The trend toward smaller outsourcing deals

The trend toward smaller outsourcing deals can easily be misinterpreted. It does not necessarily mean that the outsourcing market is declining, that enterprises will end up fragmenting their outsourcing relationships, or even that outsourcing margins will be squeezed with new cloud, mobile and analytics technology.

Declining numbers in the market

Some 2013 numbers declined from the previous year. There has been a double-digit drop in average contract value and some dips in total market revenue since 2012. Manufacturing and business process outsourcing (BPO) have been especially impacted. A trend toward smaller outsourcing deals was seen previously in 2011 the U.S. and more recently in Europe (after an initial large-deal surge in Europe with a new-found openness to offshore solutions sparked by economic uncertainty in the region).

A need to adapt

Coming into 2014, the trend reached a level at which both vendors and buyers must adapt. IT servicers with declining revenue or weak revenue growth are likely to quote the trend in part as an explanation of their revenue challenge (e.g., HP and Wipro). HP’s head of Enterprise Services, Mike Nefkens, reports that it now takes twice as many contracts as used to be required to generate the same level of revenue. In other words, their average contract size has dropped by 50%.

But not necessarily smaller outsourcing relationships

Other vendors, such as TCS, that have robust revenue growth also tend to have growth in the level of revenue that they are garnering from their largest clients. TCS CEO and Managing Director N. Chandrasekaran described his firm’s experience in its latest earnings call:

“I do not think that the size of the deal is anything to do with our sales or anything like that. On Digital, customers are learning. They may allocate a huge budget, but they cannot commit a huge budget because the whole transformation is not something that one can think through so easily. So, the whole journey of imagining the digital impact is something that the customers are going through.

They have a lot more clarity now than before, so the deal sizes have gone up from before. But please don’t expect customers to sign up half a billion dollars checks on Digital. That is not the way it is going to be done. But, they will spend half a billion dollars, but it will be in terms of a lot of projects of varying sizes; some could be a few million, some could be 10 million, that is something that will evolve.”

IT buyers gaining confidence in the new technologies

That is, the trend toward smaller deals does not necessarily mean smaller outsourcing relationships. In fact, it well could contribute to consolidation in the industry, as IT buyers can more easily gravitate to the current industry leaders. TCS has also noticed that very small, experimental deals for the likes of cloud, analytics and mobile have given way in recent months to deals in the millions of dollars range, as customers have become more certain of their commitment to new technologies.

A limited ‘best of breed’ purchasing trend

What is happening now is becoming known as a ‘best of breed’ purchasing trend, whereby IT buyers may select the best-suited provider for each small to medium-scale implementation. This trend has been noted for several years, and it has picked up steam in the sense that public cloud SaaS options are now chipping away at previously omnibus solutions. (E.g., the success of Salesforce and Workday in infiltrating the Global 1000.) But there is more to the dynamic than that.

IT buyers are moving one step at a time

In large part, this trend is driven by buyers only sorting out and committing to one step of an advanced IT investment in cloud, mobile and/or analytics at a time. It is in that sense endemic to transformational, ‘change the business’–as opposed to ‘run the business’–deals involving fast-evolving technologies. This makes sense at a time when technology investments and decisions have greater effects on the business and business executives are becoming more involved in technology decisions as well.

The benefits and limitations of smaller deals

Shorter-term and smaller-scale deals make it easier, on one hand, for buyers to maximize their leverage with providers and to rein in time and cost overruns. Such patchwork deals can cause problems, however, when too many vendors are involved. Issues of integration, continuity and ultimate responsibility inevitably come into play. Thus, the idea is not generally to pull in different IT services partners for each new project.

The enterprise buyer, as Nefkens has noted, has become more hands-on in IT implementation and management. And, one side benefit of hammering out smaller and shorter deals is that the process forces a more frequent meeting of minds between enterprise buyers and their service providers. That is a positive step for buyers.

Separating SaaS from system management, development and integration

It is easy to conflate the potential cost-extraction of SaaS and public cloud computing with declining margins for outsourcing. But the drive to outsource has long been based on a combination of both specialization and the lower labor cost of offshoring. Many SaaS services aren’t really counted among traditional outsourcing. But the complexity, importance, and rapid development requirements of cloud, mobile and analytics applications are ultimately pushing many enterprises to look for outside specialists—while also providing plenty of input and oversight. Meanwhile, for traditional offshorers, such as the major India-centric companies, it is only the move to this next generation of technology that is ultimately starting to free them from the tyranny of often-rising, offshore wages. Engagements based on these technologies are enabling higher, not lower, margins.

The net for IT buyers

The nature of outsourcing deals is changing. Outsourcers are providing more piecemeal, but transformative implementations of new technologies. Along the way, the relationship between enterprise and outsourcer is becoming higher-level and more consultative. In selected areas, it is also reaching further into the enterprise line of business. (Thus, the nature of BPO is also in flux.) The specialized skills of outsourcers are becoming more important for many companies facing daunting complexity in handling, for example, multicloud implementations. Lower offshore labor costs are still a factor, but the new technologies are enabling some providers to improve their margins. Those vendors who best manage the change will pull ahead. With smaller deals, IT buyers will find it easier to shift allegiance to the leaders in a new generation of more sophisticated and tighter outsourcing partnerships.

Relevant Analyst
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Laura Stuart

Analyst Independent Industry Research

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