Insourcing and its commercial attractiveness in boosting profitability
This article was first published in ARK Group's Emerging Approaches to Law Firm Profitability book.
Outsourcing has brought significant benefits to many organizations. It has delivered real cost savings and improvements in quality across many different sectors. Outsourcing companies have become more sophisticated and offer a wider range of services to high standards. However, in today’s increasingly complex and fast-changing business environment, it is clear that companies now need to review their outsourcing decisions and explore whether alternative sourcing options offer better ways to drive the next phase of cost reduction and quality improvements.
One of those options is insourcing, through which companies bring certain components of their IT and shared services in-house and rebalance their capability supply chain. The trend is to look for a better balance between building capability and buying it by using both insourcing and outsourcing options effectively. In our experience, by including insourcing in the mix, organizations can establish a scalable platform that achieves significant ongoing cost reduction, improves business integration, and fosters innovation.
Insourcing helps to retain the critical knowledge in-house, enables agile project delivery, and helps to identify opportunities for automation. These advantages then give organizations much greater agility to respond to changes in demand, both in their marketplace and within their businesses. As companies look to improve customer centricity, insourcing gives them greater flexibility to meet the customer needs.
As the potential benefits of insourcing have become clearer, we have seen growing interest and willingness among business leaders to consider a wider range of sourcing options. The 2017 UK IT Outsourcing Study, conducted by Whitelane Research in collaboration with PA Consulting Group, found that while there was still an appetite for outsourcing, 22 percent of IT services clients said that they now plan to outsource less. The same proportion (22 percent) said they saw outsourcing as a barrier to increased agility. There is also evidence that a number of companies are recognizing that in some areas, where business knowledge and proximity are key, insourcing can offer real benefits.
There are significant potential cost savings from insourcing
In recent decades, when driving out inefficiencies was critical to business success and even survival, outsourcing became popular because of the opportunity it brought to reduce operating costs. For many companies, that decision has proved highly effective and their outsourcing contracts have delivered significant savings.
However, it has always been necessary to weigh up the advantages of outsourcing against the downsides. This is particularly true in today’s business climate, where flexibility and responsiveness are increasingly important success factors. Outsourced services with restrictive contracts can make it hard for companies to respond in an agile way to a fast-changing marketplace. They can also stifle innovation as the contractor focuses on providing the services they are contracted to supply.
Most business decisions still come down to cost, but here again some companies are finding that outsourcing is not always the most cost-effective option. A number of organizations have discovered that when they bring services back in-house, even with already outsourced/offshored services, it gives them an opportunity to further reduce the same cost base.
While the common perception is that the insourced operations are more expensive than outsourced ones, our experience with a range of clients suggests that if insourcing is managed effectively, organizations can secure cost savings in the range of 20-50 percent, depending on the scope, where they are in the overall development of their business, and their target operating model.
There are a number of ways in which savings can be achieved through insourcing. The full range of potential savings are:
Lower end of the savings range – (a) organizations that have outsourced and offshored. Savings at this end of the range can be achieved by organizations that have already outsourced their IT and shared services delivery to a third-party supplier in low-cost locations. They should be able to reduce their operating costs by a further 20 percent when they insource the service delivery to low-cost offshore locations.
In an outsourced situation, the client’s perception of cost is usually different from the total cost of the service consumption through a third-party supplier. This total cost will be higher than the vendors’ rates by as much as 20 percent when VAT and IT overheads are included. Also, even if there is an assumption that the client has negotiated a good deal with their current service provider or even re-negotiated the contract with the incumbent or a new service provider, the fully loaded cost the supplier will charge will include the vendor’s profit margin, which will be about 20 percent.
In contrast, when a company runs the operation themselves in an offshore location, they will be able to save on the vendor margins and vendor overheads. Further, higher levels of offshoring are achievable for an insourced outfit, leading to additional gains.
Higher end of savings range – (b) organizations with current footprint largely in high-cost locations. The potential savings will be much higher for organizations that currently run most of their IT and business support functions in high-cost onsite locations. They can achieve savings of up to 50 percent in operating expenditure through offshoring the operations to a low-cost location, while still keeping the operations in-house.
With labor costs in low-cost locations about 55-65 percent lower than those in higher cost ones, companies moving their services offshore will see their existing costs reduce by up to half, after factoring in staff, building and facilities overheads. That can provide a cost reduction of about 35 percent of current operating expenditure.
Moreover, a further saving of about 15 percent on these ranges is usually achievable if companies implement a transformation plan which is focused on securing the synergies of the captive center as it matures the way it delivers services. In particular, moving to a model which is much more focused on the outcomes of the delivery teams will drive further efficiencies.
Busting misconceptions about insourcing
Despite these advantages, many business leaders have been cautious about going down the insourcing route. The reluctance stems partly from the many myths about the costs of setting up and running insourced operations, which have created a view that they are more expensive than they really are. The concerns and questions which are holding companies back from making the decision to insource are:
- Is there a huge upfront cost?
- Do I need high volumes (500 or 1000 people) to make a strong case and make it sustainable?
- What is the payback period? and
- Is there a long lead time?
In our experience, the answers to these questions should provide some reassurance that insourcing projects can be manageable and cost effective. In our work, we have seen examples where even when roles are already outsourced to offshore locations and the numbers of people involved are as low as 100, a strong business case for insourcing can be made.
While there will be upfront costs, insourcing projects can provide a return on investment much in excess of industry standard of 12 percent, a multi-million net present value (NPV) and payback in about three years. Equally, it does not have to take a long time to get the new approach in place. With right set of delivery capabilities and leadership, the lead time in setting up an insourcing operation can be as short as 12 months.
There is growing evidence that, when insourcing is done right, it offers a very attractive commercial proposition as well as real qualitative benefits through increased control and improved synergies.
How insourcing works in practice
PA has been working with various clients to help them re-balance their capability supply chain and introduce a variety of sourcing solutions. Our clients typically face increasing demands from the businesses for better control over its IT delivery and a strong desire to make better use of its existing assets, in addition to meeting a significant cost reduction target. This means that they invariably need to re-asses their global delivery strategy and how they provide services to the business.
There are multiple challenges to overcome in these engagements, not least the organization’s dependency on outsourced partners. Further problems can then arise if the service delivery organization is misaligned with the overall strategy and so has a lack of control and ownership. Location footprint and spread out assets can also prove challenging. All these create a clear case to look at doing things differently.
In response, it is best to develop and shape a sourcing strategy along with a location strategy to address these problems. Insourcing operations can provide solutions to these problems, underpinned by a strong business case that has potential to offer a multi-million NPV saving and up to a 50 percent reduction in operating expenses, depending on the scope, location and target operating model.
Once the business case is well understood, a transformation program must be built to drive the establishment of an in-house capability to deliver IT and shared services at the selected location. Once the service center is set up, multiple services can be transitioned within a span of 12 months.
Once the capability is established, it can be scaled up to keep up with continued margin pressures to deliver additional savings. Our experience of completed captive centers and the business cases for those in-flight indicate that potential net savings of up to 40 percent can be achieved when the client moves service delivery to offshore and nearshore locations. What is critical to achieving those savings is getting the right location for the captive center to ensure that it can comfortably secure the skills needed at a competitive cost.
While the benefits of insourcing are increasingly clearer, before they make a decision to go down this route, organizations do need to have a very clear understanding of their needs. That should start with a review of their current global delivery and sourcing strategy. This should include a qualitative and quantitative assessment of the full range of possible options. This can then be used to inform the creation of a high-level business case that can reshape the sourcing strategy.
In all this work it is important to be open to all the possibilities. For one of our clients, we assessed ten different sourcing options (insource, outsource, build-operate-transfer etc.) against sixteen strategic parameters in order to develop a recommendation for the final option. This comprehensive and open approach is the best way to ensure that the business can make a fully informed decision about what will work for them.
It is critical to draw up a detailed business case and benefits realization plan. This should include an analysis of the current operating model, potential demand and target location strategy. It is particularly important to get the location strategy right. The location will be critical to securing the desired savings, quality of services and scalability of the center. That means careful research needs to be undertaken to ensure that the location provides good access to the talent that will be needed and that the relevant services and skills can be secured at a competitive cost.
There is no one solution that will fit every company and it is important to develop a strategy that is tailored to the needs of each organization. However, our experience shows that, for many organizations, increasing the insourced to outsourced ratio will improve the likelihood of achieving their business objectives. It will provide a clear means to achieve the cost reductions and increased control that will give them the flexibility to manage today’s business challenges more effectively.
Manish Khandelwal and Srinivas Vadali are IT transformation experts at PA Consulting