08/18/08 As companies seek to outsource new areas of their operations—including research and development, engineering design, and analytics—to lower-cost locations overseas, the supply of knowledge-based services is proliferating. That is a good news for outsourcers seeking to plug gaps in their capabilities, but also creates tricky managerial challenges, according to a new report by Booz & Company and the Duke University Offshoring Research Network (ORN).
The study, “Offshoring the Brains as Well as the Brawn,” finds that the number of knowledge outsourcing providers has nearly doubled since 2000, with India now accounting for 50 percent of all services, followed by China (28 percent), Russia (15 percent), and others. In turn, these providers face their own obstacles, with many operators citing shortages of talent and pressure on profit margins as potential risks to their future viability.
Over the past two decades, organizations have sought to outsource many operations, including manufacturing, back-office functions, IT services, and customer support. Now, they are turning their attention to more knowledge-intensive areas, such as product development (NPD), research and development, engineering, and analytical services. This is driven partly by cost imperatives, but also by shortages of talent in home markets and the growing availability of skills in nations such as India, China, and Russia.
However, the attractiveness of knowledge-based offshoring must be weighed against the challenges of locating suitable suppliers and managing operations that are increasingly far-flung and disparate. The report—based on a survey of 120 service providers in India, China, Russia, the US, Europe, Brazil, and elsewhere—illuminates a highly diverse landscape of knowledge-based outsourcing service providers, full of both large and small operators, and an increasing range of specialists. Organizations know that to be successful they need to use the best knowledge workers the world has to offer. But they are also aware that they face significant hurdles if they are to stitch together global networks of human resources effectively.
As the outsourcing of standard business processes and IT services has become commonplace, the margins on such activities have fallen progressively. A process of commoditization has encouraged service providers to switch focus to other activities where profits are potentially greater—including “innovation services” such as NPD, R&D, and engineering. According to the study, there has been 95 percent growth in the provision of such capabilities since the millennium—making the category the second largest overall after IT. Providers of standardized services recognize that they need to focus on efficiency and more seamless client integration if they are to continue making sufficient returns. By contrast, innovation services, including everything from prototype design to credit analysis, are more complex and client-specific, and therefore are more likely to command a premium.
Knowledge-based outsourcing also shows potential on the client side, but only if outsourcers manage relationships wisely. The lack of standardization means that partner vetting is key and that outsourcers need to consider investing in captive or near-captive operations that can be sufficiently customized. That may mean turning to smaller providers, with fewer than 500 employees, that are better able to meet exacting requirements. The study shows that smaller firms, which tend to specialize in knowledge-intensive services, are often more nimble in meeting client demands, are able to recruit personnel with masters and PhD degrees more quickly than large firms, and employ proportionally more such individuals overall.
Large service providers’ traditional “body shop” approach to service provision will not work higher up the value chain. In seeking to emulate smaller rivals, they would be better to treat knowledge and innovation units as standalone entities, giving them the flexibility and autonomy that currently gives smaller firms an edge.
For outsourcers, the process of contracting with multiple small service providers in different parts of the world will be far from easy. As the report notes, many companies are barely able to integrate more standardized processes with their existing core operations. Outsourcing knowledge-intensive activities will involve a whole new level of managerial complexity, potentially upending fundamental notions of how companies see themselves and what they do. Outsourcing vital activities such as prototype design and engineering support will be fraught with risk, with potentially significant downsides. However, organizations will have little choice: the need to identify talent outside home territory will force them to work with partners overseas, whatever the pitfalls.
The survey reveals some of the problems that can arise in outsourcing relationships. Among the top issues cited by service providers are poor transitioning, a lack of skills on the client side, poor change management, and the lack of a clear outsourcing strategy. In order for outsourcing arrangements to succeed, clients need to remain constantly engaged with their service provider. Spelling out deliverables in a service level agreement and then walking away is likely to lead to problems down the line, the report cautions.
Companies that successfully manage knowledge-based offshoring will instead look to create collaborative management models that share responsibilities, risks, and rewards, enabling both sides to reach their objectives. This “co-management” approach will involve outsourcers treating contractors as valued collaborators even in cases where competitors are employing the same company. It will also necessitate joint investment in offshore staff development, helping providers to retain talent and maintain their revenue margins. Clients cannot assume that offshoring will deliver ongoing savings if they do not themselves invest in improving efficiency, quality, and consistency of service.
Knowledge-based offshoring could have significant ramifications on how companies are organized. Rather than multinational organizations with business units staffed by expatriate managers and orchestrated from a central headquarters, the organization of the future will be more globally distributed, with managers seeking out talent wherever it is located, and plugging in capabilities when needed. Unlike the outsourcing of the past, knowledge-based offshoring is not simply about labor arbitrage; it’s also about transforming companies into more nimble, flexible entities.