Karvy Global  | Newsroom

JULY 2006

Bridging the Great Outsourcing Divide

By Phil Fersht, FAO Today - Finance & Accounts Outsourcing, July, 2006

Having spent the last 12 years with a foot in both the HR and F&A worlds, I have been staggered by not only how different the issues and attitudes are among both sets of buyers, but also the strategies they pursue. However, when we look at the current health and state of both industries, it is apparent that FAO is beginning to enjoy a high percentage of deal successes, vendors are finding the experience more clean-cut, contracts are more profitable, and the industry is becoming very attractive to investors.

The HRO industry has faced a bigger struggle. When dealing with a company-wide outsourcing initiative that affects the lives of all employees and managers across the whole organization, you are already fighting an uphill battle to win the hearts and minds of early buyers. HRO service providers have been battling intensely with each other to deliver immediate cost savings, improved employee care, and common HR standards that they can deploy across their existing and future customers. The results are wafer-thin (and some negative) profits, skeptical Wall Street analysts, and a tough sell to investors that HRO vendors need to invest in clients today to build leverageable delivery models for the future.

DIFFERENT APPROACHES
Two delivery models are evolving to combat these growing pains: mega, global deals in which major outsourcers absorb the initial costs and offset them against other revenues, namely systems integration, application management, and consulting; and mid-market deals in which providers bring customers onto their pre-configured delivery models. Fig. 1 details how the HRO market is evolving into this dual model.

FAO, on the other hand, has experienced a very different growth path. Its growth has been slower in total dollar terms than HRO and is now reaching a rapid-growth phase. Fig. 2 details how it is set to outperform the HRO market this year, with an estimated 49 new multi-process FAO contracts expected.

The reality is stark: FAO buyers and suppliers simply don’t suffer from transitional and financial issues endured by the HRO industry due to a number of factors:

• Most Tier 1 FAO providers target both segments. In fact, 27 percent of recent deals have been with buyers in the $1 to $5 billion revenue category, dovetailed with a swathe of deals at the high-end. When we analyze these deals, we can see the “Big 4” of IBM, Accenture, Genpact, and ACS very active in both deal segments, with Cap Gemini, Xansa, and Progeon (Infosys) also very prominent.
   

• Barriers to entry are lower in FAO. The industry is witnessing a very level playing field across the established global outsourcers, upcoming Indian vendors, and specialists. Because FAO is more clean-cut, transactional, and easily quantifiable, it has opened the door for providers such as Tata Consultancy Services, Wipro, WNS, Progeon (Infosys), SourceNet (Mellon), and EXL to compete for global deals.

We are even seeing aggressive suppliers such as Karvy Global Services and Office Tiger (RR Donnelly) getting a seat at the table with some buyers. EDS also is entering the fray with its bold acquisition of Mphasis, which is surely being primed for an aggressive FAO move in the medium-term.

When we look at how HRO has evolved, it simply has been a survival of the biggest at the high end, with a host of service providers who never got off the ground. Accenture is building critical mass with global deals, while making an astute mid-market play with Savista. IBM is still in the game and hoping to build its global portfolio of clients in the coming months. ExcellerateHRO has finally revitalized its client portfolio with the recent Cardinal Health contract, and Convergys has stuck its neck out with its DuPont deal and other recent client wins. Hewitt is now under the microscope with its recent management upheavals due to operational issues with its HRO deals, and ADP is waiting in the wings to make some high-end plays. Many other providers who dipped their toes in the water and didn’t like the temperature have disappeared as quickly as they entered. Some still haven’t taken the plunge.

FAO is industry-specific, whereas HRO is a horizontal solution. When we look at the order-to-cash and procure-to-pay processes within buyers, they are typically unique to industry type. It is no coincidence that WNS, which was formerly the F&A services arm of British Airways, now has several travel industry clients using its F&A process offerings, underpinned by a technology platform.

Similar buyer adoption can be seen with Accenture’s client base in the energy sector, Capgemini’s in manufacturing, Progeon’s focus on high-tech/telecom, Genpact’s in financial services, ACS and IBM fixated on manufacturing and retail, and Perot’s in healthcare. The list goes on.

The key takeaway is that FAO service providers are building leverage points across their clients due to “like” processes and common standards. When you examine the future strategies of many of the FAO providers, it is often to move along industry value chains by partnership and acquisition, rather than buying out the nearest competitor for more market share.

HRO processes tend to be more unique to individual companies and are much harder with which to develop common standards. In areas such as recruitment and compensation, there are many common leverage points across similar organizations. However, these processes only form part of a much larger portfolio that includes payroll, benefits administration, and relocation, which tends to be more customizable offerings at the high end.

We see some areas of HRO—recruitment, for example—becoming standalone industries (RPO for example), as there are too many integration points within HRO for a single vendor to cope with. Bottom-line: Where an HRO strategy typically involves more than 20 very unique processes difficult to integrate, FAO engagements typically involve mainly accounts receivable, accounts payable, and general ledger processes, which are much less complex to integrate, are more tied to the ERP, and more easily tailored to a specific industry. Moreover, we increasingly see payroll being built into FAO deal structures, as it is typically tied to ERP process and tends to report into the finance function within most European organizations.

REASONS FOR OPTIMISM

FAO is a $2 billion market, growing at more than 30 percent with lots of legroom. Cumulative annual contract value of full-service FAO contracts—a useful measure of FAO market size—is currently around $1.8 billion, with a consistent growth rate of about 30 percent (CAGR of 30 percent from 2001-2006). The number of known, “live” FAO contracts—another useful measure of growth—has more than doubled in the past 18 months from 70 to 160. Further optimism stems from specific data points that show demand is increasingly driven by customer pull and not just by vendor push.

Multiple factors support continuous and sustainable growth of the full-service FAO market at this high-40-percent growth rate:

• Ample room for growth. Current penetration rates are still very low and provide ample room for growth. For large-cap companies, multiplying an assumed average spend of 2.1 percent of revenues on F&A by the aggregate S&P500 revenues of $7.8 trillion, and assuming only 25 percent of F&A can be outsourced, the large-cap FAO market is more than $40 billion1. For mid-market companies, FAO opportunities could reach $100 billion during the long-term. Even if the current FAO market continues to grow at a 30-percent rate during the next 10 years, the resulting $27 billion is still significant.
   

• Mid-market enterprises are the new Wild West! While the FAO market was pioneered by Global 100 companies, it has quickly expanded to Global 500 and more recently to even smaller organizations, with employee sizes as low as 5,000. While enterprises with more than $5 billion of revenues still represent approximately 80 percent of total FAO contract value, about half of new FAO deals were signed with customers reporting $5 billion or less in 2005 revenues, up from one-third of the deals in 2003. The mid-market presents an exceptionally attractive opportunity, due to both size (number of mid-market companies) and the attractive one-to-many economics achievable with smaller customers (who are less prone to require customization).
   

• Compliance and transparency are king. Increased regulation (e.g., Sarbanes-Oxley) and shareholder demand for transparency are strong drivers for both public and private enterprises to standardize their finance and accounting activities, provide third-party management of those activities, and allow for best practices in financial management and reporting. While initial compliance requirements kept CFOs busy and unable to focus on F&A outsourcing, now that the regulatory environment has stabilized, compliance and transparency have turned into a driver for FAO adoption.
   

• Added value is available. As processes and technology mature, BPO vendors increasingly are able to offer value beyond just cost cutting. In addition to compliance and reporting, adoption of standard tools, processes, and best practices can offer additional demand-driving benefits such as reduced working capital (through better management of cash and receivables) and reduced operational and financial risk. For example, by making order-to-cash outsourcing more efficient, customers cut the number of day sales outstanding and shorten the cash-flow cycle and reduce revenue leakage.
  

PROFITABILITY OF FAO MARKET

Several factors stand to allow FAO to be significantly more profitable for well-positioned service providers than HRO. These factors include:

• BPO is more likely to enjoy one-to-many economics, especially in the expanding mid-market segment. Many finance and accounting standards and practices are more common than are HR standards and practices (beyond payroll) across customers. This enables FAO vendors to deploy a common platform across multiple customers, provide less customization work than HRO, and enjoy the resulting one-to-many economics. In addition, many F&A functions are based on standard ERP products (more than 75 percent of FAO contracts have packaged ERP systems as the underlying technology, with one ERP vendor—SAP—leading with nearly a 40-percent market share). This fact further reduces the amount of customization workload. Moreover, F&A functions are naturally easier to integrate (e.g., an accounts payable transaction is easily translated into the required accompanying entry in the general ledger), much more so than HR-related functions.
   

• FAO deals are based on relationships between an outsourcing vendor and the finance department of a buyer. In FAO relationships, the interaction is typically between the service provider and the personnel within the finance department and, in some instances, procurement. Overall, it is less complex for service-level agreements and accountability metrics to be built into contracts. The outcome measurements are easier to quantify, and the overall governance of the contract is simpler to administer than typical HRO contracts. HRO usually affects the entire staff within an organization, and many of those deals are challenged from the onset as a result.
   

• FAO economics are driven more by labor arbitrage. FAO profitability will continue to be more attractive than HRO as its economics are driven more by labor arbitrage, as opposed to being driven by technology and automation; this simple fact provides more room for vendors to enjoy attractive margins (financial transactions rarely have intense or intimate customer interaction that HR processes have, making them easier to send offshore). Of all FAO contracts, 73 percent have a significant offshore component. Technology transformation is becoming increasingly crucial with FAO deals, but this is more from a perspective of vendors developing “tie-and-run” capabilities to enable the smooth transition of F&A processes to the service provider through wrap-around technology that builds on existing ERP.

KEY LESSONS FOR THE HRO INDUSTRY

There is no doubting the fact that most HRO engagements are considerably more complex and sensitive than those in FAO. However, there are some simple lessons HRO buyers and suppliers can learn from the current success of FAO to set expectations for buyers.

• Keep it simple from the outset. HRO has been positioned as a major strategic game-changer for companies. Focus on the transactional processes first—namely payroll and benefits administration—where buyers can take advantage of cost savings through labor arbitrage. And there are technology platforms available that can facilitate an HRO engagement without enormous complexity. Once the first transitional phases of HRO have been accomplished, the buyer can focus more heavily on aligning its retained HR organization with the corporate goals. FAO is positioned primarily as a cost-reduction play, with the issue of achieving quality service as a differentiator between suppliers.
   

• Define stakeholders effectively and execute early transition phases with extreme diligence. HRO can negatively impact an entire organization if the relationship between the service provider and the buyer’s governance team are not well-defined. This is particularly the case during the early transition phases post-transaction. Areas of impact such as the introduction of self-service tools and high-touch offshore employee care representatives need to be managed and communicated extremely diligently. HRO service providers need to work harder with their clients to help them through these early transition issues of HRO. Third-party advisors can help, but the service provider should expect to invest more attention and resources in ensuring the early transition phases are effected with excellence.
   

• Get the economics right. The industry has seen close to 140 multi-process HRO deals to date, yet we are still witnessing many leading suppliers struggle to achieve positive returns from HRO contracts, coupled with the poor publicity of trying to manage highly complex operational issues. There have been enough test cases out there for suppliers to start getting the balance right. The FAO industry has experienced a similar number of contracts, but has got its act together much more quickly, largely as a result of the contracts being smaller, and less complex. That said, there are enough benchmarks to get the economic fundamentals of HRO correctly balanced. That leading providers are taking a more cautious approach to taking on new business is an encouraging sign. Let’s hope the industry has turned the corner.