across-the-board responsibility for the HR area, integrating 20 different functions ranging from recruitment to retiree benefits.

"HR is a very fragmented function across huge multinational corporations, typically non-standard, inefficiently run, reflecting the way companies have grown through M&A," he explains. "Our basic value proposition is that we will guarantee improvement in operating efficiencies and service levels. On the cost side, we typically guarantee client savings from 15 to 25 percent of historical operating cost." And "guarantee" is a word heard a lot from the leading transformational outsourcing specialists.

Skin in the Game

"Skin in the game" is the mantra of firms at the cutting edge. "Differences between providers are major, but tend to focus on how they approach their relationships with clients, the culture of the outsourcing provider, where they've made investment in evolving service delivery, how they're recouping, flexibility on contract terms and conditions and pricing models," says Lorrie Scardino, Research Director, IT Services and Sourcing, for Gartner Inc.

"The market uses transformational outsourcing as a buzzword meaning a relationship where competitive advantages are created for the client and also for the outsource providers," she adds.

"We put incredible skin in the game," says Cap Gemini Ernst & young's Bob Pryor. "We use our own capital to fund transformational initiatives to share the ultimate benefit the client will realize. It's one thing to discount fees, another to put capital at risk. These transformations can take from 12 to 36 months, and are generally relatively capital-intensive, with significant capital spent not only on the business process elements but also the information technology (IT) requirements to drive them."

In January 2001, CGE&Y signed a $350 million, seven-year agreement to provide 1T outsourcing services to New York-based Continuum Health Partners. Already, Pryor says, "We've had a huge impact on driving out IT cost but also an impact on cash flow around the supply chain, the revenue cycle, etc. In the U.S., cash flow is probably the single most important business metric, and improving cash flow by $100 million a year is [having] a huge impact. Having that kind of impact on the bottom line is probably the best demonstration of what transformational outsourcing is all about."

Some credit Accenture with coining the term "business transformational outsourcing." The firm's landmark transformational deal was with Sainsbury's, a British food retailer that signed a seven-year, 1.8 billion-pound outsourcing deal with Accenture in late 2000. The deal involved an innovative financial arrangement that allowed Sainsbury's to avoid the big, upfront investment that characterizes most IT deals.

To make the transaction possible, Barclay's Capital and its Swan Infrastructure unit arranged a 300 million-pound issue of bonds backed by store receipts, and a 240 million-pound senior secured debt facility. Sainsbury's outsourced responsibility for all of its systems. It also defined 20 business processes and made a process-by-process determination of where it wanted to be a leader, where it wanted to be competitive and where it merely wanted to be competent and reliable.

Maggie Miller, Business Transformation Director at Sainsbury's, has said that Accenture guaranteed to reduce the chain's costs by 50 percent, while improving process performance in key areas and implementing such new initiatives as a data warehouse and an online store.

More recently, Accenture has been working with AT&T Corp. on a variety of initiatives to change how the company interacts with its customers. "We've improved their Web access, so you can take care of a billing inquiry without talking to an operator, which improves customer satisfaction while reducing cost of service. We're changing the scripts that customer service reps use to deal with customers, improving voice response capabilities," says Martin I. Cole, Accenture's managing partner for Solutions Operations. "This isn't just driving cost out, by taking work to the lowest-cost location, but improving the customer experience so that the customer likes working with you and buys more services. It improves both the top and the bottom line."

Despite these advantages, even Cole doesn't see business transformational outsourcing taking the world by storm. "It's not a retail business. It's high-value, unique solutions and small numbers but significant, meaningful engagements or relationships."

Questions Remain

If the outsourcing industry were a pyramid, the broad base would still consist of old-fashioned, commodity-like, cost-cutting outsourcing arrangements. Indeed, posted on Accenture's Web site is a survey the firm undertook in collaboration with the Economist Intelligence Unit in 2002-3. Despite the firm's emphasis on transformational outsourcing, the survey found that cost-cutting was still the main motivation for outsourcing, especially for finance and accounting functions.

When talk turns to cost savings, the subject of "offshore" is inevitable. It's a subject that can raise the hackles of Greg Secord, vice president of marketing and business development with ADP National Account Services. One of the first outsourcing firms, ADP was established half a century ago to handle payroll outsourcing. The firm has expanded its activities, mostly related to human resources.

"We're in 57 countries, with service centers throughout the world, in Australia for Asia-Pacific, in Ireland for all of Europe," Secord says. "We have a global approach to how we do business, and we have development activities in India, I don't want to get caught up in the hype [over] where the work is done. The value is in getting it done better, less expensively. If the value is better moving offshore, you can move it offshore yourself."

He adds: "From a competitive perspective, do I do things in different countries based on cost structure to deliver the savings the customer expects? Yes! But I don't want to sell anybody on the value that my call center is in India. The value is that I'm providing a service. We would hope that where the work is done is not a factor in the decision."

Offshoring isn't the only potentially touchy issue in outsourcing. Despite the impressive cost savings that IBM and Accenture have managed to deliver to clients like BP, control questions give many prospective clients pause, especially in the wake of Sarbanes-Oxley. But Tom Eubanks, Global Leader for F&A Outsourcing with IBM Business Consulting Services, says that outsourcing can make compliance with new regulations even easier.

"You'll be better about documenting service-level agreements, how processes will work, the procedures in place between the provider and client--the same documentations and processes and controls the regulations are asking for our clients to do anyway," he says. "We use [quality control program] Six Sigma in our service provision in finance and accounting globally. It highlights customer requirements and is very metrics-oriented."

Marc Schwartz, Deloitte & Touche's Global Director of Outsourcing, concurs, saying, "The notion is that you can get a highly qualified firm to provide accounting services and have a lot of confidence that they'll get better results than an internal [staff] because the external party will be doing things as described [in the service agreement]."

Outsourcing began at the dawn of the information age, when firms started to offer a lower-cost approach to handling routine, repetitive business processes that lent themselves to automation. Later, the emphasis shifted to specialists like EDS, which owned and administered information systems. In recent years, globalization, falling telecommunications costs and technological advances have made it possible for firms to outsource almost everything they need to run a business. Universal Leven, a Dutch insurance company established in 1997, didn't bother to build back-office capabilities--it merely outsourced them and focused management attention on market-facing, strategic activities.

Transformational outsourcing is almost as big a step for an established company. But with eager outsourcing service providers not only making promises but backing them with capital commitments, it's an alternative with a certain allure.

Gregory J. Millman ([e-mail].) is a New Jersey-based freelance business writer who frequently contributes to Financial Executive.