Canada: Outsourcing And Offshoring: Myths, Realities, The Hurdles And How To Do It Right (Part One)

OUTSOURCING: BUSINESS RATIONALE DRIVES LEGAL SOLUTIONS

While outsourcing has been an important legal sub-speciality since the early 1990s, over the past number of years the volume and complexity of this work has veritably taken off. The reason is simple: the volume of outsourcing activity doubled in the last decade. One estimate puts the annual growth rate of outsourcing at 20-30%. In short, outsourcing is big business, estimated at well over $1 trillion. Moreover, one leading consultancy with an active practice advising companies on the strategic and operational aspects of outsourcing, figures that only 10% of what can be outsourced actually is currently, leaving a potentially huge remaining market in this area.

To be able to advise effectively on the legal aspects of outsourcing, it is necessary to understand what outsourcing is – and is not. A working definition is: outsourcing is a long-term, commercial relationship where a service provider (SP) is contracted to provide for a user organization, in a manner determined primarily by the SP, the services (and possibly related infrastructure assets) surrounding a material business process that was previously performed internally by the user.

Various elements of this definition are worthy of further discussion. An outsourcing relationship is a "long term" one. Having a courier company deliver a package for your organization is not outsourcing; having them take over your entire logistics operations for five years is. Having a computer company fix a broken computer is not outsourcing; giving them responsibility for supporting and upgrading twice over six years your entire personal computer network, including staffing a help desk, is outsourcing.

In other words, outsourcing can be contrasted with mere purchasing; that is, in outsourcing a user transfers a business function to an outsourcer, not merely an activity. Which leads to the second important aspect of the definition, namely that the outsourcer decides how to perform the function. This is important, and underpins the key behavioural dynamic in the outsourcing relationship, essentially that once a user has outsourced a process, it should not micro-manage the performance of the process (which is not to say it should not track results, which it definitely should, as explained below).

It is also worth noting that while the definition contemplates outsourcing from the perspective of a user retaining a vendor to perform services previously performed internally by the user, one also sees, and with perhaps greater frequency, "greenfield" outsourcing. In this scenario, a company looks outside for a skill set it does not have internally; that is, in contemplating the "build or buy" decision, the user opts for buy, and skips the build stage.

Outsourcing itself comes in various shapes and sizes. Lawyers need to understand this clearly if they are to advise appropriately on the important paperwork used to memoralize the ousourcing deal. Tactical outsourcing focuses on a rather narrow problem. For example, outsourcing your payroll system because there is a payroll service that can do it more cheaply is a tactical outsourcing decision.

A strategic outsourcing maneouvre would shift the entire human resources function to the outsourcer. Similarly, in addition to farming out the personal computer network, which is a tactical exercise, a strategic move would be to shift responsibility for the whole information technology function (including operations; application development; e-commerce infrastructure; and telecommunications).

Yet a further level of outsourcing – so-called "transformational" – can be attained when the express objective is to change (sometimes modestly but often times profoundly) the actual way the business process is performed. That is, the point is not merely achieving cost and performance efficiencies, but ideally competitive advantage as you leverage yourself, through the outsourcer, into a new product or geographic market.

As you move from tactical, to strategic, to transformational outsourcing, the level of intensity of the relationship with the SP increases. At one end of the spectrum is essentially a buyer-seller situation, characterized by rather modest interaction. At the other end of the continuum is the full-bodied strategic alliance, where the outsourcer not only brings efficiency and cost benefits, but helps – very directly – to improve market share, profitability and long term success.

It is important for the lawyers crafting the relevant paperwork to understand clearly which of tactical, strategic or transformational outsourcing is being considered – and ideally the respective parties are ad idem on this – as the documentation might vary significantly for each. It’s key to remember that business rationales should drive legal solutions.

Before discussing the content and mechanics of outsourcing deals, it is worth also addressing offshoring. The widespread adoption of networked computing technologies (essentially, computers hooked up to proprietary telecommunication networks, but lately also the Internet) has given rise to "offshoring" – the increasingly important business practice of sending certain types of service work to low wage countries. American and British companies were the pioneers in offshoring work to countries like India and the Philippines, but now Canadian companies are getting into the act as well.

Offshoring presents some very interesting opportunities, not only in cost savings, but also in performance improvement. Nevertheless, it also entails legal and business risks that need to be managed carefully. Thus, the following discussion on offshoring will look at the business drivers of offshoring, and subsequently various strategies for dealing with its more problematic aspects.

Offshoring in the services sector is made possible by two critical technological revolutions. First, all previously paper-based content can now be digitized; that is, medical patient records, bank cheques, insurance claims forms, pension records and the thousands of other information building blocks of the modern services-based economy can be migrated into an electronic form (or indeed they begin electronically and never become paper-based). Second, once digitized, the resulting data, databases and electronic forms can be transmitted electronically around the world at extremely low cost, thanks to the precipitous drop in telecom charges over the past few years. This same huge drop in telecom costs also makes voice calls between, say, North America and Asia, extremely inexpensive.

The result is that clerical and back-office tasks within an organization, as well as a host of other white collar workflows, can be reorganized globally to take advantage of lower wage rates in countries like India. For example, companies like General Electric, American Express, Dell, Citibank and Nokia each have thousands of employees in Indian cities such as Bangalore and Hyderabad. Recently, Reuters hired 40 people in India to do news editing from raw data contained in company press releases. There are even services in Asia that will outsource legal document drafting for lawyers in North America and Europe!

Many companies in the US and the UK take advantage of the offshoring opportunity not by creating so-called "captive" affiliates in low wage countries, but rather by also outsourcing the particular function or job to a third party located in India (or another low wage country, like the Philippines). As a result, some Indian vendors of IT (information technology) and business process outsourcing services have experienced huge growth recently.

Wipro (see Wipro.com) had revenues of US$1.87 billion in 2004, a 39% increase over the previous year (its earnings were also up 37%). It hired 13,355 new staff in 2004, bringing its people complement to 41,857. For the quarter ended March 31, 2005, Infosys (see Infosys.com), also based in India, saw its revenue grow 50% over the same quarter a year earlier. It added 2,500 employees during this quarter alone.

The growth of the Indian IT services sector over the last decade is nothing short of spectacular. The whole country barely had four or five mainframe computers a dozen or so years ago; today, the Indian IT services industry has sales of over US$16 billion, 75% of which is derived from customers outside of India (this figure could grow to US$50 billion by 2008, and business process outsourcing could go from US$3.6 billion in 2003 to $24 billion by 2008). Bangalore, the leading city in India for high tech jobs, had a population of about 800,000 in 1951; today that figure has grown to 5.6 million.

Companies like Infosys, Wipro and Tata Consultancy (see tcs.com) are often viewed primarily as operators of call centres. And there is no doubt that offshoring call centre functions has been a major development over the past few years. But this isn’t just low tech, low touch outbound call centre activity generating the annoying telemarketing calls at your dinner time.

Consider one US financial institution’s experience with eTelecare (ET) (see etelecare.com), an operator of multiple call centres in the Philippines. ET started by supplying this particular customer support for stored-value cards. The client was pleased enough with ET’s performance that it gave ET responsibility for traveler’s cheques as well, which require a much higher skill level of the call centre operators, as they are dealing with highly stressed customers of the bank, and either have to wire funds to the bank customer, or contact the local police to commence an arrest for a fraudulent use of cheques.

The client went on to use ET to handle the call centre work for mutual fund products. This required ET’s staff to take the 16-week training course offered by the US National Association of Securities Dealers. ET’s agents in the Philippines had an average pass rate of 81%, relative to the 59% US average pass rate.

In these three call centre functions performed by ET, the client saved $2.9, $1.2 and $10.2 million a year. Similar cost savings can be achieved in sending back office work to India. The reason is not a secret. If a North America call centre worker costs $25,000 a year, one such person in Asia costs $2,500. You work the math; it’s a very compelling cost savings proposition.

The cost savings are still significant – but not as pronounced – with higher value added positions such as software engineers. A UK software programmer with five years experience might earn US$96,000, while his counterpart in the US or Canada might take home US$75,000 or US$55,000, respectively. In India, they might earn US$26,000. That’s a very material cost difference.

The rationale for offshoring, however, is not purely financial. In those earlier ET examples, ET reduced average handle times by about 35% relative to what the client experienced either internally or with another US-based outsourced call centre operator. How can this be? Presumably for the lower salary, ET can attract only a lesser quality of talent.

Not so, and indeed very often the offshore wage attracts a more highly educated recruit. And given that Indian and Philippine colleges and universities graduate 2 million and 300,000 college graduates annually, there are lots to choose from.

The real secret, however, to ET’s success, is in its ratios of frontline managers to customer service agents. In a North American call centre, this ratio is often 1:20. In ET, it is 1:8, which is a function of their lower cost model. The result is they can invest in more training, and the frontline manager can spend more time coaching and providing detailed reviews of agents’ work and performance. The front line manager can also spend time making continual process changes to improve overall performance in the call centre. In short, the lower wages allow middle managers to build a more efficient operation with lower staff turnover (high staff turnover being the bane of existence of call centres).

The work that can be digitized and telecommunicated off-shore to India, the Philippines, China, Taiwan and other low wage countries is by no means restricted to call centre activities. We have already noted the cost differential in software engineers. Have a look at the Web sites of Wipro, Infosys or Tata Consultancy to see what their software people are doing. It includes: custom application development and maintenance; system integration and consulting; software package implementation; and hard-core, high end IT R&D. Look at some of the specific projects (such as developing radio frequency identification solutions – the next big thing in retail and logistics after bar code technology) and the glowing customer testimonials (we know, they wouldn’t post unflattering statements, but look at the customers listed, and the nature of the projects). The word "sophisticated" comes to mind.

Equally, have a look at Silicon Valley start ups like July Systems Inc. or Open Silicon Inc. They each have head offices in California, but equally have R&D groups located in India. It doesn’t hurt that Silicon Valley has a large Indian expatriate community that moves easily between Palo Alto and Bangalore.

Incidentally, for the time being, Canada is also something of an offshoring destination for American firms, given our (until last year) favourable cost structure due to a weak currency, our English speaking staff, and our political stability. A UN report a few years ago noted that we won 11% of all call centre projects awarded in the 2002-2003 timeframe, ranking second only to India. But this likely will not last. And even this UN report cites that Canada only received 2% of the world’s 771 new projects in these two years involving back office functions like claims processing, accounting, logistics, HR, news reporting and R&D; India led the list of countries with 21%.

In the short term, however, Canada is still competitive for some of this work. EDS Canada (the local affiliate of the US outsourcing services giant) reported a couple of years ago that it brings more work to Canada from the US than it sends from Canada to India; it has, for example, a call centre in Nova Scotia that employs 1,700 workers.

Of course no great movement is without its critics. In particular, there is a vocal faction within the US Democratic Party that rails against offshoring. For example, during the 2004 presidential election, Democratic Senator John Kerry threatened to end tax benefits for companies that sent jobs to foreign countries. The television commentator Lou Dobbs aired a running series on the perceived evils of offshoring. He has since published a book titled: "Exporting America: Why Corporate Greed Is Shipping American Jobs Overseas".

Many of the people who oppose offshoring also don’t like free trade in manufactured goods. This is entirely understandable, as offshoring is, in a real sense, just trade in services. And interestingly, there are many parallels to trade in goods and trade in services as facilitated by offshoring.

Almost 100 years ago when Ford manufactured the Model T, the first mass produced car, Ford built virtually all of it and its components. Ford was a fully integrated manufacturing company. Very raw materials (like coal and iron ore) went in one end of the factory, and the steel was forged first and then made into the automobile. Ford even owned rubber tree plantations in Malaysia to source the liquid rubber that it made into tires at the Model T factory.

We would be pretty surprised today if Ford made its own tires (let alone owned rubber tree plantations), or produced its own steel. Rather, as the automobile became ever more complex, different firms sprang up to specialize in various component manufacturing. Steel companies built the steel, tire companies produced the tires. Ford still produces some parts today. But increasingly, car companies merely assemble parts produced by others. Networked computers connect the car assembly plants to a web of suppliers, so that parts arrive just as they are needed. The car company focuses on design, assembly, marketing and sales. Manufacturing of components is outsourced.

In other manufacturing businesses, even assembly is outsourced. Contract manufacturers such as Celestica, headquartered in Toronto but operating plants around the world, build computers and a range of electronic devices for household name suppliers in the computer and consumer electronic industries. Nortel, for example, doesn’t manufacture much anymore. It focuses on design, marketing and sales, and leaves assembly and logistics to specialized others.

The touchstone for this manufacturing model is the inexorable logic of specialization. Karl Marx said everyone should be a generalist: a doctor in the morning, and, say, a fisherman in the afternoon. Frankly, when we are ill, we want a full-time doctor. And we want a specialist, because there’s so much to know about even narrow areas of medical practice. Marx was unrealistic in this, as in so many other areas.

On matters of trade, the early 19th century economist, David Ricardo, is to be preferred to Marx. Ricardo’s theory of comparative advantage tells countries – and businesses – to focus on what they do best, and trade for the rest. Now, Ricardo was thinking about fixed factors of production like soil, climate and geography, and these still matter for a big part of the economy (it’s hard to mine nickel in a country that doesn’t have any under its soil).

Of course today the mobile factors of production are extremely important – bright people, capital and technology. And in these India might currently have an interesting advantage, given that it graduates 300,000 engineers a year. Moreover, through networked computers, Indian engineers can be brought to bear on work originating in North America, for a fraction of the cost of an American or Canadian engineer, as discussed above.

If the foregoing is true, is the future bleak indeed for North America, as unemployment skyrockets and countries like India, China and Taiwan become the economic winners in a networked world? Not so, for a number of reasons.

First, there are millions and millions of service jobs that don’t lend themselves to offshoring. The people who operate hotels, restaurants, hair salons, hospitals, schools, governments and a myriad of other organizations and institutions have to be local (some of the back office functions for all of these can be run offshore, but most jobs will still be local). And even some manufacturing work will not go offshore, especially in areas such as "advanced manufacturing", where labour costs might comprise only 7-15% of total cost of goods sold, or where logistics/transportation is a large cost factor (this is why Toyota still makes Corollas in California’s Silicon Valley, probably the most expensive place on the face of the earth to do business).

Second, even though some IT jobs, for example, will go offshore, not all of them will. Interestingly, the Indian companies mentioned above – Infosys, Wipro and Tata Consultancy – are all staffing up offices in North America, in order that the "high end" computer specialists, that have to liaise with clients in face-to-face meetings, can be physically proximate to their clients. Parts of various high tech activities need to be high touch.

Another reason offshoring will not lead to mass unemployment in North America is because the US, Canadian and UK companies that use offshore resources tend to reinvest in their home jurisdictions the money they save in the lower cost model. So, if a company can get a North American-based $100 job done in India for only $50, the resulting $50 savings is then put to work in North America, either hiring more senior staff or investing in infrastructure.

The McKinsey consulting firm has done some research in this area. True, offshoring may cause some immediate dislocation among the displaced workers, but in North America at least, they tend to find new jobs within about six months. And in many cases they get retrained for "jobs of the future", so that their marketability and relevance actually increases. This is one of the reasons why we don’t have huge unemployment rates in North America.

Another is that the North American economy is also very good at creating new jobs – work that simply didn’t exist a number of years before. Compare today to fifty years ago – let alone 100 years ago. In the US currently, there are, for instance, 139,000 psychologists, 104,000 floral designers and 51,000 manicurists. And 100 years ago we didn’t have airplanes, cars, air conditioned offices and houses, most of the medical treatments we have today, and the myriad of entertainment devices. Bottom line, the North American economy is pretty amazing at destroying – but also creating – jobs. There are a lot fewer gas station attendants than there were before technologies were developed to permit drivers to fill up their own cars. And you probably should not encourage your son or daughter to be a travel agent, as this occupation will be totally disintermediated by the Internet over the next few years (is there really anyone left who does not book their own travel over the Internet?). On the other hand, in the "new jobs" column there are the 150,000 people around the globe who make a living off the eBay online market (courtesy of the 147 million – yes, you read that correctly – registered users of eBay: if eBay were a country, it would be the 10th most populous in the world).

In some countries, a further reason not to worry about the economics of outsourcing is the so-called "demographic squeeze" brought on by a steadily aging population that does not have a fertility rate adequate to replenish itself. In short, in most advanced economies there will soon be many fewer people of working age to support a much larger percentage of retirees. One answer to this will be (and in countries like Canada already is) increased immigration.

Or, instead of bringing people to the work through immigration, the work can be sent to the people through offshoring. In 10-15 years, we predict this will be a huge driver for offshoring. As a result, many of today’s critics will change their tune, and hail outsourcing as an enlightened means by which the first world can help promote economic progress within developing nations.

Whether what is contemplated is on-shore, nearshore or offshore outsourcing, in order to craft and negotiate a sensible agreement for user and SP alike, their respective "needs and greeds" must be understood. From the user’s perspective, through outsourcing they are looking to achieve cost savings coupled with service improvement. In addition, there may well have been some key, new skill-sets that the user figured it could not attract in-house, and which warranted "buying them" from the outsourcer.

For the outsourcer, the mantra is "standardization". If the user does not require custom work, such that the SP can comfortably operate the user on a technology and service platform that is already built, then the economics for the SP begin to look very rosy. Outsourcing becomes a compelling economic proposition when the outsourcer can amortize its investment in technology and training over multiple customers.

Put another way, specialization is the driver that makes outsourcing work for both the user and the SP. By achieving economies of scale, skill and scope, the SP can transform and streamline various business processes and achieve real cost savings over the previous model where each organization was vertically integrated and performing the same processes in-house but a lot less efficiently. Thus, it is important that the user outsource not merely a discrete activity or two, but ideally the entire business process, so that the SP can achieve impressive efficiency gains. Of course, the user will usually negotiate diligently to ensure that a reasonable portion of this economic gain is shared with the user.

It is not a trivial exercise to determine what processes to outsource, and what to keep internally. Some consultants refer to a user’s "core competencies"; these should be done directly by the user’s employees, as these are critical and need to be under tight managerial and quality control. By the same token, if it’s not a core competence, it’s a good candidate for outsourcing. As IBM points out in a recent ad campaign, you do not run your own electricity generating plant, why would you run your own computing facility.

Of course things are never as simple as depicted in an ad campaign. There are indeed some computing services that look an awful lot like a utility; they are generic, fungible commodities that could be sourced from any provider, internal or external, so you might as well get them at the lowest possible cost. There are, however, certain computing functions that provide meaningful competitive advantage. You would not want your outsourcer to willy-nilly give access to these crown jewels to your arch rival in the market place. And therefore this area can be a contentious issue in an outsourcing agreement, subject to much negotiation from a legal and business perspective.

Equally, the preliminary determination of what to outsource itself needs to be made carefully. Users very often retain a consulting firm that is independent of any outsourcing vendor to assist in this decision. This is an important threshold stage in the entire outsourcing process. You can make mistakes at this stage from which it is very difficult to recover, however well you negotiate the ultimate outsourcing agreement.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.