The challenging truth about outsourcing and the opportunities that await us. (S1E2)

As I reflect on my 25+ years in the technology sector, primarily focused on services, I cannot ignore the significant impact that outsourcing has had on my career and life.

I began my journey as a technician, providing technical support for Compaq, but EDS employed me. At that time, I didn't realize that I was part of the very first cycles of outsourcing on a global scale. Furthermore, I was involved with a company that played a key role in creating the outsourcing model.

Yes, EDS, or Electronic Data Systems, played a pivotal role in the history of IT outsourcing. Founded by Ross Perot in 1962, EDS was one of the first companies to provide data processing services to other businesses. This marked the beginning of the IT outsourcing industry. EDS's success led to the growth of outsourcing, where companies increasingly contracted out IT services to specialized firms.

Today, outsourcing is very different from the past, which could be a great topic for another FORECAST.

Here we go.

It's a fascinating journey from those early days to today's global outsourcing landscape. But where are we today? Let's first understand what I call the 3 phases of outsourcing history.

3 phases of IT outsourcing

1st - The Foundation Phase (1960s-1990s): This period began with companies like EDS offering data processing services. The focus was on providing specialized IT services, often related to mainframe computing, which allowed businesses to outsource complex tasks.

2nd - The Labor Arbitrage Phase (1990s-2010s): With the rise of globalization and advances in communication technologies, companies began outsourcing IT services to countries with lower labor costs. This phase saw the growth of offshore outsourcing, particularly in countries like India, where a skilled workforce could provide services at a fraction of the cost.

3rd - The Digital Transformation Phase (2010s-present): The focus has shifted towards value addition and strategic partnerships. With the rise of cloud computing, automation, and AI, outsourcing is no longer just about cost savings but also about accessing expertise, innovation, and advanced technologies. AI and machine learning are now driving new capabilities in IT outsourcing.

In the foundational phase of IT outsourcing, companies like EDS offered a compelling value proposition. Here's a closer look:

• Specialized Expertise:?EDS brought in-depth knowledge and technical skills that were often beyond the capabilities of in-house teams, which were focused on the company's core business areas.
• Process Optimization:?EDS and similar firms developed robust processes for IT operations, increasing their clients' efficiency and productivity. This was especially valuable for companies looking to streamline operations.
• Cost Efficiency:?Outsourcing IT allowed companies to convert fixed costs into variable ones, paying for services as needed without the expense of maintaining a full in-house IT department.
• Focus on Core Competencies:?By outsourcing IT functions, companies could focus their resources on their core business areas, leveraging IT outsourcing to support their growth and innovation.

This phase laid the groundwork for the evolution of IT outsourcing, proving its value in driving efficiency and allowing companies to adapt to the rapidly changing technological landscape.

For instance, during this time, the age of mega outsourcing deals, the approach was simple yet bold.

Companies where IT was not their core business started to feel the pain of the huge investment needed - Capex mainly - to acquire, maintain, and manage IT resources (HW, Data Centers, etc.). The TCO (Total Cost of Ownership) was very significant. Companies like EDS would offer a 20% reduction in taking over the whole IT environment.

But how was this possible?

The magic formula of outsourcing in those days was productivity. To get this going, the provider (EDS, IBM, Unisys, you name it) would need to extract productivity from the processes, which was key, allied with procurement power plays (as you have more assets, you have more leverage.

The math would be like this: to get a 20% reduction and make a healthy margin (20-30%), you would need at least 40-50% productivity. So, the provider would make a huge investment upfront (first 18 months), which would take the margin to negative during the first 2-3 years (of a 5-year term contract) to invest in streamlining processes and creating a ramp-up of productivity. They would only recoup their investments in the late part of the term, which most of the time created challenges for the renewal. Clients always wanted to pay less. However, this was a significant challenge after productivity reached its peak.

Something needed to happen, and that's when we started to see the second phase of IT outsourcing: labor arbitrage.

First, let's define labor arbitrage: Labor arbitrage is the practice of reducing costs by moving jobs to locations with lower wages while maintaining or improving service quality.

During the labor arbitrage phase, several countries became prominent hubs for IT outsourcing, thanks to their large, skilled workforces and cost advantages:

·????? India: Leading the pack, India became synonymous with IT outsourcing. The country's strong education system, particularly in engineering and IT, produced many English-speaking tech professionals. Cities like Bangalore, Hyderabad, and Pune became IT hubs.

·????? China: With its vast population, China emerged as a key player, especially in manufacturing and hardware-related IT services. Its government-supported tech industry and rapid economic growth fueled its outsourcing sector.

·????? The Philippines: Known for its strong English proficiency and cultural compatibility with Western countries, the Philippines became a preferred destination for call centers and back-office services.

·????? Eastern European Countries: Nations like Poland, Hungary, and the Czech Republic offered a combination of skilled labor, strong technical education, and proximity to Western Europe, making them attractive for nearshoring.

·????? Central America (Costa Rica, Panama):?These countries emerged as attractive nearshoring destinations for North American companies. Costa Rica, in particular, built a reputation for a highly educated workforce and political stability, attracting tech companies and call centers. Panama also became a key player with its strategic location and good infrastructure.

·????? North Africa (Tunisia, Egypt):?These countries gained traction due to their proximity to Europe, cultural compatibility, and multilingual capabilities. Tunisia offered a pool of French-speaking professionals, making it a preferred choice for French companies. With its large, educated population, Egypt became known for its cost-effective services and strong government support for the IT sector.

These countries/regions capitalized on their labor cost advantages and built robust outsourcing industries, shaping the global landscape of IT services.

You're on the right track if you are thinking through the phases and saturation of outsourcing mechanics.

For instance, a company that outsourced its internal IT to a third-party provider saw increased productivity by streamlining capex and processes. By locating resources in cost-efficient regions globally, they further reduced costs through labor arbitrage. You can see the advantages of phases one and two.

What happened next?

The third phase of IT outsourcing, characterized by digital transformation, involves leveraging advanced technologies to drive innovation, efficiency, and value in outsourcing.

• Automation:?Routine tasks are increasingly automated, reducing the need for manual intervention and allowing human workers to focus on higher-value activities.
• Cloud Computing:?Adopting cloud services enables scalable, flexible, and cost-effective IT solutions, allowing companies to quickly adapt to changing business needs.
• Data Analytics:?Advanced analytics and big data allow more informed decision-making, predictive analysis, and personalized customer experiences.
• Cybersecurity:?With more data moving online, outsourcing providers prioritize robust cybersecurity measures to protect sensitive information and comply with regulations.
• Focus on Innovation:?Outsourcing partners are increasingly seen as strategic partners contributing to innovation, not just cost savings.

This phase represents a shift from traditional outsourcing focused primarily on cost reduction to a model in which outsourcing has become a key enabler of digital transformation.

Previously, bids were primarily focused on cost. Although cost remains a factor, the ability to support the company's core business, drive innovation, and enable digital transformation has become critical when selecting a partner nowadays.

This global industry is undergoing significant changes due to the aftermath of the pandemic and the excitement surrounding AI. Projections indicate that by 2024, the industry's value will reach approximately $617.69 billion, expected to grow to $806.53 billion by 2029. This reflects a compound annual growth rate (CAGR) of 5.48% during the forecast period. Mordor Intelligence

FORECAST

So What's Next? Here Is My Forecast

Firstly, the balance between onshoring/nearshoring and offshoring is increasingly becoming a priority for senior IT executives. They are considering several key factors: a) the location of resources, b) the quality of professionals compared to attrition rates, and c) the challenges posed by time zone differences from distant delivery centers and Centers of Excellence (CoEs) to their business operations.

This trend is currently unfolding, and it's evident that a shift toward achieving this balance is taking place. Additionally, outsourcing providers must diversify their delivery centers to leverage the strengths of different countries or regions, whether in cost, expertise, or managing attrition.

Geopolitical factors such as trade tensions, regional instability, and supply chain vulnerabilities further amplify the need for balanced delivery models. As businesses strive for resilience, a combination of nearshore and offshore centers strategically positioned to mitigate risk and maintain operational continuity is becoming critical.

Labor arbitrage has become saturated, and many of the world's largest companies either have their own offices in these regions or have partnered with local firms to maximize value.

As we move into the fourth phase of this evolution, IT outsourcing companies must demonstrate how they can add value to their client's core business strategies. Their success will depend on their ability to provide meaningful solutions with the highest value possible.

This could mean focusing on delivering hyper-personalized services tailored to each client's industry, co-creating innovative solutions through partnerships, or helping businesses integrate cutting-edge technologies such as advanced analytics, automation, and AI into their core operations.

Secondly, one of the big factors of the globalized delivery models is the strength of the American dollar.

Positive Impacts:

• Lower Costs:?A strong dollar allows U.S. companies to purchase foreign services more cheaply, stretching their budgets further.
• Increased Investment:?The savings from lower outsourcing costs can be reinvested into other business areas, such as innovation or expansion.

Negative Impacts:

• Currency Volatility:?Fluctuations in the dollar's value can make it difficult to predict costs, complicating budgeting and financial planning.
• Reduced Competitiveness:?A strong dollar might encourage more companies to outsource, increasing competition and potentially raising prices in popular outsourcing destinations.

Overall, while a strong dollar can make outsourcing more attractive for U.S. companies, it also introduces financial uncertainty elements that must be managed carefully.

To mitigate these risks, outsourcing providers should adopt flexible pricing models that account for currency fluctuations and explore financial hedging strategies to protect margins and maintain client cost predictability.

Finally, we are approaching the fourth phase in the history of outsourcing, which I will refer to as?The Applied AI Revolution.

We are still experiencing the excitement surrounding the most widely discussed IT buzzword, AI. However, the potential of "real AI" in business remains largely untapped for many companies, primarily due to its high costs. Beyond cost, businesses face challenges integrating AI with legacy systems and ensuring their workforce has the necessary skills to maximize AI-driven capabilities. Outsourcing providers must step into this gap by offering turnkey AI solutions and training services to bridge these barriers.

Historically, IT outsourcing companies have provided businesses with valuable technology and highly specialized services worldwide.

We are witnessing a significant shift in the outsourcing industry. Unless the U.S. economy strengthens enough to create new opportunities for labor arbitrage, we will not find alternative ways to achieve substantial productivity gains without AI.

The Role of AI in Driving Productivity and Innovation: Integrating applied AI into various services is essential not only for enhancing the margins of service providers but also for generating cost reductions for companies under financial pressure (which will always exist, even with accelerated growth).

Specific applications of AI in outsourcing could include predictive analytics for improving supply chain efficiency, AI-powered IT service management to reduce response times, and machine learning algorithms for advanced cybersecurity solutions.

Additionally, leveraging large language models (LLMs) and potentially smaller language models (SLMs) can accelerate digital transformation, which might become viable by these players with a not-so-onerous financial model and specialized AI expertise.

This emphasizes the crucial partnership needed between companies and IT outsourcing providers. We see the current phase as preparation for the fourth phase, which is coming sooner rather than later.

In this new era, companies that can successfully align their outsourcing strategies with AI-driven solutions and ensure measurable business outcomes will emerge as leaders.

What are your thoughts?

If you've read this far, thank you for your interest. Please share your thoughts, share this article with your network, and tell me if I missed the mark here.

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Thanks again,

Rodrigo S. Martineli

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