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Guidelines For IT Management: Planning for Offshore Outsourcing

The appropriate framework to consider when evaluating outsourcing models is one that balances an organization's appetite for risk versus reward. Harry Markowitz's 1952 Nobel Prize-winning Modern Portfolio Theory can serve as a model to determine the optimal risk/reward trade-off in a sourcing model.

Markowitz's model assumes that investors will only take on increased risk if they will be compensated by higher-than-expected returns. The exact trade-off will differ for each investor based on individual risk aversion. When every asset is plotted in the risk-return space, the hyperbola that forms along the upper edge of this region is known as the efficient frontier and represents the optimal combination of risk and return. Any combination along this efficient frontier represents a position with the lowest risk for the given return.

Evaluating operating models: why companies create captives

When considering sourcing models, companies typically decide between three models:

• Onshore shared services (100 percent subsidiary to the parent)
• Offshore captives (100 percent subsidiary to the parent but located in a different geography to gain labor arbitrage)
• Outsourcing through a third-party supplier

Captives prevailed as the favorite model for technology and financial institutions until 2007; but the tide turned in 2008, as companies seeking to monetize assets started selling their captives. Divestiture examples include Citigroup, GE Money, Fidelity Investments, Aviva, RSM McGladrey, and Lehman Brothers in the financial sector, as well as Motorola in the technology sector.¹ Certainly much of that activity was precipitated by the credit crunch driving demand for capital, but some of it reflected a shift in preferences.

In the ever-pressing quest to cut costs and improve processes, companies look to obtain workflow automation, operational metrics, and system consolidation with minimal investment by outsourcing those functions known as "back office."

For back-office functions, supplier maturity and scale achieved in technology, infrastructure, human capital, and expertise have driven most observers to conclude that third-party outsourcing is the most effective and lowest-cost option. For these commodity back-office functions, outsourcing pushed out the efficiency frontier, and establishment of new captives fell off.

Captives: to sell or not to sell?

Establishing a new offshore captive requires a good deal of investment to select a site, obtain facilities, obtain required government permits, recruit and onboard staff, develop procedures and workflows, migrate work, analyze and optimize processes, etc. There is also great risk that one of these critical implementation activities will experience the cost overruns associated with delays and/or rework.

Interestingly, although we are now observing more back-office captive divestitures than new openings, we are still seeing the expansion of existing offshore captives, such as JP Morgan's recently announced captive expansion.²

This expansion activity may appear to pose a contradiction to the flurry of divestitures but, in fact, it is consistent with the efficient frontier for investment in back-office captives. That is, although the establishment of new offshore captives for commodity back-office work is no longer optimally positioned on the efficient frontier, offshore captives do work and deliver significant reward. Existing captives that have been well designed and well equipped with past investments in systems, staff, documentation, and process optimization deliver great value; companies can expand them with minimal investment.

So why are companies selling existing captives if they add value and if their expansion adds value with relatively little investment? Many factors drive the sale of existing back-office captives including:

1. The expansion of a captive with minimal investment assumes that the company has already made successful investments in people, process, and systems. When this assumption does not hold, an expansion requires substantial new investment.
2. No expansion opportunities exist. That is, when a firm has leveraged the full scale of the enterprise and the firm itself is not growing rapidly, the big remaining opportunity for further cost reduction is the sale of the captive and a buy-back of the services.
3. Given the current economic climate, some firms are selling well-designed, well-managed captives simply to stop the ongoing maintenance investments and obtain a one-time influx of cash from selling a desirable captive to the right buyer.
4. Some firms are selling simply to scale back operations to focus on those that are core to the business to avoid an unnecessary drain on management time and attention.

Exhibit 1: The efficient frontier for offshore captives

As Exhibit 1 illustrates, establishment of new back-office shared service centers, which do not deliver the same value as offshore outsourcing, but also do not pose the same risks, remain on the efficiency frontier albeit to the lower left.

Creating an offshore captive requires significantly more up-front investment and management talent than onshore shared services. Additionally, it involves taking on financial, operational, legal, and organizational risks that many companies prefer an outside party assume. Captives have fallen off the efficiency frontier for commodity back-office functions.

The captives frontier - research and development

Research and development (R&D), knowledge processes, certain engineering and other proprietary functions are less frequently targeted for outsourcing, because companies are often wary of engaging an external supplier to develop or manage proprietary technology and intellectual property (IP). On the other hand, a parent can achieve scale and efficiency of customized R&D processes with better IP protection by creating a shared service center that is a 100 percent subsidiary.

However, an onshore shared service center cannot achieve the savings of offshore arbitrage. Enter the captive. In the area of R&D and a few other proprietary closely-held functions, captives reassert themselves on the efficiency frontier at the optimal junction between risk and reward. Captives allow for developing best practices and protecting IP across the enterprise, while achieving cost savings through labor arbitrage.

Additionally, unlike shared services and outsourcing, captives deliver strategic impact. For a company interested in increasing its geographic footprint and attracting international talent, the offshore captive is the perfect vehicle. Hence, we see far fewer divestitures of R&D and engineering captives.

In fact, 2008's fourth quarter witnessed significant development activity in captives performing either R&D, engineering, or knowledge processing functions, including³:

• Glaxo Smith Kline -- Bangalore
• ArcelorMittal -- Kolkata
• Rhodia -- Shanghai
• Nestle -- Beijing
• Vestas -- Singapore
• Halliburton -- Singapore
• Qualcomm -- Singapore
• Siemens -- Singapore
• Autodesk -- Singapore
• Hay Group -- Singapore

Advantages and disadvantages of captives

Advantages:

• Intellectual Property. Securing data is less complicated.
• Cost. Captives are only moderately more costly to operate than third-party outsourcing.
• Control. Decision-making authority is contained within the organization.
• Strategic Benefits. They secure a presence in new markets and provide access to a new talent pool.

Disadvantages:

• Staffing. Specialist skills in host countries are much more expensive than average wages in these countries, are harder to find, and require more time to ramp up to full productivity.
• Regulation. The parent company must now be aware of and manage to a larger and more complex set of compliance, legal, and regulatory issues.
• Management Focus. Management time and attention now requires considerable effort.
• Capital. Captives consume capital.

Successful examples: Cisco and Textron

India has been the most attractive destination for global R&D investments due to the pool of qualified scientists and engineers, availability of English language skills, low cost, and established education infrastructure. Moreover, India has a regulated patent regime. Over 150 corporations have captive R&D centers in India, besides a host of government and privately-funded R&D organizations.

Cisco famously broke ground on a one million square-foot R&D campus in Bangalore in 2005 that employs over 1400 people.⁴ The recently acquired IronPort set up an R&D captive within the Cisco campus with 150 engineers.⁵

Kautex, a Textron acquisition that creates polyethylene automotive fuel tanks, established a Global Technology Center (GTC) in Bangalore in 2007 with the goal of supporting continuously increasing productivity with design activities in a low-cost, highly-educated market. The GTC serves as a platform for each business unit, supporting design analysis for two systems, as well as product life cycle management and an international material data system.⁶

Conclusion

People apply modern portfolio theory to social sciences and psychology for the lessons it teaches in asset diversification and risk/return optimization. While establishing new captives may no longer be the favored solution for commodity back-office functions, expansion and investment in existing captives, as well as the creation of new captives for research and development deliver maximum return for the risk, according to the Markowitz theory. Especially in these economic times, a sound operating model can prevent lost margins, and financially savvy corporations must look beyond popular trends to contemplate the value they can capture from the optimal balance of risk and return.

Lessons from the Outsourcing Journal:

• Harry Markowitz' 1952 Modern Portfolio Theory can explain the current dynamics of offshore captives and outsourcing from a risk/return perspective:
  1. The establishment of new offshore captives for commodity back-office work is no longer optimally positioned on the efficient frontier.
  2. However, investment in the expansion of existing captives still delivers a return.
  3. Establishing offshore captives for proprietary research and development functions delivers a return by offering best practices while protecting intellectual property and cost savings through arbitrage, as well as creating strategic impact through an enhanced geographic footprint and the ability to attract international talent.

¹ Everest Research Institute GS Market Vista Q4 2008 -- February 2009 (internal) I-13; GS Market Vista Q3 2008, I-12; GS Market Vista Q2 2008, I-14

² Everest Research Institute GS Market Vista Q4 2008 -- February 2009 (internal) I-13; GS Market Vista Q3 2008, I-12; GS Market Vista Q2 2008, I-14

³ Everest Research Institute GS Market Vista Q4 2008 -- February 2009 (internal) I-13; GS Market Vista Q3 2008, I-12; GS Market Vista Q2 2008, I-14

⁴ "Cisco Systems Invests US $50 Million for New Campus in Bangalore," Press Release, October 21, 2005. http://newsroom.cisco.com/dlls/global/asiapac/news/2005/pr_10-21.html

⁵ Vishwanath Kulkarni. "IronPort plans captive R&D unit in Bangalore," April 17, 2007. The Hindu Business Line. http://www.thehindubusinessline.com/2007/04/17/stories/2007041704170400.htm

⁶ "Dirk Eulitz Helps Select Bangalore, the 'Silicon Valley of India,' for Textron's Global Technology Center," January 19, 2007. http://www.textron.com/newsroom/featured_stories/01_19_2007.jsp

Publish Date: May 2009

Copyright © 2009 - Everest Partners, L.P.

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