A New Metric Compares Suppliers; Currently the Indians Are Winning | Article

indian business man kneelingTraditional American outsourcing service providers, watch out. A new research study by Katzenbach Partners says the “old standbys” are no longer “the safe bet” for buyers looking to outsource their information technology. “India is here to stay,” says the August 2005 study.

The study, using new capital markets research, found that the major Indian suppliers “are positioned to serve clients better and be tougher competition than US-based outsourcers anticipate.” It predicts the American legacy players “may disappoint” their buyers in the third or fourth years of their IT contracts, while the Indian players–Infosys, Wipro, Satyam Computer Services, and Tata Consultancy Services–“will have greater market incentives to consistently serve customers and make good on promises” during this critical period in the contract.

The bottom line: Indian outsourcers “could ultimately lead on a global basis, potentially unseating such giants as EDS, CSC, Capgemini, Unisys, Perot Systems, Accenture, and BearingPoint,” according to Katzenbach Partners.

Using the Relative Value of Growth Metric To Analyze Suppliers

Dr. Nathaniel Mass, a Katzenbach Fellow, developed a new corporate performance metric called the Relative Value of Growth (RVG). RVG determines the degree the capital markets reward a company for growth and/or margin improvement. The metric compares how much extra shareholder value one added point of growth creates against that created by one added point of profit margin improvement.

Mass first came up with the idea while working at Proctor & Gamble (P&G), a company focused on growth that achieved a 7.2 RVG. That means P&G would have to increase its operating margins by 7.2 percent to achieve one more point of growth.

Mass said his quest started when he tried to determine what an extra $200,000–.05 percent of P&G’s revenues in top-line growth meant to P&G. Senior management guessed the extra income would get lost in the rounding, but Mass discovered that relatively minor sum was worth $7 billion in market capitalization. The proverbial light bulb went on. “The RVG has been a contributor to P&G’s thinking. The company believes it can increase shareholder value if it grows in a smart way,” he explains. He says Indian companies are also growing “in a smart way.”

Mass found capital markets “handsomely reward” companies with high RVGs. These companies also tend to have strong profit margins. “The incentive to grow is overwhelming, even if you have to compromise margins,” he maintains.

He found companies who come to the capital markets boasting margin improvement tend to have inferior profit margins and may realize less pronounced gains in shareholder value. This happens because of the complexities of trying to deliver cost improvements within the context of long-running customer contracts.

Mass, who published his research in the April 2005 issue of the Harvard Business Review, created a graph of 20 companies he calls the “Corporate Growth Parade.” It’s a bar chart which shows corporate RVGs of key players in an industry along a spectrum.

Dr. Richard Schroth, another Katzenbach Senior Fellow who is an outsourcing and technology expert, wondered how the other American outsourcers would fare on the Corporate Growth Parade, since “they are so extraordinarily margin-focused,” he says. He asked Mass and his team to do a parade chart comparing Indian and American outsourcers. At the bottom was EDS, which scored 0.8, a very low RVG.

The Corporate Growth Parade

How the Two Groups of Suppliers Stack Up

Mass found the majority of Indian suppliers had RVGs above 20, which is “extremely high,” he says. “I have seen only a few pharmaceutical and some software companies that have RVGs as high as they have,” he adds.

American and European suppliers had much lower scores. ACS had the highest at 2.5. All the others had RVG scores of one or below. Given these numbers, Mass believes they “may have to shut down operations, be acquired, or be vulnerable for a merger.”

Schroth asked Mass to run the numbers on Google, the “current darling of Wall Street,” as a comparison. Google had a RVG of 60, which was higher than Infosys, which scored 52.3. “That tells me Infosys has hit a home run out of the ballpark,” says Mass. “We expected some difference, not these kinds of numbers,” adds Roopa Unnikrishnan, a Manager at Katzenbach Partners, who has researched talent and operations at outsourcing companies.

At the same time, the study found that the legacy players’ size and reach did not translate into more efficient, higher quality, and more cost-effective services. “It’s been a law in outsourcing: the larger the corporation, the larger the scale. Greater scale translates into more economic value to the customer,” says Schroth. But the study found otherwise. “One of the real ‘Ah Ha’s’ of the study was scale doesn’t matter above a certain level,” Schroth explains.

Explaining the High RVG of Indian Players

He says today’s technology allows outsourcers with $2 billion in infrastructure to compete with companies that have $20 billion in infrastructure. He says that’s one of the reasons why EDS is at the bottom of the parade — it cannot rely on scale.

“Today’s there’s no competitive advantage to have large, cumbersome infrastructure,” says Schroth. “The capital markets are looking at the quality of the business instead of the size of the business.”

How Growth Helps the Indian Suppliers

Schroth says the Indian companies are “putting serious money” into funding innovation because they “have the extra cash available to invest in innovation.” Unnikrishnan says any Wipro employee who has a smart idea can ask to be freed from his or her normal job responsibilities and work on the project for six months. She adds that as much as five percent of profits at some Indian firms are allocated for innovation. “If you ever hear that from an American outsourcer, let me know,” says Schroth.

American and European suppliers, on the other hand, need to focus on managing their margins if they are to compete with the growth-oriented Indians. And that points out their big disadvantage when it comes to wages; “the cost of the people managing the infrastructure is too great.” Schroth predicts suppliers like EDS will have to cut as much as 40 percent of their infrastructure management people. “I know that’s a dire prediction,” he says, “but I don’t see how those jobs can stay in America. Wall Street is fixated on managing margins. The suppliers can’t sustain these labor costs.”

Acquisition Differences

Schroth says Wall Street is not rewarding American and European suppliers who buy similar suppliers. He questions whether these acquisitions even make sense; “acquisitions for scale are not getting them anywhere; they may just be depleting their cash,” he says. And the complexities of merging two companies can be costly in time and money.

The Indian suppliers, like their American counterparts, are buying other companies. But their purchases are to protect their labor arbitrage advantage. They are acquiring companies in China, Malaysia, and Russia, where there are deep pools of low-cost talent. “These purchases will compound the Indians’ advantage,” predicts Schroth. Roopa points out that the Indian companies have tended to acquire and recruit high-value talent in these countries, rather than just chasing cheap labor.

What This Means for Outsourcing Buyers

When suppliers are competing for an outsourcing deal, “everyone tends to look the same,” says Schroth. He says Indian suppliers should shift the discussion and change its framework. “They have more cash and the ability to invest in solutions for their new prospects,” he points out.

Schroth says buyers should ask the Indian suppliers to commit to helping them innovate their IT and business processes. “This is where the rubber meets the road,” he says. He suggests asking the Indians to outline their innovation strategies or options in the proposal. Of course, buyers should continue to expect them to be price competitive.

To American and European suppliers, he says buyers should tell them they are nervous about the relationship. “Ask them how you will receive benefits when they are cutting back their workforces or reassigning team members down the line,” he says. He also suggests buyers insist that the top people who start at the beginning be required to stay throughout the contract and not shifted to the newest account.

Schroth says the RVG metric provides a new lens for companies contemplating outsourcing relationships to gauge their long-term potential. Prospects should “bring on outsourcers that do not work purely from a restrictive, cost-driven model, which may result in a lack of flexibility or the use of less capable talent. Instead, the company should seek a partner that drives down overall costs and adapts to strategic business needs.”

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