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A Potential Resurgence of Outsourcing [CPA Journal, The](CPA Journal, The Via Acquire Media NewsEdge) Essential Questions Answered For some, the word "outsourcing" conjures thoughts of domestic jobs transferred overseas. For others, it calls to mind images of potential bottom-line improvement. And for at least one company - Renesas Electronics Corp., which produces 40% of the microprocessors used by automakers around the world - it is a way to hedge against supply-chain interruptions; the company recently reported plans to outsource 25% of its production by 2013 (up from 8% currently) in response to the earthquake and tsunami that hit Japan in March 2011 (Chester Dawson, "Even Japan Inc. Looks Offshore," Wall Street Journal, April 11, 2011). Regardless of one's personal view on outsourcing, it is a business practice that is here to stay - and it is likely to increase in the future. Businesses and their advisors should keep the following considerations in mind when looking to outsource operations. Overview of Outsourcing Although outsourcing started in earnest in the late 1970s as a business strategy that allowed companies to focus on their core competencies while moving noncore competencies to providers with relevant expertise, businesses relied on outsourcing much earlier than that. ADP, for example, began offering payroll services to companies in the 1950s; today, the company is among the world's largest providers of outsourced business processes. In its most basic method of implementation, outsourcing is the use of an external service provider to perform functions that a company prefers not to perform internally. For example, a company located in Waco, Texas, might choose to contract with a company in Seattle, Washington, for Internet sales, fulfillment, and shipment services; a call center in Toronto, Canada, for telephone customer support; and a computer services company in Bangalore, India, for application development and programming services. As shown in Exhibit 1, each of these three arrangements illustrates a different, specific category of outsourcing, based on the geographical distance between the service buyer and the service provider. In an onshoring arrangement, a company outsources work to a service provider in its home country, as illustrated by the Waco company's use of a service provider in Seattle. Offshoring, on the other hand, is the general term used for outsourcing across national borders. These types of arrangements are often referred to differently, depending upon the distance between the domestic service buyer and the international service provider. For example, if the international service provider is geographically close to the service provider, the arrangement is referred to as "nearshoring"; when the international service provider is geographically distant from the service buyer, the arrangement is referred to as "farshoring." There is no single outsourcing solution that is ideal for all companies; rather, each company must consider which combination of onshoring, nearshoring, and farshoring will allow it to best accomplish the strategic and operational goals set by management - a practice that is sometimes called "rightshoring." This article, however, will use the generic term - outsourcing - rather than distinguish between the various specific methods. While not technically outsourcing arrangements, shared service centers and captive centers represent alternatives that companies might consider. A shared service center is an internal business unit that provides services across a company, such as information technology (GG) support or procurement services; this allows the company to reduce redundancies by consolidating functions into a single location. Bain & Company's "Management Tools & Trends" 2011 survey found that the use of shared service centers is declining, and some early adopters of this business model have turned to outsourcing. A captive center is basically a shared service center that is located in a foreign country, often one with lower wages, in order to realize cost savings without having to deal with a middleman outsourcing provider. First seen in the 1980s, the use of captive centers has grown more than 300% since 2003 (Jan Erik Aase, 'TomNew Offshore Captive Center Models," July 27, 2011, http://www.cio.com/article/ 686791/4_New_Offshore_Captive_Center_ Models). But some companies have begun to sell off these centers to reduce fixed costs and free up invested capital, as Citibank did when it sold captive centers to Tata Consultancy Services and Wipro in 2008 and 2009, respectively. Who Is Outsourcing There are two sides to an outsourcing partnership - the service buyer and the service provider. A company of any size can act as an outsourced service buyer, and companies in any industry can outsource their operations. As an example of the variety of industries that participate in outsourcing arrangements, Verizon, Procter & Gamble, Catholic Health Partners, Barclays, and Thames Water have all signed new outsourcing agreements in the past several months. There are myriad outsource service providers, and the International Association of Outsourcing Professionals (IAOP) compiles an annual list of the best outsource service providers - The Global Outsourcing 100. The JAOP's 2012 full list can be found online (http://www.iaop.org/content/ 19/165/3437). Why Are Companies Outsourcing The main reason that companies turn to outsourcing is to reduce operating costs. In a survey by AMR Research, 78% of middle-market companies and 79% of enterprise companies stated that this was the primary reason for outsourcing (Josh Hyatt, "The New Calculus of Offshoring," CFO.com, October 1, 2009). Secondary drivers for outsourcing differ, however, depending upon the size of a company. Enterprise companies are more likely to use outsourcing in order to make global operations more effective and to transform or reengineer existing processes. Middlemarket companies, on the other hand, are more likely to see outsourcing as an opportunity to gain access to new skill sets or technology that the company doesn't have in house. When it comes to outsourcing finance and accounting operations, cost savings were the primary driver of future finance and accounting outsourcing deals for 92% of companies that took part in a recent survey, Global Finance and Accounting Outsourcing Service Provider Performance and Satisfaction Survey 2010, conducted by outsource advisor EquaTerra (which was acquired by KPMG in February 2011). The next three most important drivers were quality improvement (49%), financial flexibility (24%), and access to skills (19%), according to the survey. What Are Companies Outsourcing The answer to this question might be "What are companies not outsourcing " All functional areas are candidates for outsourcing, as long as the decision to outsource makes strategic and operational sense. The most commonly outsourced functions are GG, human resources, finance and accounting, procurement, and faculties management, according to an EquaTerra report, 4Q10 Advisor and Service Provider Pulse Survey Results. One major area that is frequently outsourced is GG. A company might choose to outsource all of its GG operations or it might choose to outsource one or more discrete areas. These outsourcing arrangements can be large, as evidenced by the recent five-year, $200 million contract for ACS to provide managed GG services for MGM Resorts Ind. Exhibit 2 gives a snapshot of the extent and forms of GG outsourcing, as recently reported by a Computer Economics survey of 210 G organizations in the United States and Canada. Software as a service (SaaS), a relatively recent phenomenon, has been embraced by 58% of the surveyed organizations. As the use of cloud computing increases, it is likely that even more companies will utilize this type of outsourcing. The Computer Economics survey also found that outsourcing differs between smaller and larger organizations. For instance, 66% of large companies (as measured by GG budgets) reported outsourcing application development functions, compared to only 45% of small and mid-sized firms. While the survey examined the extent of outsourcing a number of individual GG functions, the discussion below focuses solely on application development in order to illustrate the extent of the differences that exist between companies of various sizes. Furthermore, the future of outsourcing application development functions differs according to organization size, with 43% of large firms expecting to increase the level of outsourcing, compared to only 19% of small and mid-sized firms. A small percentage of these entities expects outsourcing of application development to decrease in the future (12% for small to mid-sized firms; 5% for large firms). This expectation for decreased outsourcing likely resulted from dissatisfaction with the quality of current outsourcing arrangements and the realization that, in some cases, outsourcing functions is more costly than providing the service internally. Finance and accounting functions are ripe for outsourcing. EquaTerra followed the development of finance and accounting outsourcing (often referred to as FAO) and examined 110 FAO contracts, with a total value of over $1 billion, in its survey, Global Finance & Accounting Outsourcing Service Provider Performance and Satisfaction (SPPS): 2010. The survey found a high degree of consensus on the finance and accounting functions that organizations are outsourcing. As Exhibit 3 shows, the "procure to pay" cycle is the most frequently outsourced finance and accounting function. Doing so allows organizations to not only reduce their operating costs, but also realize cost savings from the reduced purchase prices that result from the volume discounts that the outsource provider is able to negotiate. Where Are Companies Outsourcing To The entire world is available to a business looking for a location to outsource its operations. Since 2003, A. T. Kearney has conducted an annual study of the most attractive outsourcing destinations and has ranked the top 50 of these using a weighted score that includes financial attractiveness (40%), people skills and availability (30%), and business environment (30%). The top three most attractive locations for outsourcing - India, China, and Malaysia - have not changed since 2007. Rounding out the rest of the 2011 top ten are Egypt, Indonesia, Mexico, Thailand, Vietnam, the Philippines, and Chile (http://www.atkearney.com/index. php/Pubhcations/offshoring-opportunitiesamid-economic-turbulence-the-atkearney-global-services-location-indexgsli-2011.html). While there appears to be relative consistency in the top 10 locations overall, this is not the case when examining the three individual components of the overall ranking. As Exhibit 4 shows, several countries that are not in the top 10 overall global outsourcing locations still fare well when looking at individual characteristics. For example, Singapore has the best business environment for outsourcing and the United States (in "second-tier" mid-sized cities such as Madison, Wisconsin; Raleigh/Durham, North Carolina; and New Orleans, Louisiana) has the greatest advantage for people skills and availabihty, but neither country places in the top 10 overall ranking. These differences mean that decision makers will likely need to make some trade-offs when selecting an outsourcing location. Not all countries are created equal when looking at the type of activity that is best outsourced there, as shown in Exhibit 5. For example, the 201 1 Kearney report found that India has a high level of outsourced activity in business process outsourcing, voice operations, and G outsourcing. China, on the other hand, has very low levels of outsourced voice operations. And while Thailand is viewed as the seventh most attractive location for outsourcing, it has actually seen little outsourcing activity to date. When considering FAO, India is a clear choice, followed by Central and Eastern Europe, as shown in Exhibit 6. These differences illustrate that outsourcers must consider the type of processes being outsourced, and the ability of a particular location to handle those processes at an acceptable level of service, when choosing an outsource location. Just as different industries outsource different business processes, they also choose to outsource those processes to different locations. Based on results reported in BDO 2011 Technology Outlook: Executive Summary, it appears that this choice of location changes over time. Exhibit 7 shows the preferred outsourcing locations from 2008 to 2011 for technology companies. The percentage of technology companies surveyed that outsource operations in India has steadily declined during this period, while those using Western Europe has increased. Looking to the Future Predicting the future is always a tricky business, and outsourcing is no different. In a 2004 study of offshoring, Forrester Research predicted mat 3.4 million service jobs in the United States would be offshored by 2015- up from 315,000 in 2003 (John C. McCarthy, Near-Term Growth of Offshoring Accelerating, May 14, 2004). Other studies have conjectured that as much as 25% of jobs in the United States are potential candidates for offshoring (Linda Levine, Offshoring (or Offshore Outsourcing) and Job Loss Among U.S. Workers, Congressional Research Service, January 21, 2011). But outsourcing advisors and service providers appear to disagree on where outsourcing is heading, as reported in EquaTerra's 4Q10 Advisor and Service Provider Pulse Survey Results. Exhibit 8 shows that providers and advisors differ most on the future of social media and social networks used for business purposes, as well as on the poor economic conditions driving companies to look for additional outsourcing opportunities. As companies look to establish new outsourcing contracts or renegotiate existing ones, the contract details will likely look different from those of the past Companies are realizing that outsourcing is more than just securing initial operating cost savings. The unexpected costs that arise during a long-term contract can negate those initial cost savings. Unstable political environments in some countries that are home to outsourced operations increase the potential for a deal to go bad. New contracts will be shorter and will include the ability to renegotiate the contract as circumstances change during the life of the contract. These contracts will also focus more on pay-for-performance metrics to ensure that promised efficiencies and cost savings are actually realized (Josh Hyatt, "The New Calculus of Offshoring," CFO.com, October 1, 2009). If past events are any indication, outsourcing might be headed for a resurgence. The recessions of bom the early 1980s and 2001 saw companies turning to outsourcing as a means of reducing operating costs and focusing on core business competencies. The latter recession saw more companies outsourcing white-collar jobs, as the supply of highly educated, low-cost professional workers grew in low-wage countries like India. With the recent economic woes around the world, increased levels of outsourcing may be on the horizon. Because unemployment has risen in the United States during the recent economic crisis, some believe that companies are now bringing previously offshored jobs back to the domestic front As second- and thirdtier cities in the United States become more attractive locations for outsourcing, previously offshored work might return to the United States. For example, Starbucks recently announced plans to move some manufacturing of coffee mugs from China back to a dormant plant in Ohio. But even though this movement might be occurring to some extent for manufacturing jobs, businesses are still interested in the use of nearshore and farshore outsourcing, as well as captive service centers, for business services, such as GG, finance and accounting, and human resources, according to a KPMG report, Sourcing Advisory 4QU Global Pulse Survey. Over 50% of outsourcing providers and advisors surveyed believed that there would be either some or a significant increase in the demand for nearshore and farshore outsourcing in the future. While specific predictions about the future of outsourcing are impossible to make with exact accuracy, one thing seems certain - outsourcing is here to stay. With the recent economic woes around the woild, increased levels of outsourcing may be on the horizon. Charles E. Davis, PhD, CPA, is the Walter Plumhoff Professor of Accounting in the Hankamer School of Business at Baylor University, Waco, Tex. Elizabeth Davis, PhD, CPA, is an executive vice president and provost, also at Baylor University. (c) 2012 New York State Society of Certified Public Accountants |