Sony joins the BPO bandwagon

Alfred Chandler’s reading of the historical course of the consumer electronics market was that Japanese firms such as Sony, Sharp, and Matsushita have insuperable advantages moving forward into the “electronic century”. However, recent upheavals and power shifts in the industry signal the risks of using history to guide the future. A recent Wall Street Journal article (March 10, 2005) described how American companies such as Kodak, Apple and palmOne have “seized the momentum” from the Japanese leaders to achieve rapid growth in revenue and market share. Lower manufacturing costs and a focus on core competences including design and development of digital (and digitization of) products were cited components of the American business model that are fast changing the rules of the game in consumer electronics and other industries. The enabler of this business model? Business Process Outsourcing. The bulk of Kodak’s cameras are built by contract manufacturers in China, while Apple’s iPod is predominantly assembled in Taiwan. Compare this to Sony’s in-house manufacturing and proprietary technology to discern distinct cost advantages and organizational flexibility enjoyed by the American firms.

However, Sony's operational model seems all too likely to change. This article reports that Sony Computer Entertainment president Ken Kutaragi has stated that the company is considering the possibility of outsourcing production of the PlayStation Portable (PSP) overseas, possibly to China or Taiwan. Kutaragi remarked that this was a response to the need to increase production capacity - “...we're not prepared to start selling in Europe, we've run out of units in the U.S. and it's still selling well in Japan,” Kutaragi told Bloomberg News at a games industry meeting in Tokyo recently. Sony is aiming to ship 12 million units of the PSP this fiscal year, after missing targets for the previous year. Currently 2.97 million PSPs have been shipped to the U.S. and Japan (a European launch is not scheduled until September) while around 6 million units of the rival Nintendo DS portable have been shipped worldwide. As the competition puts the pressure on Sony to grow, it's their turn to join the bandwagon.

So...IT doesn't matter?

Nicholas Carr's controversial Harvard Business Review article "IT Doesn't Matter" engendered a visceral response from academics and practicing managers alike. The article, more nuanced than its title, states that the ubiquitous nature of IT is reflective of a change in its organizational role from a powerful strategic lever to a commodity input that's the cost of doing business. Allied IT management too shifts from identifying opportunities to reducing risk.

The contrarian view highlights the incompleteness of Carr's argument, and that the technological revolution has not peaked as Carr would have us believe. For example, in an article in the current issue of Optimize magazine, Erik Brynjolffson, a prolific researcher on linkages between IT investments and productivity, states that IT-intensive companies tend to be more productive, and that companies have not yet figured out how to take advantage of information technologies. However, he adds that the organizational-capital investment in productive "digital organizations" is typically 10 times larger than the average IT investment. Therefore, "IT is the catalyst, but organization capital is the hidden bulk of the iceberg". Brynjolffson enumerates seven practices that characterize the top-performing firms: (1) Digitization of processes (2) open, widespread information access to employees (3) Employee empowerment (4) Meritocratic incentive structures that link employee pay to performance (5) Investment in corporate culture (6) Recruitment of quality personell (7) Investment in human capital.

Correct me if I am wrong but it seems like Brynjolffson's argument converges with Carr's. IT is a necessary investment to boost productivity but it is not what sustains competitive advantage. The key to success is not technology management but sound organizational practices that have been around longer than the Digital Age. IT doesn't matter.

Sarbanes-Oxley - Is it working?

The Basics: SOX, enacted in 2002, is one of the most controversial pieces of corporate legislation introduced in recent times. It was established to better organizational transparency and governance, and improve managerial accountability to shareholders in a post-Enron world. The Act includes provisions for quarterly certification of financial results (Section 302) and management's annual assertion that internal controls over financial reporting are effective (Section 404). Section 404, which has received most attention from publicly traded firms, requires formation of an accounting oversight board, the maintenance and evaluation of adequate internal control structures and processes as they pertain to financial reporting, an attestation examination by independent auditors and the consequent disclosure of material weaknesses.

What's the price? The methods and implications of SOX have led many firms to believe that the costs of compliance far outweigh the benefits. For example, 48% of the respondents to a survey conducted by CFO magazine (September 2003) responded that they will spend at least $500,000 on SOX compliance. An allied result was argued by Deloitte - large firms have, on average, spent nearly 70,000 additional man-hours complying with the act (The Economist, May 2005). The perceived benefits of the statute, however, are less immediate and tangible - fewer incidents of accounting fraud, better internal controls and supporting infrastructure, and quality business processes.

SOX and BPO: The complexity and ambiguity underlying quantification of compliance costs and benefits turn more pronounced at the intersection of SOX and BPO. In the case of outsourced business processes that are deemed pertinent to the user firm’s financial reporting, the user firm will either (i) need to conduct an evaluation of the service provider’s controls or (ii) obtain a SAS No. 70 service auditor's report from the service provider to gain an understanding of its controls. It is perceived that compliance may increase the short-term costs of BPO (including learning and audit costs) but will decrease over a long-term period. The user firm saves on service audit costs, and analogous to quality certifications such as CMM, the demonstration of adequate controls will help the service provider build trust with its clients and reduce the costs of multiple audits.

Another bites the dust

Information Week reports Sears Holding Corp., subsidiary of Sears, Roebuck and Co., terminated its 10-year, $1.6 billion IT outsourcing deal with Computer Sciences Corp. (CSC) less than a year into the agreement. CSC was contracted to support Sears' desktop computers, servers, and voice and data networks. It also supported systems that ran the retailer's Web sites and its decision-support systems. In a SEC filing, Sears said it ended the engagement "for cause, due to CSC's failure to perform certain of its obligations in accordance with the terms of the agreement."

William Bierce, a New York City-based attorney who specializes in outsourcing contract law, speculates that Sears is backing away from the agreement in its early stages because "the transition has failed". Others, however, believe internal politics at Sears may be a bigger factor.

The company's outsourcing contract with CSC was authored by former CIO Gerald Kelly. Kelly, however, was ousted earlier this year following the merger of Sears and Kmart. Kmart CIO Karen Austin was given the top technology post at the combined company.

Concurrently, Kmart chairman Edward Lampert wants to cut administrative costs at Sears and Kmart. Michael Guilbault, Technology Business Research analyst, remarked, "A $1.6 billion outsourcing deal may have looked like an easy target."

We're not outsourcing!

Business Week had a great article on Taiwan - Why Taiwan Matters - as part of their international cover story, which examines the growth of the country from a marginal player in the electronics industry to a dominant manufacturer whose companies are increasingly proficient at original design.

The article asserts that the country's advantages go beyond cheap labor - an entrepreneurial culture, effective government involvement that manifests in research groups that work closely with local companies and scientists from American universities such as MIT, CMU and UC Berkeley, and one of the deepest reserve of high-tech talent in the world. The article reports that Taiwanese companies control 72% of the world's production of notebooks PCs (valued at $22bn), 70% of chip foundry services (valued at $8.9bn), 68% of LCD monitors (valued at $14bn), 33% of the servers market ($1.8bn), 79% of the PDAs market ($1.8bn), and 34% of the digital stills camera market ($2bn). Further, as the much-sought-after Taiwanese engineers provide ingenious solutions to manufacturing and design conundrums, the companies are hoping to control design and innovation while handing over much of the manufacturing to China.

Victor Zue, co-director of the Computer Science & Artificial Intelligence Laboratory at MIT, quotes my favorite piece in the article: "In Taiwan, people say the U.S. understanding of outsourcing is backward. It feels more like the Taiwanese are outsourcing marketing and branding to the rest of the world."

Of the High-Tech Brain Drain: Love 'em or leave 'em

"It ain't where the puck is, it's where the puck will be." - Wayne Gretzky

Here are two complementary articles from the Wall Street Journal (gotta love the journal!) which point out that a U.S. education system that's not producing enough science and engineering talent and IT outsourcing are mutually reinforcing dimensions of the same coin.

The first article, High-Tech Brain Drain (May 5, 2005), reinforces the long-standing complaint of business leaders that the U.S. education system is not producing requisite science and engineering talent - we produce a little more than 5 engineering and natural science undergrad degrees, and rank sixth worldwide in the number of people graduating with bachelor degrees in engineering.To quote the journal, "...China is graduating some four times as many engineers as the U.S., and Japan -- with less than half of our population -- graduates twice as many engineers as we do...the percentage of incoming undergraduates planning to major in computer science declined by more than 60% between 2000 and 2004, and is now 70% below its peak in the early 1980s." The U.S. now ranks 17th world-wide in the number of undergraduate engineers and natural scientists it produces; that's down from 1975, when the U.S. was No. 3 (after Japan and Finland).

So, its only natural that American companies such as Microsoft, Intel set up research operations in India and China. Business leaders like Bill Gates make the argument that immigration curbs on the entry of foreign professionals and international students only serve to aggravate the problem further and take away significantly from the country's edge in innovation and its position as the world's technology leader. A few weeks ago, Mr. Gates said immigration policies are threatening U.S. competitiveness like never before. Asked how he would change current law, he replied, "I'd certainly get rid of the H1-B visa caps. That's one of the easiest decisions."

The second article, "Career Journal: Even Tech Execs Can't Get Kids To Be Engineers" (March 29, 2005) looks at the problem in reverse. It demonstrates that "some of the nation's tech elite -- including many immigrants who benefited greatly from engineering careers -- are finding even their own children shun engineering. One oft-cited reason: concern that dad and his contemporaries will ship such jobs overseas." Experts cite a variety of other reasons for the U.S.'s engineer shortage - poor math and science curricula in public schools and a persistent image problem - but the risk of career flight is an important factor that weighs into the decision.

Perhaps, when the widely cited benefits of outsourcing - higher productivity and organizational flexibility at reduced costs of ownership- become more apparent, it will allow firms to create more positions that speak for the lucre of a career in engineering. Until then, I declare myself confused. But, heck, to quote "The Leadership Advantage" (Warren Bennis), if you're not confused, you don't know what's going on.

Medical Tourism?

I came across this article in the Wall Street Journal today - dated but still relevant, given the persistent high costs of healthcare and the demand for inexpensive medical treatment. "Traveling Cure: India's New Coup In Outsourcing..." examines India's capitalization of these very costs to emerge as a "global health care provider". To quote the journal,

"...The Indian government sees health care as a growth industry. Public and private Indian universities are churning out 20,000 doctors and 30,000 nurses a year, some of them destined for jobs in western countries. That is roughly triple the pace at which nurses were trained during the 1990s.

In the so-called medical-tourism business, the focus is on big-ticket surgical procedures from face-lifts to liver transplants. Asian countries such as Thailand, Malaysia and Singapore have taken the lead in this field. Promoting health-care services alongside tourist destinations, the countries attracted more than 600,000 patients in 2003 alone, according to officials in Thailand and Malaysia.

(India-based) Apollo Hospitals offers cardiac surgery for about $4,000, compared with at least $30,000 in the U.S. Apollo's orthopedic surgeries cost $4,500, less than one-fourth the U.S. price. Consulting firm McKinsey & Co. says medical tourism could become a $2 billion-a-year business in India alone by 2012; the category is so new it previously wasn't measured..."

I can think of a lot more factors that make this a more lucrative proposition - read fewer malpractice/ litigation costs, allied recovery costs and overheads, etc. What if insurance companies agree to fund travel costs for offshore treatment, and even promote incentives that propel such decisions? Well, the issue is not unexplored - the following website offers comprehensive information on the possibilities of medical tourism.

http://www.medical-tourist.org/

Another example of a truth poser that raises the debate between efficient markets and government intervention.

Of SOX Compliance, and IT and Process Controls

Internal control over financial reporting, as mandated by Section 404 of SOX, is, to a large extent, contingent on allied process and technology controls.

The following document provides a beginner's guide to three popular frameworks or methodologies that bring discipline to software development and IT processes. These include: ITIL, a library of best practices for the provision of quality IT services, COBIT, an IT governance framework that can be applied to the entire IT realm and its processes in general, and the Capability Maturity Model (CMM), a more detailed and granular approach to controlling individual processes within the IT realm. It also investigates the role of software configuration management (SCM) and process/workflow management solutions in implementation of critical processes that provide reliable data for an IT audit.
http://www.vsj.co.uk/articles/display.asp?id=386

For a comprehensive treatment of IT controls as they pertain to internal control over financial reporting, refer to the document "IT Control Objectives for Sarbanes-Oxley" authored by the IT Governance Institute (http://www.itgi.org).

SAS 70 in the post-Sarbanes Oxley World

The Sarbanes-Oxley Act, enacted two years ago, requires establishment of extensive internal controls for financial reporting. Outsourced business process that are part of the user firm's corporate information system are considered part of its internal control over financial reporting. In this regard, the Statement on Auditing Standards (SAS) No. 70, Service Organizations, a recognized auditing standard developed by the American Institute of Certified Public Accountants (AICPA), which enables an independent auditor to evaluate and report a service organization's controls, assumes significance. An important question of interest to user firms and BPO service providers is:

What types of outsourcing activities result in a service organization arrangement addressed by SAS 70? What types of outsourcing activities are part of a company's internal control over financial reporting?

In the Staff FAQ (June 23, 2004) regarding "Auditing Internal Control over Financial Reporting", the PCAOB addresses this question with examples of situations in which the service organization's services affect the user firm's information system. A direct inference is that the outsourced business process is part of the user firm's information system if it impacts any of the following:

• The classes of transactions in the company's operations that are significant to the company's financial statements.
• The procedures, both automated and manual, by which the company's transactions are initiated, authorized, recorded, processed, and reported from their incurrence to their inclusion in the financial statements.
• The related accounting records, whether electronic or manual, supporting information and specific accounts in the company's financial statements involved in initiating, authorizing, recording, processing and reporting the company's transactions.
• How the company's information system captures other events and conditions that are significant to the financial statements.
• The financial reporting process used to prepare the company's financial statements, including significant accounting estimates and disclosures.

You can download a copy of the FAQ at the PCAOB website:

http://www.pcaobus.org/

A comprehensive online resource dedicated to the SAS 70 auditing standard and third-party assurance for service organizations is:

http://www.sas70.com/index2.htm

Paradox solved

Our research offers some interesting explanations for the BPO paradox:

We find that governance capabilities, when aligned with outsourced process requirements, lead to higher service satisfaction. In fact, when such capabilities are misaligned with outsourced process requirements, they adversely impact service quality and satisfaction. However, we find that most outsourcing managers design BPO governance structures to the exclusion of process requirements. Therefore, dissatisfaction with outsourcing may be explained by either (1) an under- or over- investment in governance capabilities or (2) design of governance capabilities to the exclusion of process requirements in favor of other factors such as broad strategic objectives, environmental dynamism, mimetic adoption of industry practices, etc.

Deloitte's study also reflects sampling issues and the flaw with averages. It is necessary to control for factors such as firm size, industry, etc. while analyzing service satisfaction in BPO. For example, we find that most firms tend to use BPO as an organizational lever that provides access to skills and capabilities required to deal with dynamic business environments, i.e. they outsource the risk associated with volatile, uncertain business environments. However, they also seem to outsource the management of such uncertainty - we find that environmental uncertainty adversely impacts service satisfaction. This speaks for a decision bias amongst managers that contributes to the paradox.

A copy of complete findings will be emailed to survey respondents soon.

BPO Paradox?

The fundamental value premise of BPO is greater organizational flexibility and process efficiency with reduced costs of ownership. However, 70% of the participants in a recent survey by Deloitte Consulting ("Calling for a Change in the Outsourcing Market", April 2005) said that they had significant negative experiences with outsourcing projects and now exercise greater caution in approaching such deals. The study states that although outsourcing is largely driven by cost-related objectives, firms experience hidden costs related to contract administration, profit margins, and in-house management. Therefore, the management of BPO relationships was more complex, expensive and time-consuming than anticipated. Such complexity calls into question the potential of BPO as a strategic driver for organizational cost savings and flexibility. BPO Paradox?

It's the process, stupid

Much remains to be understood about BPO. In this installment of "Higher Learning" from CIO magazine, I, in collaboration with three other researchers at the McCombs Schol of Business—Anitesh Barua, Prabhudev Konana and Andrew Whinston—draw on empirical research to propose questions that managers must address to properly manage a BPO relationship. We point out that success in BPO relationships is contingent on a deceptively simple fact - a comprehensive and early understanding of the risks and challenges associated with outsourcing a business process and the design of a governance structure that best internalizes such risk. A closer look at the outsourced process offers insights in this direction.
http://www2.cio.com/higher/report3503.html