Upcoming Mallesons seminarsMallesons held a CIO/Senior Technology Counsel Summit in Melbourne on 19 November 2003.
It involved over 20 key technology leaders from the major ASX 100 corporations in Melbourne, with key note speakers being Jeff Smith (CIO - Telstra) and David Boyles (COO - ANZ). The event was co-hosted by TPI.
The open forum facilitated strong discussion and interaction from all participants. The main theme for the discussions was the current state of outsourcing in Australia - particularly prevailing trends in the present phase of mid-term/end-of-term reviews.
The key points highlighted were:
- customers are increasingly focussing on quality and predictability of results over pure price savings;
- end-to-end, business output based service levels and performance measures are increasingly being demanded by customers (particularly in the multi-provider context);
- customers are becoming more sophisticated in supplier selection (eg. looking in detail at a supplier's leadership, personnel and existing customer base);
- off-shore outsourcing (particularly to India) is likely to continue and increase - it is no longer just for major companies;
- mid-term/end-of-term reviews need to follow a careful methodology to ensure the right results are achieved by the customer;
- sourcing relationships need proactive management to ensure the customer’s business objectives and negotiated benefits are realised;
- leading organisations who have chosen not to outsource (for example, if technology is viewed as a core competency), have adopted internally many of the disciplines commonly associated with outsourcing (quality process strategies and clear service definitions/service level regimes internally); and
- regular market-testing is conducted by most successful customer organisations - to ensure supplier/internally provided services continue to be market competitive.
Similar events are planned for Canberra and Sydney next year.
Quentin Lowcay
Senior Associate
T +61 2 9296 2080
quentin.lowcay@mallesons.com
Benchmarking clauses have been included in long-term IT services agreements from their inception. However our experience with the use of these arrangements shows that benchmarking is often not used strategically to best effect, and therefore seldom delivers what customers expect.
The rationale behind benchmarking
Benchmarking is the ability for a customer to go to the market (usually through employing an independent third party analyst) to test the pricing / services / service levels under their current services or sourcing contract, against what is generally available at a given point in time.
The pricing / services / service levels are then adjusted, or a process is entered into to agree a path to reset the contract to a market level.
It is usually argued that customers need to have this right in long term services and sourcing relationships, as the deal that was signed three or more years ago is unlikely to keep pace with current market practice. Changes to technology, to the customer's business needs and even to the supplier's risk profile (as the supplier will now know the customer's environment and requirements intimately), may mean that the original pricing for services to be delivered, and/or service levels (including any service credits) and/or general delivery of the services themselves, should be revisited.
Effectively, it is the ability for the customer to re-open the contract and adjust certain levers to keep it market-competitive.
Benchmarking problems
This potential re-opening of the pricing of existing arrangements is the foundation of problems that arise where benchmarking is used inappropriately.
The dynamics in technology generally mean that the cost of providing most IT services either reduces over time or the services improve in quality/reliability. This coupled with new technologies continually emerging, means that suppliers who have developed a cost structure and pricing model to provide certain services, usually find that the market (especially with new entrants or technological advancements) now has a lower cost base or improved service offering over time. It is not just fixed pricing elements that are affected - the supplier will have costed its variable pricing components on an assumed pricing model which will now simply not hold true.
The supplier is faced with a dilemma. Do they incur the capital expenditure of new technologies and write-off previous investments in existing infrastructure?
Not only will the supplier be left with their existing cost structure (plus the additional cost to move to new technologies to provide lower costs/increased quality/improved functionality), but the revenue will also decline if the benchmarking exercise results in the supplier having to lower their pricing.
Another problem is the re-opening of service levels or service delivery. Again, the supplier will have developed and costed a method of delivery to a certain standard. This will involve assumptions over staffing numbers, skill sets and refresh cycles. If this is then 're-calibrated' to market, the supplier is then faced with a requirement to significantly change its operational model midstream - again without any additional funding from the customer.
Supplier behaviour
A benchmarking approach that requires a supplier to bear all of these legacy infrastructure costs and to bear the cost of investing in new technology to receive less money, or simply reshape their delivery or quality of service without compensation, is fundamentally flawed and doomed to failure. In those circumstances, it is in the supplier's interest either to delay the benchmarking process itself (so the customer loses interest) or attack the components of the process (how the benchmarking is actually conducted).
Benchmarking requires both parties to work together - even if only to discuss or implement the end results. Suppliers can drag the consultation or implementation process on for months (even years) to effectively wear down the customer.
Another tactic by a supplier is to attack the benchmarking itself. Who is the benchmarker, are they really independent? Is the benchmarker in fact an organisation that sells consulting services in competition with other suppliers, so their independence can be questioned? Is the benchmarking taking into account all relevant factors? Legacy infrastructure is often inherited or special service or operational circumstances exist that need to be considered by the benchmarker. Is the result a true 'like for like' comparison? Very few complex environments can be easily mirrored elsewhere.
This debate about the benchmarking procedure can delay the process or put the results into dispute - increasing the costs dramatically or limiting the effectiveness of the whole procedure.
Customer behaviour
For these reasons, a customer that wants to use benchmarking simply as a mechanism to drive down price or improve service delivery will find it a costly and frustrating process. Benchmarking is expensive and time consuming even with a co-operative supplier, let alone with an un-cooperative one.
Exercising a benchmarking right in these circumstances is a sign that the customer is dissatisfied with the services or wishes to be reassured as to value for money. That is, the parties are already diverging. In our experience, few if any customers do not already have a good idea of whether equivalent or better services can be obtained in the market more cheaply.
The answer?
Benchmarking is expensive and time consuming.
An automatic adjustment following benchmarking simply will not work for any supplier with a committed or inherited cost base. It is also unlikely to be agreed to in any event.
A simple 'agreement to agree' statement means nothing - and having a third party impose solutions in the event of a dispute just replaces one benchmarker's opinion with another.
Benchmarking is really all about re-opening negotiations. Clearly the customer is not happy, and a commercial solution should be jointly worked on. If the parties cannot agree, then those 'uncompetitive' services should be provided elsewhere or brought back in-house. If the services simply cannot be 'pulled apart', then termination may be the only option.
Alternatively, the parties could agree to share jointly any variations in price, or jointly fund any service delivery/quality improvements. This would be an equitable result where the market has simply moved, but the relationship is still strong and otherwise working well.
In our experience, benchmarking rarely delivers what it promises. We have seen many situations where customers have exercised their market power to renegotiate the relationship - whether through mid-point reviews or just out of the need to re-shape the deal to meet business requirements.
Benchmarking has in many instances produced results that are controversial. This detracts from the real message of the need to have a general review and re-open the foundations of the relationship.
Maybe it is time to own up to the fact that benchmarking simply is not guaranteed to work for technology services contracts.
Quentin Lowcay
Senior Associate
T +61 2 9296 2080
quentin.lowcay@mallesons.com
The hype
We have all heard the hype about how offshore outsourcing can save you a fortune. It is no wonder that offshore outsourcing is the fastest growing IT segment globally. Meta Group Inc, predicted that offshore will grow more than 20% annually pushing it to a US$15 billion industry by 2005.
India has led this move offshore, and is at present the logical choice for those looking not only for cost saving benefits, but also quality improvements. Over the last couple of years, a number of multinationals such as HSBC, DHL, Standard Chartered and GE have outsourced their back office functions offshore to take advantage of a large supply of quality workers at low cost in India.
Recent figures for Australia from Gartner, show that while only 2% of Australian firms have taken the leap offshore with their development and integration work, this still represents a market slice of US$47.52 million - shared by only five Indian firms. The potential market in Australia for such development and integration work is US$2.376 billion (according to Gartner).
Deloitte Consulting estimates that within 10 years, three quarters of leading financial institutions and investment banks globally will allocate tasks to developing countries - with India at the top of the list.
Our own experiences confirms that this cost driver is paramount, but price is followed closely by the need for high quality and access to well developed processes.
Australia - the trend towards offshore
Australia has a unique set of factors pushing corporates to adopt the offshore model. First, by going offshore, Australian companies will have immediate access to the latest breed of infrastructure and well-developed business processes from leading international organisations (derived from the other customers of the offshore suppliers). Such opportunities are either not available domestically, or the capital cost cannot be justified in the Australian market.
The second main feature of outsourcing in Australia is the considerable time-lag in relation to the more mature markets in the US and Europe. Generally, Australia follows trends in key global markets with a two year delay.
This means that Australia is just at the verge of the offshore trend, and corporations here can benefit from the last two years of actual experience by US and European companies, possibly avoiding many of the pitfalls experienced by their overseas counterparts.
There have been a large number of major Australian corporations to follow the worldwide trend to send business offshore to obtain the infrastructure and business process advantages offered by countries such as India. However, only a small number of deals are ever made public - perhaps due in part to client concerns over potential 'PR' damage inflicted on corporate image by sending jobs abroad. Insurance Australia Group is one of the latest groups to send its software development work to an Indian company, Phonex Global Solutions, to develop a new application for the insurer. Telstra has also joined the ranks by using Indian based Infosys Technologies for full range outsourcing services (including software development).
Not unexpectedly, at the time of both announcements in Australia, unions, commentators and politicians voiced predominantly negative opinions about these business initiatives. That being the case, why did these companies still decide to go offshore?
True perceptions
Is offshore outsourcing a phenomenon based on facts and economics, or hopes and dreams?
Cost pressures top just about every company's list of reasons for sending business processes and developments offshore. IT labour rates in India and elsewhere are claimed to be as much as 70% - 80% lower than those in Australia and the US/Europe.
But as we have seen, an equally compelling reason is the quality of the work. In one commonly used offshore model, foreign IT workers are not contractors but employees of the home based company. They receive the same training, use the same software development tools and adhere to the same business processes as their IT counterparts in the home country. It is as if the company had set up a branch in Bangalore. The deciding factor is the lower cost and disproportionately high quality return for the company. This is the model adopted by ANZ. Another example is GSX in the US, which estimates that by shifting 70% of GXS' internal IT projects and 40% of its IT work on customer applications offshore, it has saved about US$16 million a year in the past three years.
A common example of the quality control processes which are possible in India is in offshore data entry services. In some Indian operations, two sets of data entry operators enter the data. Each operator enters the data independently of the other - any discrepancies are then immediately identified and corrected. Such physical duplication to eliminate errors cannot be justified in Australia due to the expense of our labour.
Another quality assurance aspect is the high certification of Indian programmers. 85 Indian companies have acquired the prestigious SEI CMM Level 5 assessment - out of only 127 companies worldwide.
We have seen many development services go offshore for this reason - especially if the output is required to work to global certification standards for multi-national Australian corporations.
As Australian firms base their executive incentives on financial and performance objectives, it is a logical move to look to India as a solution to both objectives in difficult economic times.
Of course, the offshore model would only be possible if large amounts of bandwidth were available on global networks. Thanks to the increased stability of network infrastructures and communications services, plus a large over supply of global capacity, bandwidth requirements can be met - all helping offshore's take-up among major corporates. Offshore services can be delivered cost effectively, efficiently and at a high quality, which adds up to an unbeatable value proposition.
On the surface, it all sounds too good to be true. It seems to make economic sense, but will the economic arguments hold in the long term?
Reality bites
As attractive as it seems, it's not all pappadums and mango lassies. Outsourcing in India, like outsourcing in any other country, has some serious drawbacks and risks that need to be effectively managed to realise any benefit at all.
Choosing a Model
No IT model would be complete without numerous variations on the theme. The same is true with offshore. Australian corporates can choose a variety of flavours:
- pure offshore: using a solely offshore based supplier with the work being performed there and then shipped back (the Y2K development centre model)
- onsite-offshore: creation of a satellite operation offshore for the customer - working alongside, or in the supplier's premises (the customer branch model)
- onsite-onshore-offshore: presence of the supplier locally in-country as the prime interface with the customer, with the bulk of the operations being performed offshore (the supplier branch model)
In the UK, our experience has been that the most successful model is the third model - allowing specifications, processes or work flows to be properly understood, and then developed offshore. The customer has the added comfort of dealing with the supplier in its own environment.
In Australia, for large scale developments of existing offshore products, we have seen clients adopt an onsite-offshore model very successfully. However, this only works if key personnel also spend large amounts of time offshore to truly establish a local presence and build a relationship of common understanding. It is not a 'fly-in, fly-out' proposition.
Both the latter two models (if properly implemented) allow for a high degree of interaction between the supplier and customer - essential in all successful outsourcings because it establishes and builds a relationship. The first model is by far the riskiest, effectively creating a straight supplier/customer role which has historically caused the highest level of failures in outsourcing transactions.
Selecting a supplier
This is key. Like all outsourcings, it is vital that a supplier is selected who clearly aligns with your business philosophy today - and is likely to continue along the same lines tomorrow. A relationship is needed - it is not a box-drop, or an over-the-counter purchase.
As few Australian firms have Indian sourcing experience, either the use of one of the five 'mega-firms' (Tata Consultancy Services, Infosys Technologies, Wipro Technologies, Satyam Computer Services or HCL Technologies, or use of an intermediary (such as neoIT), are the only realistic choices for contemplating an offshore relationship. This has certainly been our experience to date.
Still, as with any outsourcing, a competitive selection process should be adopted to ensure the potential vendors understand your business needs and can provide a cohesive and cost effective solution that stands up to business scrutiny.
In addition, the customer's need to conduct detailed due diligence in the offshore location can add significant travel costs and time to the offshore option.
The cost of vendor selection is estimated to be around 1-2% of the total deal.
As growth continues in this area, the outsourcing market in Australia becomes more sophisticated. Choosing a supplier will become easier as suppliers will have increased their market reputation in Australia or Australian companies will have had more experience in handing over processes and projects offshore.
Cost of transition
The transition period is perhaps the most risky stage of the offshore process. The risks of transition in a local outsourcing are amplified by distance and culture in the case of an offshore outsourcing, and the fact that very few staff will transition over to the supplier. Retained knowledge cannot be relied on, and so transition planning is key. The same common sense rules apply, they just assume greater importance in an offshore context.
Like any outsourcing, it is vital to identify all competencies, roles, people and knowledge that need to be retained. All critical decision-making activities should be kept in-house, as well as developing (or acquiring) vendor management/integration management skills.
A comprehensive transition plan also needs to be developed - with timelines and milestones. Part of the plan needs to address the labour impact - cost of redundancies/relocation options/ redeployment strategies. This labour cost can be significant in the offshore model, as few (if any) staff are required to transition to the offshore supplier.
Also, a feature of transition could be the establishment of the local branch offshore. This may involve licensing/consents from government, establishing physical facilities/infrastructure (including importing componentary), banking arrangements and network connections. Often many costs are only discovered once you are on the ground locally.
Overall, we have seen transition costs anywhere between 3-5% of the total transaction value.
Productivity costs
Labour rates are clearly far lower in India. A recent example is a US$100 per hour database operator in the US currently only costs US$20 per hour in Bangalore for the same experience and quality level.
Still, even though analysts state this means a 70-80% saving, most US firms after several years of experience are only realising 20-30% savings.
While not insignificant (probably a 20% saving would support the move offshore anyway), factors such as lower productivity offshore need to be considered. In regions where labour is 'cheap', over-staffing is endemic. There is simply no incentive to create an efficient use of labour to further lower costs. Generally, many Indian operations have 20-30% higher staffing levels than would normally be expected in operations their size.
The need to ensure that specifications or requirements are clearly understood in a different culture can also require more face-to-face interaction than initially expected (leading to travel and time costs). There is a cultural difference in how we work - an Australian programmer may challenge a product's direction and suggest quicker alternatives, while in India work might only be done to specification, with no incentive to offer more efficient alternatives. Overall, this difference in approach can lead to cost and time increases. In our experience, all of these issues need to be identified early and managed for the company to get the most out of the offshore outsourcing.
Cost of managing the offshore services
The distance involved in an offshore solution may mean that any problems with your service provider are not simply fixed. Resolution may require an 18 hour plane trip to your offshore facility. Travel in India can be very time consuming, with the additional health and security risks, frustrations and delays. There is also the cost of maintaining an on-the-ground facility, if the customer is using the onsite-offshore model. This can be a significant cost, and hard to budget for, as it is a new activity for most organisations.
Certainly, vendor management is critical - as with all outsourcings. However, as the IT capability in India is at a very high standard, firms in Australia may find themselves having to raise their own internal technical standards to properly interact with the Indian supplier. The cost and time delay in doing this has been an unexpected, yet considerable factor for some US corporations.
Organisations like DHL in the US have found that the role of managing the offshore supplier is between 6-10% of the transaction value. We have found similar or slightly higher numbers for Australian corporations.
Intellectual property
IP risk can be a critical factor in assessing whether to go offshore.
While the Indian government has instigated many import, tax and regulatory concessions in the IT sector to encourage foreign involvement and investment, software is still protected as a literary work under the equivalent Copyright Act in India.
As in Australia, this means only the expression of the idea is protected - not the idea itself. This allows re-expression of the idea, or recreation of the technology from scratch. This is a very real possibility in a country with highly skilled, yet 'cheap' labour.
While you may be no worse off than in Australia in terms of legal protection, if processes or procedures are outsourced, then over time the supplier will change these to make them more efficient. Who owns these 'improved' processes? Also, if a customer is migrated onto the supplier's processes on transition, who owns these processes at the end of the relationship?
All these IP issues need to be properly addressed in the outsourcing contract - as with any outsourcing arrangement.
Other legal issues
Australian corporations should carefully consider whether they want Australian law or Indian law to apply to their outsourcing. As the Indian legal system is complex, it may be easier to use Australian law - which should be upheld as the applicable jurisdiction by Indian courts.
However, this choice of law only works if one of the parties is non-Indian. Structuring the deal with appropriate companies from the customer group (i.e. not local Indian subsidiaries) is therefore important.
But there is a real risk that courts in India are not obliged to enforce judgments from Australian courts, as India has not enacted the necessary legislation to provide for this. This would mean that for an Australian corporation outsourcing to India, if there was a dispute and this went to court, any resulting judgment in Australia may not be enforceable against the supplier in India.
It is therefore critical to get legal advice from the outset, and to make an assessment of what assets are available to be claimed against, either locally in Australia, or elsewhere (eg, in the US or UK where Australian judgments can be enforced).
Political backlash
In Australia, UK and US, offshore outsourcing has become a political issue. Foreign workers taking jobs at the expense of workers at home is an issue that has plagued most industry sectors at some stage in history.
Domestically, companies that engage in offshore outsourcing are seen as 'un-Australian'. In the US, state governments have debated and passed legislation prohibiting the practice (for example, Washington, Connecticut, Maryland and proposed in New Jersey). Lobby groups are working on US Congress for a Federal equivalent.
This backlash can affect the market reputation and sales of a corporation moving to an offshore model - reducing the value of the potential savings through a domestic boycott of that company's products or services.
Coupled with the impact of redundancies (in terms of cost, labour disputes/claims and impact on the productivity of 'survivors'), this may mean that the implementation of an offshore solution could itself be detrimental to an organisation overall.
To date, we have not yet seen a major swing against offshore solutions in Australia, but this is not surprising given the current low level of Australian jobs affected. We believe as offshore outsourcing grows, Australia will track the US in terms of public reaction.
Geopolitical risk
War, terrorism and political unrest can severely impact the ability of your supplier to operate. After September 11, many Indian based vendors introduced business continuity capabilities, ensuring call centre and development facilities were opened in other countries throughout Asia.
However, as the recent Pakistan/India escalation in tensions showed this year, as the region is less than free of stability concerns. This could undermine the choice of India as a location almost overnight if hostilities break out.
Conclusion
The fact that over 200 of America's Fortune 500 companies are now actively involved in offshore outsourcing, is a figure too large to ignore. The offshore model has the potential to provide tremendous financial benefit.
However, there are real issues to be considered and companies need to ensure proper evaluation and assessments are conducted to minimise the hidden costs and risks.
Like all outsourcings, offshore needs to be very carefully entered into after a proper period of evaluation and due diligence. A long-term relationship needs to be created in an environment foreign to the customer.
Offshore outsourcing is not going to be the right option for everyone, but for those who learn from the mistakes of others, it should be a successful Eastern adventure.
Quentin Lowcay
Senior Associate
T +61 2 9296 2080
quentin.lowcay@mallesons.com
You're negotiating with a US vendor for a complex software development.
In response to the unwillingness of the vendor to give strong warranties around functionality, you propose a standard, staged acceptance test. Full acceptance will only occur after detailed tests have been passed. The vendor says "Well, we'd love to offer that, but we can't. The problem is accounting standards. We just could not recognise the revenue."
Have you ever been in that situation or know someone who has? Ever wondered what the vendor is talking about, why it is important and more crucially, should you accept that line?
Accounting - the root of evil?
Love it or hate it, accounting is the language of business. And accounting standards are the spelling and grammar rules that you have to follow.
Under US accounting standards, revenue cannot be recognised until it is certain. For a vendor this means:
- you have done the work asked for;
- you are entitled to be paid; and
- you are in fact likely to get paid.
The problem is in the IT world, sometimes these things are not all present at once.
Take acceptance tests. In IT, it is common that no payment is due until the tests are finally passed. This is despite much of the initial the work being done, and only the rectification still to be performed. In IT terms, as the customer has not received the end deliverables to a satisfactory standard and meeting the specifications, payment is deferred until the faults are rectified by the vendor. Unfortunately, this means under US accounting rules, the vendor cannot account for the revenue until the tests are indeed passed (if at all).
Why is this important?
The fact that a US vendor cannot "recognise revenue" would not cause many customers to lose sleep. But it does have a consequence for the vendor. US vendors typically report quarterly on the number and value of deals signed. The US market then values the worth of the vendor by its pipeline of work. If a deal cannot be recognised until the passing of acceptance tests or completion of some other criteria, then the deal is not valued until that point. The vendor suffers.
But are the vendors right?
US vendors claim that the inability to recognise revenue means that acceptance tests can't be set up in such a way that the customer is not obliged to pay for work that does not pass those tests. Vendors would rather say that the fixes will be done for free later, but the customer's obligation to pay exists now.
In essence, we are only talking about a timing difference - the delay between performing the work and the passing of an applicable acceptance test. If the vendor performs as required, then they will get the revenue - only slightly later.
The second point to note is that by simply restructuring the payments into milestones, the whole issue can be avoided.US accounting for construction contracts have for a long time recognised that a "percentage of completion" method will allow revenue to be recognised depending on how complete a project is.
In the IT world, this has translated into milestone payments. Progressive revenue can be recognised as the milestones are achieved - one being the passing of acceptance tests for a software development, but several may be earlier stages.
Result?
This approach of using milestones will allow progressive revenue recognition - depending on the nature of the milestones themselves.
So, a US vendor can recognise some of the revenue in stages - but importantly for the customer the balance is withheld until the vendor actually achieves the final task. This means the customer is not obliged to pay until they actually receive what they have contracted for.
A well-structured pricing schedule, and honest discussion of where each party is coming form should resolve this "revenue recognition" issue.
And accountants are not even to blame.
Quentin Lowcay
Senior Associate
T +61 2 9296 2080
quentin.lowcay@mallesons.com