Offshoring Support Services: Outsourced or Captive?

In the early years of offshoring support services, from roughly 2000 through 2004, many companies aggressively pursued offshore outsourcing as a means of lowering costs. However, a number of outsourcing deals during this period were characterized by a limited scope of services, ill-defined business cases, and, in many instances, overambitious cost-cutting goals. In addition, many organizations underestimated the complexity of managing the outsourcing relationship. Problems arising from these factors led some organizations to conclude that the hard and soft costs of offshore outsourcing, and the related people and change challenges, could offset the financial benefit.

The good news is that the market has evolved dramatically since then, as companies have begun to approach offshore support service delivery in a more systematic, thoughtful manner. Many companies are now expanding their goals for their large-scale offshoring efforts from a tight focus on cost reduction to pursue potential benefits such as increased service quality and talent sourcing opportunities. In addition, many companies are now taking advantage of the benefits of offshoring by setting up wholly owned "captive" service centers in low-cost countries, often combining the use of a captive with the services of various outsourced service providers.

We believe that the increasing maturity of the offshore outsourcing industry, plus the emergence of the captive offshoring model, make pursuing offshore service delivery considerably less risky than it was just a few years ago. However, offshore outsourcing and captive outsourcing do differ in several important respects. Each comes with its own set of advantages and disadvantages, so it’s important for a company to carefully consider its own current and future needs, options, and trade-offs before deciding which route to follow for their support service needs. The following primer, written for managers at companies that have just begun to explore their offshoring options, discusses some of the basic considerations that should be taken into account when pursuing offshore service delivery.

Options for Offshoring

In a full outsourcing relationship, the vendor provides services to the client as specified in a commercial contract. How the work is actually performed is at the vendor’s discretion, as long as all contractual and service-level requirements are met. In contrast, with a pure captive center, a company builds an entire service operation from scratch, from finding the physical facilities to obtaining local business licenses to hiring and training the people. Because they are typically built from the ground up, pure captive centers require time and investment before they produce the expected savings. This sweat equity can be significant and should not be underestimated.

A third option, which might be termed a "collaborative" model, steers a middle course between full outsourcing and a pure captive model. In collaborative sourcing, a company hires an outside service provider in the chosen offshore market to help set up an offshore service center on the company’s behalf. Three popular models are: 1) the so-called "build-operate-transfer" (BOT) model, in which the vendor initially builds and operates the center and eventually hands over ownership to the parent company; 2) the "assisted captive" model, where the vendor assists the parent company to build the center but the actual work is performed by the parent company; and 3) the "joint venture" model, in which the service center is set up as a joint venture between the parent company and the vendor. Although the use of these models is declining as offshore sourcing markets mature and companies become increasingly comfortable with moving offshore, they can still be a viable choice for companies that wish to avoid some of the risks of building a captive center wholly on their own.

How can a company decide which option to pursue for any given set of services? To help answer that question, here are some of the factors we believe that companies should consider.

Scale

Scale is one of the key factors a company should keep in mind when making the outsourced versus captive decision. In general, the less work there is to be offshored, the more attractive outsourcing may be compared to a captive model. Outsourcers offer their clients ready-made economies of scale because of the size of their own operations, and for a company that wants to offshore only a few dozen (say) full-time employees (FTEs), the outsourcer’s ability to provide the fixed-cost infrastructure for those FTEs can be a real advantage. So if a company doesn’t have a certain critical mass of work to be offshored – and if, importantly, it anticipates that it will never have that scale – outsourcing may be the more attractive choice.

On the other hand, companies that do have what they consider a critical mass of work may find that a captive model makes good economic sense. The fixed overhead costs of operating an offshore service center remain relatively constant no matter how many people the center employs. Once those fixed costs are established, a company that moves a large amount of work offshore has the opportunity to realize considerable economies of scale.

Cost and Speed of Implementation

Very generally speaking, an outsourced offshoring arrangement can cost less up front to set up and implement, and can be implemented more quickly, than a captive center. A pure captive center typically requires the parent company to make a significant up-front investment in time and money to build the infrastructure, hire the people, and meet the requirements of the local government. A collaborative captive model may enable a company to set up an offshore center relatively quickly, but working with a vendor or joint venture partner may result in substantial financial costs. Because of its potential short-term cost and speed advantage, outsourcing can be an attractive option for companies that are looking for more immediate cost savings and speed of implementation.

When it comes to long-term cost savings, the difference between captives and offshoring may not be as clear-cut. On the one hand, the greater control a parent company typically has over a captive can make it easier to negotiate changes to processes, service levels, and chargebacks with a captive than with an outsourced service provider. For example, one company that initially realized substantial savings by its cash applications process found, after changing its cash applications policy some time afterwards, that the policy change generated many processing exceptions at several times the original contracted cost. Unable to negotiate changes to the contract, the company wound up paying the outsourcer significantly more than originally expected.

Having said that, it’s also possible for a company skilled at managing vendor relationships and negotiating contracts to build enough flexibility into an outsourcing agreement for changes to service levels and costs to be less problematic. Recent outsourcing contracts, for example, often include volume threshold flexibility clauses to avoid issues such as the one described above. There’s also the possibility that changes to a captive center can be hampered by internal politics and less-than-ideal governance processes.

The lesson here is not that outsourcing is necessarily more or less challenging than a captive model with respect to flexibility and cost, but that effective governance is critical to realizing ongoing value in either case. To determine the importance of flexibility in its sourcing arrangements, whether outsourced or captive, a company should always consider the ability of new service models and contracts to accommodate change when deciding what model fits its needs. A business that anticipates significant change – one that is pursuing an aggressive merger, acquisition, and divestiture strategy, for example, or that expects to grow or expand rapidly – should think carefully about how such events may affect its relationship with its support service providers. The management time and attention needed to negotiate and resolve service level changes can be significant. In our experience, negotiations with an internal captive center can be easier to revisit than discussions with outsourcers, which may be one reason for companies undergoing rapid change to consider a captive model.

Presence in the Target Country

There’s no question that it’s easier to set up an offshore service center if a company already has a presence in that country. A company without an established brand in a particular country is likely to have difficulty recruiting employees to work for it in that country; a company that lacks local facilities and infrastructure will need to build them from scratch instead of being able to leverage what’s already there; and a company that has no leadership in a country will have a tough time finding the management talent, practical know-how, and cultural savvy to obtain local operating licenses, negotiate economic development incentives, and otherwise manage a captive build-out. For these reasons, companies that have no local presence whatsoever in their country of choice may find an outsourcing or collaborative captive model more realistic than trying to manage the process of creating a captive wholly on their own.

An outsourcer’s or a collaborative captive vendor’s existing presence in a country can be especially helpful when seeking a quick resolution to regulatory issues. One company, for example, that lacked a local hiring license to set up a service center in Panama turned to a BOT to serve as its legal agent in that country. The vendor provided the physical space and facilities for the company’s center and hired local staff using the vendor’s hiring license. When the company obtains its own Panamanian hiring license, the employees will be terminated by the vendor and hired by the parent company. As an additional benefit, the BOT vendor had considerable brand recognition in Panama while the parent had virtually none, making it easier for the BOT to recruit and retain the center’s staff.

That’s not to say a company absolutely needs a physical presence in a country to be able to set up a captive service center. If a company employs business leaders in its home-country offices that are originally from the selected country, or who have extensive experience in that country, it may be possible to assign those leaders to oversee the development of a captive without assistance from a vendor. This decision, of course, will depend on how much risk the company is willing to take and the level of trust it has in the leadership team to execute.

Data Protection and Intellectual Property

A company with a high degree of concern about data security, privacy, and intellectual property issues may be more comfortable with a pure or collaborative captive model, in which the parent company has greater control over both the information handled in the center and the people who do the processing than would be the case with outsourcing. In fact, intellectual property concerns are one of the main reasons for not outsourcing any process that is strategic or "core" to one’s own business. It can be challenging to verify that an outsourcer is following appropriate handling procedures for intellectual property, which can have regulatory as well as security and privacy implications. Also, unless the contract explicitly forbids it, an outsourcer could transfer staff members from one company’s account to that of a competitor, which can present obvious intellectual capital risks.

Access to Talent

There are two considerations around access to talent that come into play in evaluating outsourcing versus a captive model. The first question is whether a company can attract enough qualified people to staff the captive center. As discussed previously, it’s easier for a company with a recognized brand name in the local market to recruit staff. Because these markets are typically very dynamic, staying on top of the "war for talent" can be a daunting effort. An outsourcer, besides having an established brand in the marketplace, may maintain a much broader recruiting and training engine to replace open positions, and is likely to have strong processes for recruiting, hiring, training and retaining offshore employees. A company without a brand in the local market may need to spend considerable time and effort to build one up before it can effectively recruit staff, which can be one reason for such a company to consider an outsourcing or collaborative captive model.

The second question regarding access to talent is whether the company is interested in using a captive service center as a recruiting ground for talent to transfer into mainstream operations. Here, we believe that the advantage clearly lies with the pure captive model, or with a collaborative captive model in which the service center’s staff are employees of the parent company. If the people who work at the center are employees, a company can identify and recruit those who contribute value or have "hot skills" important to the business. This mining of talent would be impossible with an outsourced service provider.

Additionally, any investment a company makes in training its own offshore employees stays within the company, at least as long as the employees remain at the center. This is not normally true with a company’s investment in training people employed by an outsourcer, who may be able to transfer people into and out of a client’s account at any time without necessarily obtaining the client’s approval (unless the contract specifies otherwise). Further, turnover among an outsourcer’s employees cannot be directly controlled or influenced as would be possible with a captive, which can have a large hidden cost.

Ease of Exit

Companies generally find it easier to leave an outsourcing relationship than to close down a captive center. Leaving an outsourcing relationship is usually a matter of executing the termination clause in the contract. Shutting down a captive center can not only be more time-consuming than terminating an outsourcing relationship, but also force a company to pay significant severance and infrastructure expenses.

On the other hand, a company that leaves an outsourcing relationship will not have a hard asset "left over" from the relationship. A company with a captive center it no longer needs, in contrast, may have the option of selling the center to an outside party at a tidy profit. However, this is by no means a guaranteed outcome. A company with a highly specialized service center may find it difficult to find a buyer who needs those particular capabilities, no matter how well-run and productive the center has been for the original parent company.

Making the Decision

The choice of sourcing model is as individual as the company that’s making the decision. Our view is that the choice between captives and outsourcing may lie largely in a company’s comfort level with different kinds of risk: relatively greater execution risk with a captive center, relatively greater economic risk with outsourcing. A company that lacks confidence in its internal capability to set up a captive center – perhaps because it has no presence in the target country or has a history of difficulty in implementing major organizational change – and/or views managing vendor relationships as a strong suit may favor outsourcing or one of the collaborative captive models. In contrast, a company with a strong presence in the target country, that is confident in its ability to establish captive center operations in that country, and/or that perceives the risk of having work performed by an outside party as greater than the risks of managing a captive center may be more likely to favor a captive approach.

A final note: a company that chooses a particular offshore sourcing model to begin with can certainly change its approach in the future as its needs evolve. Many companies, in fact, begin by outsourcing their offshore support services and then move toward a captive model as they gain a more significant foothold in the offshore market. Others draw on a mix of sourcing alternatives, running a captive center or centers at the same time as maintaining various outsourcing relationships – a mixed sourcing strategy that is becoming increasingly popular. However a company chooses to obtain its offshore support services, the decision should always be guided by a well-thought-out sourcing strategy that aims to align the company’s overall sourcing activities with its comfort level regarding the chosen option’s risk/reward profile as well as its overall business goals.

This article contains general information only and Deloitte Consulting LLP is not, by means of this publication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor. Deloitte Consulting LLP, its affiliates and related entities shall not be responsible for any loss sustained by any person who relies on this publication.

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About the Authors

David H. Brainer
Regional Managing Director
Strategy and Operations Principal
Deloitte Consulting LLP
e-mail: dbrainer@deloitte.com

Mr. Brainer is a senior partner in the Strategy & Operations practice of Deloitte Consulting LLP. He is one of the organization’s leaders in designing and managing large business transformation programs. He has provided a broad range of strategic advisory and implementation services, including corporate strategy, enterprise cost reduction, business restructuring, shared services, post-merger integration, customer strategy and sales force effectiveness, strategic sourcing and change leadership.

Peter Lowes
Principal
Deloitte Consulting LLP
e-mail: plowes@deloitte.com

Peter Lowes leads the Outsourcing Advisory Services Practice at Deloitte, serving corporations in the areas of business process and IT outsourcing and offshoring. Mr. Lowes’ experience with offshoring and global services delivery began with engagements in the early ‘90s where he helped organizations deliver complex software products with integrated teams operating across the U.S., Europe and Asia. He has subsequently been involved in the creation of local market-facing and remote business and IT services organizations in over 30 countries.