Process Standardization - The New Business Imperative

Irving Wladawsky-Berger has an interesting post on how process standardization fosters innovation and drives competitive advantage. He suggests that "we need to evolve from today's labor-intensive and one-of-a-kind approach to building business solutions, and embrace methodologies based on science and engineering, using sophisticated tools and disciplined processes, much as happened during the Industrial Revolution. And, as was the case with the Industrial Revolution, we need to standardize those processes where differentiation brings little or no incremental value, so as to avoid the huge inefficiencies involved in re-inventing the same process over and over again. We can then apply our energies to innovating around those processes and business models that bring true differentiation and value to the business."

I think this "process revolution" that Wladawsky-Berger discusses will soon emerge as an imperative for competitiveness in modern businesses. Its growth will be abetted by three management trends: an increased organizational emphasis on supply chain costs to produce a healthy return on invested capital, the increasingly information intensive nature of business processes and the increased representation of services in business revenues. Standardization of business processes helps to improve supply chain efficiency and performance and is aided by the information intensive nature of the process. The latter enables technology to be an integral part of the process, which in turn, renders automation and standardization easy. Finally, the increased emphasis on services facilitates rapid permeation of process standardization throughout the company.

Wladawsky-Berger states that standardization will occur for business processes "where differentiation brings little or no incremental value". But, process standardization may well give rise to a class of service providers that, while competing along dimensions of process expertise, best practices and business improvement, may level the playing field sooner and across a wide range of business processes. Therefore, while I agree that process standardization will engender the culture of innovation that Wladawsky-Berger mentions, I also think it improves management focus and reinforces the rise of a new class of function-based companies. Competitive advantage in this emerging class will stem from clarity of understanding on what core functions drive competitive advantage in an industry, and using outsourcing as a tool for process standardization and as a lever to develop scale and skill in such core functions.

Advantage MNCs

ComputerWorld has an interesting article on the competition that Indian offshore firms are facing from MNCs that are increasingly coordinating a global network of offshore bases to deliver value. The article, which draws from a recent survey by TPI, states that the MNC edge comes from:

• Lower expectations of the financial markets of profit margins. The margins expected for multinational service companies is less than 15%, while it is close to 30% for Indian outsourcing companies. This allows the MNCs to offer a lower price relative to Indian competitors.
• An increasing trend to outsource to multiple providers stemming from the need to lower costs further and mitigate outsourcing risks.
• Closing of the cost arbitrage gap

Hopefully, the Indian CEOs are taking notes.

The High-Wage Paradox - A Closer Look

Its what Deloitte calls the "high wage paradox" - if foreign direct investment (FDI) be perceived as a means to relocate manufacturing production, sourcing and processing, one would expect such activity to increase in the emerging, low-cost countries and decrease in the developed, high-wage countries. However, as the following figure from a recent Deloitte study illustrates, while FDI in high wage countries has remained fairly steady between 1999 and 2002, hovering at approximately US$25 billion per year, global investments in low-wage countries reflect a drop of 83 percent from US$12 billion in 1999 to a mere US$2 billion in 2002.

Deloitte points out that this conversion of capital to expense (through arm's length outsourcing contracts and the like) reflects a failure of the US firms to take direct control of their manufacturing activities. They predict that this shift in the hub of manufacturing activity will be accompanied by an allied shift in the hub of innovation activity, thereby creating competition in the low wage countries that will likely dent the competitiveness of US firms.

Deloitte may well find the solution to the high-wage paradox in one of its earlier reports, "Calling a Change in the Outsourcing Market". More than 70% of the survey respondents in the study cited negative experiences with outsourcing. The financial ramifications of failed outsourcing relationships are pronounced and include an adverse impact on customer value and overall firm competitiveness. These ramifications are aggravated when the process is located offshore and governed through captive units. As outlined in an earlier post, the need to extract value from an asset, a volatile labor movement that disrupts captive operations, and pressure from local managers seeking independence, allied with the frustration felt by headquarters about running a distant unit are some of the factors that adversely impact the management of captive units. Citigroup's recent divestment of its 43% stake in i-Flex Solutions, GE's offloading of 60% of its stake in GE Capital International Services to a pair of private equity firms are responses to such difficulty in management of captive units.

Further, corporate governance and regulatory compliance issues have emerged as significant influencers of M&A activity in the emerging economies. For example, in a recent survey by AT Kearney that assessed the FDI confidence index of various countries (and oh, China ranked first), 30% of investors indicated that corporate governance would pose a risk to their firms' operations compared to 25% who said the same last year. Therefore, M&A decisions are increasingly impacted by factors such as infrastructure, financial and political climate, safeguards for intellectual property and quality control, factors which may outweigh the cost advantage of low-wage countries.

Finally, US firms invest where they've already created assets. The FDI flow mirrors the distribution of accumulated capital stock of the US firms. 61% of U.S. FDI stock is in the top
10 recipient developed countries, whereas only 17 percent is held in the top 10 recipient developing countries. This, of course, is not a causal link, it only emphasizes Deloitte's findings.

As the outsourcing market matures and aligns itself with normative guidelines for design and management of outsourcing relationships, we may witness an increase in investor confidence and a surge in U.S. FDI in emerging low-wage countries. Right now, they're treading slowly.

It bodes well

In an earlier post, I had commented on how Gartner's dire predictions for the Indian outsourcing industry, including erosion of as much as 45 percent of India's market share by 2007, were significantly off-base. The recent € 1.8 billion outsourcing contract signed by ABN Amro with five IT vendors for a period of five years offers initial support to my arguments. First, the surging European demand for IT services will power growth in the Indian outsourcing industry. The growth in Infosys' revenue from Europe of more than 50% attests to this prediction. Industry analysts point out that in the next few years, Europe will likely account for approximately 30% of total revenue of the large Indian service providers, up from the current 20% levels. The bulk of the outsourcing contracts in Europe are still awarded to indigenous service providers. However, that is fast changing. For example, TPI, an outsourcing advisory firm, stated that over 40% of the contracts awarded in 2004, on which it advised, contained an offshore element. Therefore, the predicted growth levels may be revised upward as Europe turns more accepting of the offshoring phenomenon.

Further, I had pointed out that the Indian outsourcing industry may adapt to changing labor conditions such as wage inflation and attrition by outsourcing the business process to the emerging low-cost destinations and developing skills as an integrator who manages a geographically distributed process. This is evidenced in the growing number of acquisitions by the Indian outsourcing firms. For example, Infosys is hiring thousands of workers in Eastern and Central Europe to create outsourcing hubs that sustain strategic advantage by successfully leveraging established standards, processes and systems and emerging low cost labor pools. This also helps to counter wage inflation and attrition problems in the Indian industry. Infosys also is targeting China as a potential pool of talented, low-cost knowledge workers. The company plans to spend $65 million in the next five years to set up software development centers in China and hire more than 6,000 engineers.

This is good news. As the Indian outsourcing industry develops scale and skill in various IT enabled services and strengthens its global delivery model, it may be poised to move up the innovation ladder and marshal the creativity and skills of workers around the world to deliver value. The Indian industry may well craft the future structure of outsourcing services and in a world where the lines between strategy and structure are blurred, it may speak for a strategy for capturing competitive advantage.

I digress

Just picked up Commanding Heights. Great reading - offers very interesting insights into the events and ideas that have shaped the present global economic system. Will write more on this soon.

The Goldilocks Economy...or not?

Krugman, in an off-base slant, informs us that although the G.D.P. of the U.S. is rising, it isn't showing up in workers' wages because it's going to (no surprise!) corporate profits, to rising health care costs and to a surge in executive compensation. Zimran enlightens in his post that although executive compensation in the US may be significantly disproportionate to the value created by executives, it's still a tiny fraction of money compared to total wage payout:

"Even if every executive in the US was paid $0, workers would not get much extra money (last time I calculated that figure it was around $30 extra per year per worker).."

Present other substantiations of the above argument, we might conclude that more plausible reasons for the lack of increase in workers' wages include macro shifts in the world economy and the U.S.'s ability (or lack of) to discern sources of competitive advantage in this shifting economy. Some economists suggest that these shifts speak for a new "Goldilocks Economy" which is not too good, not too bad. For example, India and China have emerged as significant sources of productive capital that enable good and services to be produced at lower costs. So, as a U.S. consumer, while my bonuses and wage raises have been stalled, low inflation rates are not reducing my real wages and the goods and services that I consume are getting cheaper.

While I agree in part with this argument, I still think the "not so good" part of the Goldilocks economy is that the "not so bad" is not being heard. The New York Times grudgingly pointed to the good news in its recent article "Suggestions of Strength in Economy" -

• Last year, the economy grew at an annual rate of 4.2%. Preliminary estimates for the last quarter are approximately 3.4% for the last quarter. This is the ninth straight quarter in which the economy has grown at more than 3%. The NY Times article points out that this was below expectations but heck, while we're applauding the Clinton administration, it compares with a 2.1 percent rate, and falling, in the last quarter of the Clinton administration.
• Record levels of spending by businesses and households have seen depletion of inventory levels, setting the stage for faster economic growth during the rest of the year.
• Real compensation was growing at an annual rate of 2.8 percent when Bush was settling into the White House; it grew at a significantly faster 3.9 percent rate in the first quarter of this year.
• When Bill Clinton left office almost 138 million Americans were at work; this June, that figure stood at close to 142 million.

Not all is well though. Inequality as measured by the gini index, has increased from 40.8 in 2000 to 43.5 (a value of zero represents perfect equality, a value of 100 perfect inequality, or a situation where one individual has all of the income). Add to this a bad fiscal situation, an ailing tax reform, and an unemployment rate of close to 5%. Not so good.

Still, on balance, there's opportunity for trumpeting. And it seems like its not so much a mixed bag - not so good, not so bad. Its more good.

Recovering from failure

One thought floating around in ITToolBox, an IT community where I blog, is that not only are firms unprepared for the transformation that outsourcing brings, they also don't have a sound strategy to transfer failed outsourced operations back in-house. While much has been said on the former, recovering from a failed outsourcing deal is a topic that has received much lesser attention in the business press. Will dwell on this more and post later. Due diligence is an answer but I think we need more on what's an efficient response that mitigates the adverse impact of a failed outsourcing deal on customer value and firm competitiveness.

Its not over yet!

CNN Money has an article on the future (or lack of) of the Indian BPO market. It somewhat echoes my sentiment on an earlier post, viz. that process ownership savings from outsourcing to India may thin out in the face of wage inflation and a labor crunch. However, the article predicts a more dire future - erosion of as much as 45 percent of India's market share by 2007! The article bases its findings on a recent Gartner report which cautions that a host of emerging countries such as the Philippines, Malaysia, and East European nations including Hungary and Poland, are starting to challenge India's leadership in offshore business process outsourcing (BPO). Gartner warns that an imbalance in the labor demand-supply equation, the onset of wage inflation and high levels of attrition are all factors that threaten India's outsourcing industry.

Here's why I think the findings of the report are slightly off-base. First, the Indian service providers have developed scale and skill in various outsourced business functions over the past decade. Further, the Indian firms have acquired an allied reputation and customer empathy that the outsourcing firm must include in the costs of switching to a new provider. If the truth of the positive impact of trust and prior cooperative association on performance of inter-firm alliances be believed, such expertise, reputation and customer empathy are sources of (sustainable) competitive adantage for the Indian firms. Gartner forgot to mention a probable solution. The Indian outsourcing industry may adapt to changing labor conditions such as wage inflation and attrition by outsourcing the business process to the emerging low-cost destinations and develop skills as an integrator who manages a geographically distributed process. This mirrors the American outsourcing phenomenon - after all, although a business process is outsourced to a low-cost location, the American consumer of that process believes he is interacting with the American firm. So too with the Indian outsourcing firm. Therefore, to assume that a decline in the labor force will result in a decline in market share is a simplistic and premature argument.

Second, there is not adequate insight into the coordination costs of BPO relationships serviced by emerging low-cost countries. For example, institutional factors such as mandatory health insurance, unstable political systems, etc. may all add to the labor costs of externalizing a business process to emerging low cost countries such as Hungary and Poland. The incentive structures and work norms in these countries are farther from the US work ways than India, and may require correspondingly more management attention and resources. Third, the Indian outsourcing industry is moving up the food chain and increasingly servicing processes such as R&D, new product development, etc. that are complex and strategically important. This, in conjunction with process innovation, is a timely solution to a resource-constrained market that receives no mention in the article.

Finally, the study focuses on American firms that have outsourced one or more business processes to an external provider. As Europe and other non-English speaking markets emerge as popular client markets, the US-focused Indian outsourcing industry may well shift attention to these markets.

All is not over yet.