The evolution of outsourcing: the next step for many companies is "transformational outsourcing," allowing them to leverage strategic relationships to enhance their own capabilities. (Innovation & Outsourcing).

* Enterprises choose to outsource various functions for all kinds of reasons. The most common ones, according to the Outsourcing Institute, are to reduce and control operating costs, to improve company focus, to gain access to world-class capabilities and to free internal resources for other purposes, in that order. While all are valid reasons, in some important respects they are more retrospective than indicative of where outsourcing is headed.

"Traditionally, the outsourcing market focused on infrastructure, data operations and cost takeout as primary drivers," explains Martin Cole, managing partner for Outsourcing and Infrastructure Delivery at Accenture. "Now, in addition to reducing the cost of operations, enterprises are looking to outsource business areas to achieve greater flexibility and to gain greater ability to respond nimbly. It is critical to be able to respond to changing market conditions and a competitive environment frequently driven by mergers and acquisitions."

Essentially, outsourcing is evolving into a strategic tool for change -- a development Accenture dubs "transformational outsourcing" -- and this change is having an impact on the types of services involved, suggests Dr. James Brian Quinn, a professor at Dartmouth College's Amos Tuck School and author of Innovation Explosion: Using Intellect and Software to Revolutionize Growth Strategies (Free Press, 1997). He posits that the big shift in this area has been to intellectually based service activities, such as research, product development, logistics, human relations, accounting, legal work, and marketing and market research.

Quinn, who has been studying innovation for 50 years and wrote some of the first articles on core competencies and strategic outsourcing, asserts that if an enterprise does not excel in an area yet continues to do it in-house, it gives up an important competitive edge. "Outsourcing to the best in the world ups the value and lowers the cost," he says.

A collaborative approach

Allie Young, a chief analyst at Stamford, Conn.-based Gartner, Inc., explains that the outsourcing market has been shifting gradually from a cost focus to a business focus, and that a new emphasis on access and speed to market has emerged. "The focus now is on business outcomes, not just infrastructure," she says. "This is about taking advantage of relationship types and models, and a variety of contracting modes and structures. It is very complex."

Another factor contributing to that complexity is the truly collaborative nature of these agreements. "Since the late '90s, we've seen a trend toward a more collaborative approach to outsourcing," says Cole. To be effective, a transformational outsourcing deal requires that each partner have a considerable stake in the game, and often that means sharing both risk and reward. To make that work, the deal must fund the necessary investment at the best possible cost of capital and simultaneously motivate the outsourcing partners' commitment by aligning goals.

While the financial structure of conventional outsourcing arrangements typically includes bonuses and penalties based on the achievement of minimum service levels by the supplier of the outsourced service, business transformation outsourcing deals focus instead on upside targets. They align incentives around enterprise-level outcomes such as market share and return on equity.

As might be expected, outsourcing at this level raises a number of challenges, particularly in the areas of management and measuring results.

With intellectually based service activities, the job of coordination becomes more "interesting," Quinn understates. Companies are dealing with best-in-world suppliers of intellect as opposed to very good suppliers of a physical product or conventional service. In the latter case, organizations generally have in-house personnel who are familiar with the product or service, which facilitates performance tracking and makes it easier to outsource.

It is more difficult to outsource legal, financial, design and similar activities, Quinn says. As a result, there is a shift taking place in the management of outsourcing, and a higher quality and level of management is required for a successful outsourcing strategy. Managing intellect is a combination of human and technological management processes, and requires greater investment in training and in generating, capturing and leveraging knowledge.

A critical management difference is that you can't give orders when managing intellect, since you want the person to be free to generate new ideas. "People, education and software are the critical resources, and the old measures of performance become irrelevant," Quinn says. "Return on investment doesn't mean much when you can't keep track of the 'I' that you put into people, i.e., education and software."

On the upside, it is possible to leverage intellectual ability almost indefinitely, which is not the case with physical assets. "The physical can only produce so much plastic or product or cars," Quinn points out. "Once you have an intellectual idea, it can be leveraged by everyone in the world who uses it, who improves on it, who makes it better. The consequence is you benefit from their input."

Old paradigms no longer apply

Conventional business wisdom holds that good managers match accountability with control -- an approach that works just fine with traditional outsourcing. As executives target higher-value opportunities through outsourcing, however, they face new challenges related to metrics and incentives. For outsourced functions that span multiple departments, units and locations, simply establishing a baseline can be a daunting task. Higher-level deals often link the outsourced operation to other business processes in rich and sometimes entangling ways. The need for flexibility also interferes with simple metrics.

Managing this type of outsourcing requires an understanding of both industry dynamics and the human dynamics of intellectual endeavor, says Howard Lackow, senior vice president and director of outsourcing services at the Jericho, N.Y.-based Outsourcing Institute, and Quinn agrees. That creates some complexity, but the impact -- and potential payoff -- is huge, which is why a growing number of organizations are adding chief resource officer-type capability.

The CRO, who can be the chief executive or some other C-level executive, must have the resources, capability and authority needed to ensure the outsourcing partner is consistently working on the organization's behalf. At the same time, the CRO must be able to learn from the partner -- and from other industry sources -- at a prodigious rate to keep the company at the frontier of its field. The kind of networking of resources that theoretical scientists rely on to stay abreast of developments in their industry is becoming essential to outsourcing.

Why bother?

What the rapid evolution of outsourcing beyond the simple reengineering of support processes means for chief executives is, in a word, opportunity. Outsourcing can be used as an effective tool to transform a business or organization, and that is happening in the real world, right now. "As we move toward a transformational agenda, there are growing opportunities to focus more on gains-sharing and results rather than just cost," Cole says. "There is a raised level of complexity involved, but that is consistent with much higher rewards."

According to Jane C. Linder, senior research fellow and a research director of the Accenture Institute for Strategic Change, nearly one-third of the companies the Institute has studied are partnering with outsourcers not just to reengineer support processes but to dramatically improve business capabilities that are critical to their success. While the structure and mechanisms of those relationships vary from case to case, they all share one unique characteristic: they are being used to transform entire enterprises.

Gartner, too, has noted an important shift in outsourcing's strategic positioning at many forward-looking companies and organizations. "We are seeing indications of involvement at a much higher level, with outside partners taking over entire business processes -- not core competencies, but important competencies," Young says. "These deals are being done at a level that can truly influence outcomes. The real change going on is that the influencers and decision-makers in outsourcing now are the business unit and executive level leaders, not those at the operational levels."

A case in point is the recently signed $2.6 billion, five-year deal between Accenture and AT&T Consumer to transform the latter's long-distance sales and customer care operation. Described as a "co-sourcing" agreement, it leverages the strengths of both partners, with each contributing to the management, staffing, technology and culture of the operation.

Under the terms of the agreement, AT&T Consumer retains responsibility for establishing strategic business direction, defining marketing strategies and designing product offerings. Accenture brings to the table new technology development and ongoing management direction for the transformation of AT&T Consumer's long-distance sales and customer care operations. (See "Co-sourcing Calling," page 15.)

When it was announced, AT&T Consumer President and CEO Betsy Bernard said that the deal would address a "plethora" of technology issues. "This agreement will enable us to continue to deliver the world-class customer care consumers rightly expect from AT&T, while at the same time transforming our business to dramatically increase our operational efficiency and significantly reduce costs," she said.

Describing Accenture's role in the alliance, Accenture Chairman and CEO Joe W. Forehand said the two companies would be "transforming an award-winning sales and customer-care team by merging the experience and skills of both organizations. This, combined with state-of-the-art technology, will enable AT&T Consumer to serve its customers more quickly and efficiently than ever before."

Commenting on the deal's significance, noted telecommunications analyst Jeffrey Kagan said that it signals a new focus on the customer experience not only for AT&T but for the entire industry. As customers increasingly make buying decisions based on perceived differences in customer care, "wowing" the customer will become a key differentiator among competitors.

By targeting the customer experience -- which Kagan predicts will supersede price and differences in the services as the most important factor in a customer's choice of a telecommunications supplier in the future -- the alliance between AT&T Consumer and Accenture epitomizes what business transformation outsourcing is all about.

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It is a law of physics that a body at rest tends to stay there, and the same principle of inertia influences business decisions--or the lack of them. Given the option, most chief executives would forego the disruption of seismic change in their organizations in favor of sustained, even aggressive, incremental change. In today's volatile business environment, however, CEOs are faced with the need to change their operating models more frequently than ever before, often without having all the needed skills and capabilities in-house. For leaders in that situation, transformational outsourcing may be the answer.

It's new and unconventional, but it certainly is not untried, says Martin Cole, managing partner for Outsourcing and Infrastructure Delivery at Accenture. "Some of the best companies in the world, such as AT&T, BP and DuPont, have adopted transformational outsourcing as an important addition to their competitive arsenals," he notes. Still, not every organization may be ready for such a drastic approach. Accenture suggests that the best candidates for transformational outsourcing are companies that:

* Need a radical change to be competitive in their industries

* Are faced with speed as a critical factor in implementing that change

* Are led by a chief executive who is willing to sponsor the initiative personally

* Are willing to accept a difficult transition

* Are willing to work with a partner to accomplish it, even if it means ceding some control to the partner

* Are willing to share in the benefits with their partner.

Organizations that are not quite ready for the radical nature of full-blown transformational outsourcing can still benefit from the trend in that direction, Cole says. Among the steps he suggests CEOs take:

(1) Challenge your staff to identify breakthrough opportunities for the organization that are currently blocked by poor processes. "Rank them in order of importance, then ask your staff to consider how outsourcing might deliver the results you're looking for," Cole says.

(2) Make a "wish list" of all the services and resources you would like to be getting from your current outsourcer. Use it to challenge your partner to come up with solutions and services that could make a truly radical difference in your organization's performance.

(3) Take a trial run at transformational outsourcing by converting a conventional outsourcing agreement into a collaborative business partnership in which both parties share accountability for the results. A good time to try this strategy is when an existing outsourcing agreement comes up for renewal.

Partnering for Future Success

Among the most powerful drivers behind the evolution of outsourcing to a business transformation model are the rapid pace of change in today's technology-driven economy and ratcheting levels of competition that virtually dictate alliances as a strategy for success, and even survival. Those forces play a major role in the financial services industry, where the Internet and advances in telecommunications technology have revolutionized the marketplace. They are something Jill Considine, chairman and CEO of the Depository Trust & Clearing Corporation [DTCC], must deal with on a daily basis.

The collaborative approach called for in the transformational model is not one that comes naturally to the financial services industry. "Our mission," says Considine, "is to become the provider of choice worldwide for investment servicing solutions."

Yet she acknowledges that going it alone is no longer an option in today's marketplace. "We must partner effectively with our counterparts around the world to provide the infrastructure services that intermediaries need globally. While we recognize that we live in a competitive world, enduring, reciprocal, effective partnerships will be the cornerstone of our future success," she says.

DTCC itself is a reflection of that business philosophy. It was formed in September 1999 as a holding company overseeing two principal subsidiaries: the Depository Trust Company and the National Securities Clearing Corporation. Those firms provide the primary infrastructure for the clearance, settlement and custody of the vast majority of equity, corporate debt and municipal bond transactions in the United States.

With the increasing globalization of the financial services industry, DTCC has been incorporating partnering strategies into its operating processes for some time. It forged its first link with a foreign central securities depository 18 years ago. Through its partnering experiences both globally and domestically, the company has learned to integrate systems, cultures and approaches. That is a competency that outsourcing expert James Brian Quinn says will become increasingly important in the 21 st-century marketplace.

One example of DTCC's reliance on collaborative strategies is Omgeo, which it developed with Thomson Financial's ESG unit. Omgeo brings together investment managers, broker/dealers and custodian banks in 40 countries, allowing clients to process trades on a single a-commerce-enabled platform.

Addressing the growing needs of customers and bringing innovative technology solutions to market quickly requires a highly disciplined approach. To achieve this objective, DTCC is partnering with Accenture to bring added process management support to the highly talented technology team at DTCC. The goal is to sustain DTCC's reputation for reliability while speeding development time frames and doing so at a lower cost to customers.

There is no doubt that competition will continue to be a dominant force in financial services, but Considine is emphatic about the changes taking place. "We have many years of experience as the preeminent provider of centralized processing for the securities industry, but we don't presume to have all the answers," she says. "That is why we are strong advocates of partnerships. We don't have a monopoly on good ideas. What we do have is an instinct for good ideas wherever they can be found, and we will continue to seek out the concepts considered best in class."

Michael J. McDermott is a freelance writer based in Carmel, N.Y. With more than 20 years of journalism experience, he specializes in business, technology and finance topics.