September 14, 2004

By 2010, no business will remain competitive in its industry without outsourcing a significant portion of its IT activities and the business operations those systems support. Even companies with the financial resources to conduct every operation and information system in-house -- such as Dell, General Electric and Microsoft -- will have trouble competing unless they're off-loading substantial operations and IT to others. All three industry giants, in fact, outsource IT and business processes to China and India.

I'm not talking merely about outsourcing operations and systems that are easy to farm out, such as payroll, employee retirement accounts or the company's e-mail network. Depending on the business, I'm referring to major manufacturing operations, warehouse and distribution networks, and in some cases, R&D, as well as the ever-growing, ever-important IT behind those business processes.

IT outsourcing is here to stay, but not necessarily with its first-generation innovators, Computer Sciences Corp., Electronic Data Systems and Perot Systems. Even as demand is building, the provider landscape is shifting rapidly. Traditional domestic outsourcing vendors that have relied on the value proposition, "We'll take it off your hands and deliver you a little cost efficiency," will ring as hollow as a $1 rebate on a $1,000 purchase. They must get a lot better at their game and offer customers substantial value in the form of better business-process/IT performance. Otherwise, the windfall revenue will go to second-generation offshore-IT outsourcers, such as Infosys Technologies, Tata and Wipro Technologies, or third-generation business-process outsourcers, such as Affiliated Computer Services, Hewitt Associates and United Parcel Service of America.

Viewed unemotionally, the offshore outsourcing of IT and call-center work to India is merely the most recent step in a 100-year-old trend in which large corporations farm out pieces of their value chains, through which raw material becomes finished products to be marketed, sold and delivered. Before this, many of the biggest corporations -- such as Ford Motor Co. -- wanted to be independent of suppliers. As late as the 1930s, Ford still produced his own tires, steel, glass and even the wood with which its early cars were built.

But business-world complexity since then has rocketed. No automaker can keep up with the fast-evolving processes and materials used to build car components, whether it's tires, brakes, steel, glass, electronics, airbags or even paint --nor do they want to stray from their core business focus and competencies. As a result, employment among traditional auto OEMs has shrunk precipitously. In 1979, for every million cars that General Motors produced, it employed roughly 91,000 people. Today, that number is 24,000. Of the 67,000 jobs that were eliminated, 40,000 were through productivity improvements, and 19,000 shifted to on-shore, tier-1 component suppliers, such as ArvinMeritor, Johnson Controls and Lear Siegler; another 8,000 went to offshore suppliers. GM, like its competitors, has used outsourcing and offshoring to spread the burden of innovation and efficiency. Because of this, the company cut the cost and time for new-model development in half, and automotive innovation is accelerating.

While automotive companies were selectively outsourcing, other companies watched their IT spending soar in the 1980s and 1990s. IT budgets in some financial institutions reached billions of dollars, forcing managers to put on the brakes. One popular answer was to outsource IT activities -- software maintenance, data-center operations and sometimes information-systems implementation. Long-term contracts with first-generation IT-outsourcing companies, such as Accenture, CSC, EDS and Perot Systems appeared, at least on balance sheets, to rein in large corporations' burgeoning technology expenditures.

But cost cutting isn't the primary driver for outsourcing anymore -- or at least it shouldn't be. Growing complexity and the need to invest large sums in many parts of business operations to stay competitive are forcing managers to choose which operations to keep and which to farm out. All managers must decide how and where to invest their resources -- talent, time and money -- in business-process innovation.

Managers need to closely examine which operations enable the company to provide unique and attractive value to the customer -- that is, the bundle of benefits that differentiates a company and attracts customers to buy its product or service rather than someone else's. These processes need to be closely managed and typically aren't candidates for outsourcing. But everything else is up for grabs. After all, if a process merely contributes to competitive parity -- what I call threshold customer value -- in all the dimensions that don't differentiate that process, isn't it better to let someone else invest in maintaining that threshold position? Why consume resources that could be better applied to areas of differentiation? By "threshold," I mean the ability to meet average industry levels of performance, not superior performance, and to meet, but not exceed, customer expectations.

From my ongoing research of market-leading companies, I've found three basic ways of differentiating and providing value to customers: offer the lowest total cost (operational excellence); offer the best, most unique product (product leadership); and offer a solution that can be best tailored to the customer's need (customer intimacy). JetBlue Airways and Paychex, for example, have thrived on operational excellence, while 3M and Sony have competed on product leadership. Examples of customer-intimate champions are Nordstrom and GE Medical Services (see chart, below).

The business operations that are most important in operational-excellence companies typically contribute to the lowest net cost of operations or the highest standard of hassle-free service. JetBlue has the most efficient cost per seat-mile in the domestic-airline industry, created by copying and updating Southwest Airlines' playbook on how to run a point-to-point airline network. Paychex has built a hassle-free payroll-processing service, aimed at small employers that value their time as much as their money. Paychex's close-to-the-customer servicing processes are the core of what differentiates it from Automatic Data Processing and Ceridian, the closest competitors.