Next generation OUTSOURCING AND OFFSHORING -

Transcription

1 Next generation OUTSOURCING AND OFFSHORING - capturing value in financial services by Chris Disher, Charles Teschner, Anil Kaul and Myles Wright, Booz Allen Hamilton Financial services companies around the world are outsourcing and offshoring both core and non-core activities to reduce annual running costs, avoid major capital investment, improve capabilities and service quality, and allow to focus on creating value. Outsourcing and offshoring of business processes has permanently changed the way financial services companies operate. Companies are evaluating nearly every activity for benefits they can attain through better of services and better deployment of a global footprint. While this focus on evaluation is widespread, most companies are actually less aggressive about actually implementing outsourcing than press reports suggest. Without a doubt, outsourcing and offshoring initiatives in financial services receive positive press. Over the last four years, positive mentions have outnumbered negative mentions on average by four to one (see Exhibit 1). Despite the prevailing perception of success, Booz Allen s experience indicates that many financial services companies are failing to capture value through their outsourcing and offshoring efforts. Companies are not always attaining the expected value from these deals despite media hype to the contrary. In fact, in stark contrast to this media hype, many financial services outsourcing initiatives destroy value because both complexity and costs increase while service quality declines or stagnates. Furthermore, value is often eroded because companies fail to engage in sufficient upfront planning and analysis and fail to accurately estimate the effort and attention needed to make the deal successful. The critical question is whether financial services companies can actually capture value through outsourcing and offshoring - or whether they must settle for simply basking in positive media spin. In contrast, non-service industries such as manufacturing have successfully and selectively used outsourcing and offshoring to fundamentally change the way they do business, and in the process, have created significant value. For example, automotive manufacturers have outsourced and offshored for decades. They started with non-core activities such as basic car parts, and are now outsourcing core activities such as the entire vehicle production. BMW, for instance, now outsources the complete manufacture of the new X3, a sports activity vehicle, to Magna Steyr International in Graz, Austria. More recently, financial services companies have also begun to outsource (and even offshore) core activities 1

2 Financial services outsourcing and offshoring receive positive press Exhibit 1 100% 80% Four-year average 81% Positive press articles as a % of all outsourcing articles 60% 40% Includes negative social aspects of outsourcing (e.g., job losses to India, job losses through outsourcing) 20% 0% Year 95% confidence level, p = 0.02 Source: Factiva, Booz Allen analysis Examples of financial services next generation outsourcing Exhibit 2 Non-core activities Next generation outsourcing (core activities) Insurance Life & health Non-life Banking Retail Corporate banking Investment banking Asset Retail Institutional Shared services Asset accumulation HR & benefits Finance & accounting Procurement controlling etc. IT Applications development Applications maintenance IT infrastructure & procurement Front office/ distribution Agents Broker IFAs Research and analysis Branches IFAs Banks Agents IFAs Business processes Product/portfolio Product development Actuarial services Legislation Product development Risk Portfolio Treasury Research Portfolio Customer care/ processing Channel support Client proposals Underwriting Service centre Policy administration Claims Securities services Payments Account services Consumer credits Credit risk analysis & reporting Service centre Processing Custody Funds accounting Reporting Source: Booz Allen Research 2

3 such as mortgage and claim processing, investment bank research, and payments processing (see Exhibit 2). Manufacturing companies took nearly four decades to successfully outsource core activities. In contrast, financial services companies have tried to make the same journey from outsourcing non-core to core activities in less than a decade and a half. Unfortunately, the majority have failed to capture value from outsourcing, and it is clear financial services companies have much to learn from the experiences of manufacturing firms. Despite the many failures, however, a select few financial services companies have been taking advantage of next generation opportunities and are successfully outsourcing core activities. While outsourcing is here to stay and the benefits are many, financial services companies should embark on these initiatives with eyes wide open. More specifically, Booz Allen client work indicates that financial services companies can benefit from outsourcing and offshoring and create value if they avoid falling prey to common misconceptions that is, outsourcing myths and if they adhere to certain critical best practices when setting up outsourcing arrangements. Our goal in exploring both outsourcing best practices and myths is to ensure that financial services companies can capture value by successfully implementing outsourcing and offshoring strategies. To that end, this article: outlines seven pragmatic outsourcing best practices to help financial services companies overcome the key challenges to next generation outsourcing; and ensures financial services companies can achieve greater success by dispelling five common outsourcing myths. SEVEN PRAGMATIC OUTSOURCING BEST PRACTICES Outsourcing challenges are significant, and the most successful companies will be those who can: 1. Manage complex relationships with multiple internal and external suppliers. 2. Assess external factors, such as value-added tax, labour laws, and financial services regulations. 3. Establish clear service parameters, such as definitions, service level agreements, and cost baselines. 4. Overcome lack of in-house negotiation experience in structuring complex outsourcing arrangements. 5. Avoid overly optimistic expectations about the time required to outsource. 6. Structure the agreement flexibly to handle changes in volumes and requirements. 7. Practice financial engineering carefully so fundamental economics are not traded away to achieve short-term objectives. Organisations that bring a disciplined and rigorous approach to implementing these best practices will be best equipped to meet the complex and complicated challenges of outsourcing and reap the financial rewards. Here is a more comprehensive assessment of each practice: 1. Manage complex relationships with multiple internal and external suppliers. Most next generation outsourcing deals involve complex relationships with multiple internal and outsourced suppliers. To be successful, companies must plan for this complexity by developing new organisational structures and processes and by ensuring that staff have the right skills to manage the new constellation of relationships. Failing to prepare sufficiently ensures savings will be lost and the overall health of the outsourcing arrangement will decline. Recently, a large European bank sought to outsource nearly half of its 4bn business processes and technology activity. The initiative failed because the bank did not sufficiently prepare both the outsourcer and the other internal and external suppliers. A key element of the failed initiative was outsourcing mortgage processing. The bank failed to achieve cost and service targets because it could not manage and coordinate the 10 suppliers involved in the overall 3

4 Differences between forecast and actual workload for a credit card company Exhibit 3 Strategic IT projects New system replacements, Right to match any like for like market test Turnaround Consultancy services as required on a preferred supplier basis CLIENT EXAMPLE Forecast: 22%-40 % of total Actual: ~50% of total Factory Enhancements to in scope systems In scope package amendments Forecast: no commitment Actual: ~5% of total Support Support of all in scope systems Support of new in scope systems Forecast: 37%-55% of total Actual: ~10% of total Forecast: 22%-25% of total Actual: ~35% of total Source: Booz Allen Forecasting multiyear volumes and costs Exhibit 4 CLIENT EXAMPLE 30% 25% 20% 15% Industry peers (insourced) Current best practices 14% 17% Industry (outsourced) 23% 21% 19% L Likely Outc outcomes om 25% Annual ROI 10% 5% Pessimistic (current cost) 5% 10% Optimistic costs 0% 10,171 9,433 8,695 7,957 7,219 6,482 5,744 5,006 4,268 3,530 2,792-5% Note: Discount rate 4% 4 year contract Annual indirect costs per user (lower indirect costs = improved annual ROI) Source: Booz Allen 4

5 mortgage process. Five of the suppliers were internal in separate business units, and provided mainframe, data input, and bank customer number maintenance. Another internal group provided IT infrastructure, such as networks and desktops to all participants. Similar complexity existed with external suppliers to the mortgage outsourcer. Customer service quality costs increased three fold and the time required to make changes to the process increased significantly. The contract was nearly cancelled, and a senior executive was diverted from other critical activities to implement new organisational structures and processes and to hire experienced staff. Many companies outsourcing business processes today have already outsourced major components of technology. Therefore, companies must decide whether to maintain current technology and process outsourcing agreements or bundle them into new agreements with the outsourced business processes. This requires that critically analyse how current activities and services are being executed, and then decide whether to cancel or change these arrangements to reduce relationship complexity. 2. Assess external factors, such as value-added tax, labour laws, and financial services regulations External factors, such as financial service regulations and taxation and labour laws, are often critical stumbling blocks to successful outsourcing. Meeting these regulatory requirements is a lengthy process. Financial services companies must ensure that they allocate enough time to get all of the necessary regulatory approvals and meet requirements. For example, legal transfers require a long interim period because regulatory authorities will not provide proforma approvals in advance. Further, organisations must assess value-added taxes and their impact on the economic value of the initiative. Depending on the activity outsourced, previously exempt activities can be subject to value-added tax, which can weaken deal economics. For example, value-added taxes range from 7% in Switzerland to 25% in Sweden, and this variation can significantly change the attractiveness of potential outsourcing agreements. Finally, labour laws in many countries serve to block deals if not carefully planned for and managed. In continental Europe, and even the UK, financial services organisations must adopt a transparent and open approach to working with labour groups to achieve success. 3. Establish clear service definitions, service level agreements, and cost baselines. Outsourcing deal success hinges on clear service definitions of what will be outsourced. Furthermore, service level agreements must be clearly defined with robust cost and volume projections that cover the length of the proposed agreement. Unfortunately, most financial services companies do not explicitly define service levels or the costs of internally delivered activities. Sufficient time and resources must also be provided to allow teams to create - usually from scratch - current cost and service levels and also to project demand. For example, a major European insurance provider spent twelve months mapping processes and defining current and projected costs and volumes before moving activity to an Indian outsource provider. 4. Overcome lack of in-house negotiation experience in structuring complex outsourcing arrangements. Outsourcing suppliers negotiate many deals each year and have professional deal teams that focus on generating value. Financial services companies must field similarly skilled teams with process re-engineering, financial, and legal skills. Most important is experience in negotiating contracts. A common error is to have current process owners negotiate the deal. This practice often results in missed opportunities to reduce cost, improve service quality, or to fundamentally change the way an activity is executed. Furthermore, many companies rely on the internal sourcing 5

6 Strategies for determining deal structure Exhibit 5 CLIENT EXAMPLE Op. profit % Overall operating profit 11 Base service markup - 21% average across all contracts 1.8m of this profit comes from payment on target instead of actuals m 50 m 25 0 Cost base 77 Current spend company X Current op. profit Base services markup 8 Project markup Project markup - 27% estimated across all contracts 3 Risk reward Time value of advance payment Risk reward - 65% estimated. Company X generally hits 8% annual savings 1 Time value of payment in advance Source: Booz Allen Companies outsource only selected processes and not whole functions Exhibit 6 100% % respondents who outsource functions 80% 60% 40% 20% 0% 41% 80% 82% 64% 54% 55% 49% 43% 35% 28% 17% 17% 18% 8% 4% 1% 3% HR Finance IT Purchasing Facilities Risk 0% No outsourcing Selected processes Most processes Source: Booz Allen 2003 Survey of 150 Global Companies 6

7 department to negotiate deals. Although these staff are experts at negotiating contracts for discrete commodities such as photocopiers, technology and paper, negotiating complex outsourcing agreements is not their forte. A major European credit card company outsourced and offshored IT development and certain business processes. The deal was negotiated by the IT and operations director, supported by the sourcing department. Only nine months into the outsourcing contract, several penalty clauses were breeched resulting in a 50% cost increase. At issue was the actual type of work required by the business users, which was significantly different from that agreed to in the negotiation (see Exhibit 3). The sourcing team, inexperienced in outsourcing major contracts, failed to negotiate key clauses related to volumes and type of work. Instead, they focussed on negotiating a 5% reduction in the hourly cost of the outsourcer s staff. 5. Avoid overly optimistic expectations about the time required to outsource. Success demands that companies make realistic estimates of the time required to project costs and service levels, negotiate, transfer legal ownership, and implement an outsourcing deal. Most companies grossly underestimate timeframes to outsource, and as a result, often shortcut key elements to implementing outsourcing agreements. In addition, outsourcing suppliers often push to shorten the analysis and estimation phase in an effort to bury critical issues such as cost projections and service levels key elements of the agreement. Furthermore, internal pressures to deliver value can quickly lead to unrealistic timeframes. Finally, many companies underestimate the time required to ensure internal stakeholders are on board; more specifically, they fail to allocate the time needed to obtain explicit approval for outsourcing from internal clients, audit, finance and operational risk. At a major UK bank, a recent outsourcing agreement for branch cash handling was delayed because internal clients were not sufficiently consulted. The bank wrongly assumed that the business owners would not be interested in the details of who was providing the service. 6. Structure the agreement flexibly to handle changes in volumes and requirements. Most outsourcing agreements fail to acknowledge that the new arrangement will have consequences for the business, both for its requirements and workload; it is unlikely that business requirements and volumes in two years will be the same as current levels. Best practice companies spend significant time forecasting future scenarios (see Exhibit 4) and design flexible contracts for a changing organisation. 7. Practice financial engineering carefully so fundamental economics are not traded away to achieve short-term objectives. Most outsourcing agreements require significant change costs and upfront investment, and can take up to two to three years to break even. However, most firms cannot wait this long. Financial engineering techniques, such as funding upfront costs through supplier financing, venture capital, and even bond issues, can help companies address these issues and achieve their shortterm objectives such as reducing cost: income ratios, reducing headcount, and ensuring that costs are changed from fixed to variable. While financial engineering can be a deal enabler, companies must ensure that the cost benefits of the arrangement are transparent over the length of the contract. Financial services companies must be especially wary of the financial engineering offered by suppliers and must first ensure that deal economics are sound and transparency is evident. Caution is critical because suppliers often use financial engineering to mask deal economics by turning the focus from overall cost reduction and service improvement to short-term financial savings. Booz Allen has analysed several large outsourcing contracts and found that at first glance, the overall deals were positive, with savings 7

8 8 early in the contracts. However, once the entire life of each contract was analysed, the economics of the deals were not as compelling. One European financial services company recently worked with a venture capital group to finance the outsourcing of a core business process. The venture capital group funded necessary investments and even guaranteed savings several years into the future. This allowed the company to record savings immediately and achieve cost:income and headcount reductions promised to investors, without sacrificing long-term economic benefits. Although important to achieving short-term objectives, financial engineering was performed only after the deal economics were agreed upon, ensuring transparency for all parties. Despite the significant challenges of implementing next generation outsourcing and offshoring, financial services companies can enjoy success by adhering to the above best practices. FIVE COMMON OUTSOURCING MYTHS In addition to implementing these critical best practices, financial services companies can improve their chances of success by rejecting outsourcing truisms or myths that have gained popular support and often determine how companies implement outsourcing deals. The following myths, often advocated by suppliers or sometimes even by internal company staff, lead to the failure of outsourcing core and non-core agreements: Myth one. Partnerships lead to successful outsourcing agreements. Myth two. A highly competitive bidding process will ensure the best deal. Myth three. Outsourcing reduces complexity. Myth four. Don t outsource a broken process until you fix it first. Myth five. Everyone is outsourcing whole functions. A closer examination of each myth makes clear that popularity is no substitute for veracity and value. 1. Partnerships lead to successful outsourcing agreements. The concept of partnership as the key to outsourcing success is a common fallacy. While strong open relationships are critical, relationships must be based on well-defined contracts that capture all aspects of the relationship. Financial services companies must insist upon transparent agreements that explicitly define exit clauses and include clear risk-reward structures all within detailed contractual frameworks. Outsourcing suppliers often push to leave elements of the contract vague in order to close deals and to structure the deal in their favour. Furthermore, strong relationships between senior executives, while important, are no substitute for detailed contracts, as these relationships rarely serve to resolve complex issues, particularly those with economic implications. Recently, a major European banking group outsourced a critical customer facing process based on the handshake between CEOs. When issues surfaced and customer service levels began to drop, the partners struggled to resolve them. Due to lack of clear guidelines and a detailed contract, it took nearly a year and a half for customer service to return to pre-outsource levels, and transaction costs increased by almost 50%. 2. A highly competitive bidding process will ensure the best deal. While loosely defined partnerships can scuttle outsourcing efforts, so can overly competitive bidding processes that push suppliers to the lowest cost. Clearly, competition is important to ensure good pricing, but suppliers must make a sustainable margin. When assumptions are unrealistic, suppliers often try to make up the shortfall by designing inflexible agreements and increasing charges when requirements or volumes change. Indeed, overly aggressive bidding can thwart economic gain. A large company sought to outsource a

9 critical customer facing activity and negotiated aggressively with all bidders to achieve a lower than industry cost structure. As customer demands changed and processes required adjustment, the outsourcer invoked several costly change clauses. Furthermore, the agreement did not sufficiently account for required upgrades in the underlying technology. As a result, several key changes designed to improve market share were delayed. As financial services companies seek to outsource increasingly complex core activities, instead of focussing on overly competitive bidding processes, they should instead focus on developing transparent cost plus structures, ensuring a sustainable margin for suppliers (see Exhibit 5). Firms should also supplement these transparent agreements with risk-reward objectives. 3. Outsourcing reduces complexity. Many companies mistakenly assume that outsourcing will reduce complexity and simplify running an organisation. In reality, complexity increases when activities are outsourced for one primary reason: while activities can be outsourced, understanding of these activities and their processes cannot. To manage and achieve positive change within a financial services organisation, must understand in detail how processes are executed and why. A large retail bank recently sought to implement a new customer strategy focussed on basic customer experiences, such as account application through receipt of debit cards, cheques and the first transaction. Parts of the account opening process had been outsourced for several years, including data entry, call centre support, and sending customer cheque books and most bank managers had lost touch with how the processes were operating. As a result, a significant effort was required for these managers to re-learn the bank s processes so they could plan and implement the new customer strategy. One of the advertised benefits of outsourcing is freeing up time to focus on critical value creation activities. In reality, unless managers understand the workings of the outsourced processes, they will need to spend a significant amount of time managing outsourcer interfaces instead of focusing on high value activities. 4. Don t outsource a broken process until you fix it first It is not necessary to fix broken processes before outsourcing: it is important to understand the broken processes and the cost of fixing them. In fact, companies can enjoy a competitive advantage during negotiations if they understand the processes and the potential benefits of reengineering them. Who fixes the processes is less relevant. Cost savings of 10% - 30% are possible through process improvements. Companies should invest in the requisite up-front analysis, and then work with the outsourcer to identify savings and agree upon a clear action plan to capture and share them. Business process reengineering assumptions and savings should be part of the negotiation, and each supplier should be asked to submit a realistic plan of how they will implement the savings. 5. Everyone is outsourcing whole functions. Not all activities can be outsourced. Today, it is hard to imagine a bank outsourcing activities to the extent BMW has outsourced to Magna. In fact, most financial services companies are struggling to outsource even basic technology successfully. In a recent Booz Allen study of CFOs of global companies, we identified only a handful of pioneers who are outsourcing whole functions (see Exhibit 6). Most companies are outsourcing processes only very selectively. Even within non-core functions, such as IT, which is the most readily outsourced, only about 28% of the respondents are outsourcing it fully. Other non-core activities like Finance and Human Resources are even further behind. While some financial 9

10 institutions are starting to outsource core activities, most still have a long way to go. One of the reasons financial services companies are lagging in outsourcing core functions is that regulators place stringent requirements on them when they outsource these activities. To meet these regulatory demands, financial services companies must prove they can manage the operational risk of outsourced activities, and only those with deep outsourcing skill and experience will be able to pass this test. CONCLUSION Outsourcing is here to stay and can create significant value - despite significant challenges. Booz Allen s experience suggests that financial services companies that succumb to the allure of myth or fail to embrace the best practices above will fail to create value. However, financial services companies that enter into these arrangements with eyes wide open will achieve success with next generation outsourcing and offshoring and will ensure their own competitive advantage. Chris Disher, Vice President, Booz Allen Hamilton, Chicago. Tel: +1 (312) disher_chris@bah.com Charles Teschner, Vice President, Booz Allen Hamilton, London. Tel: +44 (20) teschner_charles@bah.com Anil Kaul, Principal, Booz Allen Hamilton, Chicago. Tel: +1 (312) kaul_anil@bah.com Myles Wright, Senior Associate, Booz Allen Hamilton, London. Tel: +44 (20) wright_myles@bah.com 10