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JANUARY 30, 2006


The Future Of Outsourcing
How it's transforming whole industries and changing the way we work

Globalization has been brutal to midwestern manufacturers like the Paper Converting Machine Co. For decades, PCMC's Green Bay (Wis.) factory, its oiled wooden factory floors worn smooth by work boots, thrived by making ever-more-complex equipment to weave, fold, and print packaging for everything from potato chips to baby wipes.

But PCMC has fallen on hard times. First came the 2001 recession. Then, two years ago, one of the company's biggest customers told it to slash its machinery prices by 40% and urged it to move production to China. Last year, a St. Louis holding company, Barry-Wehmiller Cos., acquired the manufacturer and promptly cut workers and nonunion pay. In five years sales have plunged by 40%, to $170 million, and the workforce has shrunk from 2,000 to 1,100. Employees have been traumatized, says operations manager Craig Compton, a muscular former hockey player. "All you hear about is China and all these companies closing or taking their operations overseas."

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But now, Compton says, he is "probably the most optimistic I've been in five years." Hope is coming from an unusual source. As part of its turnaround strategy, Barry-Wehmiller plans to shift some design work to its 160-engineer center in Chennai, India. By having U.S. and Indian designers collaborate 24/7, explains Vasant Bennett, president of Barry-Wehmiller's engineering services unit, PCMC hopes to slash development costs and time, win orders it often missed due to engineering constraints -- and keep production in Green Bay. Barry-Wehmiller says the strategy already has boosted profits at some of the 32 other midsize U.S. machinery makers it has bought. "We can compete and create great American jobs," vows CEO Robert Chapman. "But not without offshoring."

Come again? Ever since the offshore shift of skilled work sparked widespread debate and a political firestorm three years ago, it has been portrayed as the killer of good-paying American jobs. "Benedict Arnold CEOs" hire software engineers, computer help staff, and credit-card bill collectors to exploit the low wages of poor nations. U.S. workers suddenly face a grave new threat, with even highly educated tech and service professionals having to compete against legions of hungry college grads in India, China, and the Philippines willing to work twice as hard for one-fifth the pay.

Workers' fears have some grounding in fact. The prime motive of most corporate bean counters jumping on the offshoring bandwagon has been to take advantage of such "labor arbitrage" -- the huge wage gap between industrialized and developing nations. And without doubt, big layoffs often accompany big outsourcing deals.

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The changes can be harsh and deep. But a more enlightened, strategic view of global sourcing is starting to emerge as managers get a better fix on its potential. The new buzzword is "transformational outsourcing." Many executives are discovering offshoring is really about corporate growth, making better use of skilled U.S. staff, and even job creation in the U.S., not just cheap wages abroad. True, the labor savings from global sourcing can still be substantial. But it's peanuts compared to the enormous gains in efficiency, productivity, quality, and revenues that can be achieved by fully leveraging offshore talent.

Thus entrepreneurs such as Chapman see a chance to turn around dying businesses, speed up their pace of innovation, or fund development projects that otherwise would have been unaffordable. More aggressive outsourcers are aiming to create radical business models that can give them an edge and change the game in their industries. Old-line multinationals see offshoring as a catalyst for a broader plan to overhaul outdated office operations and prepare for new competitive battles. And while some want to downsize, others are keen to liberate expensive analysts, engineers, and salesmen from routine tasks so they can spend more time innovating and dealing with customers. "This isn't about labor cost," says Daniel Marovitz, technology managing director for Deutsche Bank's global businesses (DB ). "The issue is that if you don't do it, you won't survive."

The new attitude is emerging in corporations across the U.S. and Europe in virtually every industry. Ask executives at Penske Truck Leasing why the company outsources dozens of business processes to Mexico and India, and they cite greater efficiency and customer service. Ask managers at U.S.-Dutch professional publishing giant Wolters Kluwer (WTKWY ) why they're racing to shift software development and editorial work to India and the Philippines, and they will say it's about being able to pump out a greater variety of books, journals, and Web-based content more rapidly. Ask Wachovia Corp. (WB ), the Charlotte (N.C.)-based bank, why it just inked a $1.1 billion deal with India's Genpact to outsource finance and accounting jobs and why it handed over administration of its human-resources programs to Lincolnshire (Ill.)-based Hewitt Associates (HEW ). It's "what we need to do to become a great customer-relationship company," says Director of Corporate Development Peter J. Sidebottom. Wachovia aims to reinvest up to 40% of the $600 million to $1 billion it hopes to take out in costs over three years into branches, ATMs, and personnel to boost its core business.

Here's what such transformations typically entail: Genpact, Accenture (ACN ), IBM Services, or another big outsourcing specialist dispatches teams to meticulously dissect the workflow of an entire human resources, finance, or info tech department. The team then helps build a new IT platform, redesigns all processes, and administers programs, acting as a virtual subsidiary. The contractor then disperses work among global networks of staff ranging from the U.S. to Asia to Eastern Europe.

In recent years, Procter & Gamble (PG ), DuPont (DD ), Cisco Systems (CSCO ), ABN Amro (ABN ), Unilever, Rockwell Collins (COL ), and Marriott (MAR ) were among those that signed such megadeals, worth billions.

In 2004, for example, drugmaker Wyeth Pharmaceuticals transferred its entire clinical-testing operation to Accenture Ltd. "Boards of directors of virtually every big company now are insisting on very articulated outsourcing strategies," says Peter Allen, global services managing director of TPI, a consulting firm that advised on 15 major outsourcing contracts last year worth $14 billion. "Many CEOs are saying, 'Don't tell me how much I can save. Show me how we can grow by 40% without increasing our capacity in the U.S.,"' says Atul Vashistha, CEO of outsourcing consultant neoIT and co-author of the book The Offshore Nation.

Some observers even believe Big Business is on the cusp of a new burst of productivity growth, ignited in part by offshore outsourcing as a catalyst. "Once this transformation is done," predicts Arthur H. Harper, former CEO of General Electric Co.'s equipment management businesses, "I think we will end up with companies that deliver products faster at lower costs, and are better able to compete against anyone in the world." As executives shed more operations, they also are spurring new debate about how the future corporation will look. Some management pundits theorize about the "totally disaggregated corporation," wherein every function not regarded as crucial is stripped away.

In theory, it is becoming possible to buy, off the shelf, practically any function you need to run a company. Want to start a budget airline but don't want to invest in a huge back office? Accenture's Navitaire unit can manage reservations, plan routes, assign crew, and calculate optimal prices for each seat.

Have a cool new telecom or medical device but lack market researchers? For about $5,000, analytics outfits such as New Delhi-based Evalueserve Inc. will, within a day, assemble a team of Indian patent attorneys, engineers, and business analysts, start mining global databases, and call dozens of U.S. experts and wholesalers to provide an independent appraisal.

Want to market quickly a new mutual fund or insurance policy? IT services providers such as India's Tata Consultancy Services Ltd. are building software platforms that furnish every business process needed and secure all regulatory approvals. A sister company, Tata Technologies, boasts 2,000 Indian engineers and recently bought 700-employee Novi (Mich.) auto- and aerospace-engineering firm Incat International PLC. Tata Technologies can now handle everything from turning a conceptual design into detailed specs for interiors, chassis, and electrical systems to designing the tooling and factory-floor layout. "If you map out the entire vehicle-development process, we have the capability to supply every piece of it," says Chief Operating Officer Jeffrey D. Sage, an IBM and General Motors Corp. (GM ) veteran. Tata is designing all doors for a future truck, for example, and the power train for a U.S. sedan. The company is hiring 100 experienced U.S. engineers at salaries of $100,000 and up.

Few big companies have tried all these options yet. But some, like Procter & Gamble, are showing that the ideas are not far-fetched. Over the past three years the $57 billion consumer-products company has outsourced everything from IT infrastructure and human resources to management of its offices from Cincinnati to Moscow. CEO Alan G. Lafley also has announced he wants half of all new P&G products to come from outside by 2010, vs. 20% now. In the near future, some analysts predict, Detroit and European carmakers will go the way of the PC industry, relying on outsiders to develop new models bearing their brand names. BMW has done just that with a sport-utility vehicle. And Big Pharma will bring blockbuster drugs to market at a fraction of the current $1 billion average cost by allying with partners in India, China, and Russia in molecular research and clinical testing.

Of course, corporations have been outsourcing management of IT systems to the likes of Electronic Data Systems (EDS ), IBM (IBM ), and Accenture for more than a decade, while Detroit has long given engineering jobs to outside design firms. Futurists have envisioned "hollow" and "virtual" corporations since the 1980s.

It hasn't happened yet. Reengineering a company may make sense on paper, but it's extremely expensive and entails big risks if executed poorly. Corporations can't simply be snapped apart and reconfigured like LEGO sets, after all. They are complex, living organisms that can be thrown into convulsions if a transplant operation is botched. Valued employees send out their résumés, customers are outraged at deteriorating service, a brand name can be damaged. In consultant surveys, what's more, many U.S. managers complain about the quality of offshored work and unexpected costs.

But as companies work out such kinks, the rise of the offshore option is dramatically changing the economics of reengineering. With millions of low-cost engineers, financial analysts, consumer marketers, and architects now readily available via the Web, CEOs can see a quicker payoff. "It used to be that companies struggled for a few years to show a 5% or 10% increase in productivity from outsourcing," says Pramod Bhasin, CEO of Genpact, the 19,000-employee back-office-processing unit spun off by GE last year. "But by offshoring work, they can see savings of 30% to 40% in the first year" in labor costs. Then the efficiency gains kick in. A $10 billion company might initially only shave a few million dollars in wages after transferring back-office procurement or bill collection overseas. But better management of these processes could free up hundreds of millions in cash flow annually.

Those savings, in turn, help underwrite far broader corporate restructuring that can be truly transformational. DuPont has long wanted to fix its unwieldy system for administering records, payroll, and benefits for its 60,000 employees in 70 nations, with data scattered among different software platforms and global business units. By awarding a long-term contract to Cincinnati-based Convergys Corp., the world's biggest call-center operator, to redesign and administer its human resources programs, it expects to cut costs 20% in the first year and 30% a year afterward. To get corporate backing for the move, "it certainly helps a lot to have savings from the outset," says DuPont Senior Human Resources Vice-President James C. Borel.

Creative new companies can exploit the possibilities of offshoring even faster than established players. Crimson Consulting Group is a good example. The Los Altos (Calif.) firm, which performs global market research on everything from routers to software for clients including Cisco, HP, and Microsoft (MSFT ), has only 14 full-time employees. But it farms out research to India's Evalueserve and some 5,000 other independent experts from Silicon Valley to China, the Czech Republic, and South Africa. "This allows a small firm like us to compete with McKinsey and Bain on a very global basis with very low costs," says CEO Glenn Gow. Former GE exec Harper is on the same wavelength. Like Barry-Wehmiller, his new five-partner private-equity firm plans to buy struggling midsize manufacturers and use offshore outsourcing to help revitalize them. Harper's NexGen Capital Partners also plans to farm out most of its own office work. "The people who understand this will start from Day One and never build a back room," Harper says. "They will outsource everything they can."

Some aggressive outsourcers are using their low-cost, superefficient business models to challenge incumbents. Pasadena, (Calif.)-based IndyMac Bancorp Inc. (NDE ), founded in 1985, illustrates the new breed of financial services company. In three years, IndyMac has risen from 22nd-largest U.S. mortgage issuer to No. 9, while its 18% return on equity in 2004 outpaced most rivals. The thrift's initial edge was its technology to process, price, and approve loan applications in less than a minute.

But IndyMac also credits its aggressive offshore outsourcing strategy, which Consumer Banking CEO Ashwin Adarkar says has helped make it "more productive, cost-efficient, and flexible than our competitors, with better customer service." IndyMac is using 250 mostly Indian staff from New York-based Cognizant Technology Solutions Corp. (CTSH ) to help build a next-generation software platform and applications that, it expects, will boost efficiency at least 20% by 2008. IndyMac has also begun shifting tasks, ranging from bill collection to "welcome calls" that help U.S. borrowers make their first mortgage payments on time, to India's Exlservice Holdings Inc. and its 5,000-strong staff. In all, Exlservice and other Indian providers handle 33 back-office processes offshore. Yet rather than losing any American jobs, IndyMac has doubled its U.S. workforce to nearly 6,000 in four years -- and is still hiring.

Smart use of offshoring can juice the performance of established players, too. Five years ago, Penske Truck Leasing, a joint venture between GE and Penske Corp., paid $768 million for trucker Rollins Truck Leasing Corp. -- just in time for the recession. Customer service, spread among four U.S. call centers, was inconsistent. "I realized our business needed a transformation," says CFO Frank Cocuzza. He began by shifting a few dozen data-processing jobs to GE's huge Mexican and Indian call centers, now called Genpact. He then hired Genpact to help restructure most of his back office. That relationship now spans 30 processes involved in leasing 216,000 trucks and providing logistical services for customers.

Now, if a Penske truck is held up at a weigh station because it lacks a certain permit, for example, the driver calls an 800 number. Genpact staff in India obtains the document over the Web. The weigh station is notified electronically, and the truck is back on the road within 30 minutes. Before, Penske thought it did well if it accomplished that in two hours. And when a driver finishes his job, his entire log, including records of mileage, tolls, and fuel purchases, is shipped to Mexico, punched into computers, and processed in Hyderabad. In all, 60% of the 1,000 workers handling Penske back-office process are in India or Mexico, and Penske is still ramping up. Under a new program, when a manufacturer asks Penske to arrange for a delivery to a buyer, Indian staff helps with the scheduling, billing, and invoices. The $15 million in direct labor-cost savings are small compared with the gains in efficiency and customer service, Cocuzza says.

Big Pharma is pursuing huge boosts in efficiency as well. Eli Lilly & Co.'s (LLY ) labs are more productive than most, having released eight major drugs in the past five years. But for each new drug, Lilly estimates it invests a hefty $1.1 billion. That could reach $1.5 billion in four years. "Those kinds of costs are fundamentally unsustainable," says Steven M. Paul, Lilly's science and tech executive vice-president. Outsourcing figures heavily in Lilly's strategy to lower that cost to $800 million. The drugmaker now does 20% of its chemistry work in China for one-quarter the U.S. cost and helped fund a startup lab, Shanghai's Chem-Explorer Co., with 230 chemists. Lilly now is trying to slash the costs of clinical trials on human patients, which range from $50 million to $300 million per drug, and is expanding such efforts in Brazil, Russia, China, and India.

Other manufacturers and tech companies are learning to capitalize on global talent pools to rush products to market sooner at lower costs. OnStor Inc., a Los Gatos (Calif.) developer of storage systems, says its tie-up with Bangalore engineering-services outfit HCL Technologies Ltd. enables it to get customized products to clients twice as fast as its major rivals. "If we want to recruit a great engineer in Silicon Valley, our lead time is three months," says CEO Bob Miller. "With HCL, we can pick up the phone and get somebody in two or three days."

Such strategies offer a glimpse into the productive uses of global outsourcing. But most experts remain cautious. The McKinsey Global Institute estimates $18.4 billion in global IT work and $11.4 billion in business-process services have been shifted abroad so far -- just one-tenth of the potential offshore market. One reason is that executives still have a lot to learn about using offshore talent to boost productivity. Professor Mohanbir Sawhney of Northwestern University's Kellogg School of Management, a self-proclaimed "big believer in total disaggregation," says: "One of our tasks in business schools is to train people to manage the virtual, globally distributed corporation. How do you manage employees you can't even see?"

The management challenges will grow more urgent as rising global salaries dissipate the easy cost gains from offshore outsourcing. The winning companies of the future will be those most adept at leveraging global talent to transform themselves and their industries, creating better jobs for everyone.

By Pete Engardio, with Michael Arndt in Green Bay, Wis., and Dean Foust in Charlotte, N.C.

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