Can the outsourcing market provide a glimmer of hope through the economic gloom?

The outsourcing market will continue to grow in 2009, though it is not immune to the downturn. Allie Young writes that both providers and buyers of outsourcing services have to however develop relationships that not only address near-term cost objectives but also factor in longer-term performance improvements and enhancements when the situation improves

Allie Young is Vice President and Distinguished Analyst at Gartner

In the last few months the global economic uncertainty has become so widespread and the path to economic recovery so obscured that ‘cautiously optimistic’ is the most positive position most organizations can muster. With a globally connected economy and intertwined market behaviors that tether multiple vertical sectors to each other, the complexity is almost unfathomable.

In this uncertain and rapidly changing environment, the outsourcing market represents something of a dichotomy. On the downside, organizations’ outsourcing strategies may negatively impact market growth (i.e. IT budget constraints, lower cost deals, and contract renegotiations will occur), but at the same time, the upside is that outsourcing can help organizations to work through financial and competitive challenges. The potential for outsourcing to address immediate cost pressures as well as long-term recovery goals will be unprecedented in the coming months and years. However, only organizations that are diligent about understanding the pitfalls of cost-focused outsourcing and that apply business-outcome-focused outsourcing will be successful.

Looking back at the contracts that have been signed in 2008, many of our points of analysis—contract size, contract terms, vertical uptake, deal type and ‘megadeals’—show continuations of past trends—though admittedly there was some softness in large deal signings, but no catastrophic declines. In part, this continuation of past behaviors is because external forces don’t change the basic drivers of outsourcing—organizations still outsource for cost, efficiency, access to skills, focus on core business, innovation, modernization and even business transformation.

Looking forward, however, things are likely to be less predictable. One thing we can say for sure is that, for the next year at the very least, organizations will be under extreme pressure to cut IT costs. For most buyers, a concerted and deliberate focus will be put on cost-cutting or driving predictability of costs through outsourcing. Some organizations will renegotiate existing outsourcing contracts, and others will sign new contracts focused on reducing costs and getting cash for adjustments.

Unfortunately, because of this focus on low-priced IT services provisioning, some bad deals that have no provision for enhancement or innovation when recovery begins, will also be signed. More first-time outsourcers will fall into the trap of signing long-term cost-cutting deals that will turn into bad deals for both parties within two years. Shortcuts on sourcing strategy development and provider selection will be common. In order to counter-act these trends and avoid unsatisfactory outsourcing relationships, organizations of all sizes must develop sourcing and vendor management competency and invest accordingly.

Another given in the current market is that more requests for proposals (RFPs) will focus on price comparisons and price competitions for deals, particularly for standardized IT outsourcing (ITO) services, where competition will be fierce. In some cases, best practices in sourcing strategy and management will be given short shrift and buyers will be lured by ‘lowball’ pricing from providers trying to make quarterly revenue goals or build market share. In other cases, providers will be pressured to accept low margins for revenue growth and buyers will make decisions based on who will promise the lowest cost. Either scenario paints a grim future one or two years into the deal if the provider’s cost to deliver increases or exceeds revenue and service quality degrades. Providers and buyers must work together to apply sourcing discipline and craft outsourcing relationships that address near-term cost objectives and longer-term scalability and enhancement when growth rebounds.

Undoubtedly, executive scrutiny of IT budgets and internal costs controls will lead many to focus on outsourcing as a means to reduce labor costs. However, risk avoidance will also inhibit some companies from outsourcing, even though they could gain efficiencies from managed services and performance-based contracts with an external provider.

Some areas of the outsourcing market will naturally fare better than others. Gartner predicts that outsourcing of infrastructure, applications and business processes will all increase. However, in the application area, key applications such as critical application modernization and portfolio rationalization may be overlooked to avoid near-term cost with longer-term payback. Similarly, pressure to standardize, virtualise and automate to gain cost-benefits and variable pricing will subtly shift the market away from highly customized environments.

Green IT issues are likely to grow in importance and will no longer be considered discretionary, but green IT initiatives will be fully embraced only if they reduce costs. Alternative delivery and acquisition models (ADAMs) will see a net boost in adoption as a direct result of economic conditions in 2009. ADAMs will increasingly deliver IT services through new approaches such as software as a service (SaaS), business process utility (BPU), infrastructure utility (IU), remote management services (RMS) and Web platform/cloud computing.

Bucking the trend of recent years where the proliferation of service providers has defined the competitive landscape, in 2009, only the strong will survive. Providers that have recurring revenue from outsourcing relationships will have the staying power and competitive edge. As a consequence of heightened competition, merger and acquisition activity will accelerate; targets will be other service providers of all sizes, captive centers of organizations, and tier-II and tier-III offshore providers struggling to achieve revenue growth.

Cash-rich providers will become well-positioned to make strategic acquisitions for technical, vertical or geographic competencies, leading to the potential for India-based companies to take leadership positions among the top-five global service providers.

Indeed, the current environment will establish cost as the necessary competitive condition, regardless of other service characteristics such as breadth and scale, provided by global players, or differentiation, provided by local players. The combination of the restrictive economic scenario and the growing maturity of business process service providers will accelerate the adoption of outsourcing services on a worldwide basis.

As a result, 2009 looks like a good year for outsourcing providers in many developing economies. ‘Chindia’ may well be work in progress and the outcomes are far from determined, but early signs indicate continued positive movements; both China and India are growing individually at the same time that they are growing relationships between the countries. Similarly, 2009 will be the year that the Latin American countries join the ‘offshore’ services race in earnest. Mexico will continue to be an attractive near shore services destination for US organizations although the Mexican economy, being strongly tied to that of the US, will undoubtedly suffer more than other Latin American countries. Conversely, the strong Brazilian internal economy and its broad portfolio of international trade partners will lessen the impact of the economic downturn, making it one of the least affected countries. Near shore outsourcing from Eastern Europe will continue to grow and increased investment is expected in areas such as North Africa.

Overall, wherever you are in the world, the demand for strategic business value from outsourcing will percolate upward as the economic downturn is prolonged. Flexibility is the operative word for outsourcing strategies and contracts because ultimately, outsourcing can never be separated from business goals. To drive the desired results, outsourcing must constantly evolve. Organizations with successful outsourcing relationships will understand where they are in the business cycle and make adjustments. In down economic cycles, cost will be paramount, but when growth returns, organizations and their service providers must be prepared to adjust their sourcing goals.