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As we have reported in previous installments on this ongoing series of articles on Finance and Accounting Outsourcing (FAO), the primary driver of FAO is cost reduction through labor arbitrage (see Global Sourcing Changes the Way CFOs Think about Sourcing F&A Services) So, if cost reduction from labor arbitrage is a common factor in almost all FAO transactions, should we expect a similar business case across companies who employ FAO? The answer is a resounding NO!

If we look at F&A work outsourced from a given country, say the USA, to a given location, say Bangalore, we might expect similar direct- cost improvements for companies that move the same percentage of work offshore. And we would be wrong.

The primary determinate of the direct-cost benefit from any initiative is the difference between the one-time up-front transition costs and the ongoing savings from cost reduction and cost avoidance. There are many factors that influence a company's business case. Look at Figure 1 below.

Factors Influencing Savings

Assuming that each FAO buyer moves all of its work offshore that can be moved, the three biggest factors that influence savings are: costs, productivity, and scale. All of the factors are important, and none of the factors are independent.

1. Costs: What is the current cost structure? This will vary a great deal due to location, industry, and other factors. Obviously, companies in low-wage industries that are located in low-cost areas are going to have thinner savings per position outsourced.
2. Productivity: In addition to labor arbitrage, the suppliers will look for productivity improvements. They know the range of what is possible with respect to transactions processed per person for invoices, travel expense reports, journal entry vouchers, account reconciliations, etc. The higher the existing productivity, the less opportunity for improvement.
3. Scale: None of the factors are independent. The thinner the savings per position due to either existing low costs or high productivity, the greater the number of positions required to offset the transition costs.

In addition to these factors influencing cost reduction, business case differences across companies will also vary by the differences in cost avoidance. Cost avoidance can be significant for some companies and can include the avoidance of future costs in systems, recruiting, training, office space, and compliance.

Factors Influencing Transition Costs

No two companies will have the same transition costs in aggregate or per position outsourced. The three biggest factors influencing transition costs are centralization, standardization, and severance.

1. Centralization: To what degree is the work decentralized? The greater the number of locations and the greater the distance between locations, the greater the transition costs for the supplier. To take on the work, suppliers must know what they are taking on, which requires work shadowing and documenting. The more sites there are to visit, the higher the transition cost.
2. Standardization: Closely linked to centralization is standardization. The more standard the processes and systems are across locations, the lower the number of sites that the supplier must physically visit.
3. Severance and Systems: Buyers also incur transition costs. The largest two costs are almost always severance and systems. Which of these costs is largest for any given buyer depends upon the average length of service of employees, wage rates, and severance policy, versus the need for new systems and tools to support the outsourcing solution.

The bottom line is that the savings per position outsourced times the number of positions outsourced must be great enough to produce a reasonably quick return on the up-front transition costs, and the factors that influence the calculation are so numerous that the outcome is unique for each prospective buyer of FAO.

What Implications Does It Have For Buyers

FAO is currently growing at 40 percent per year. CFOs are bragging of big savings, and competitors on the sidelines are feeling the pressure of competitive disadvantage. In the rush to do an FAO deal, many companies are not investing in an up-front detailed business case that explores all of the unique factors influencing the potential business case for their firm.

Direct savings are not the only reason why firms outsource, and research continually shows that results tend to be better when the transactions are done for a broader set of benefits (e.g., improved compliance, improved visibility to enterprise-wide data, flexibility, ability to support acquisitions and divestitures, conversion of fixed costs to variable, and focus on core operations). When direct savings is the primary driver, take the time to estimate what the savings will be before taking the plunge.

Lessons from the Outsourcing Journal:

• The primary driver of FAO is cost reduction through labor arbitrage
• There are many factors that influence a company's business case. These factors influence both the ongoing savings and transition-cost components of the business case.
• Assuming that all of the work that can be offshored is offshored, the biggest remaining factors influencing the achievement of ongoing savings are cost, productivity, and scale.
• The biggest factors influencing the transition costs are centralization, standardization, and severance.
• When direct savings is the primary driver, take the time to estimate what the savings will be before taking the plunge.

Publish Date: September 2006

Copyright © 2006 - Everest Partners, L.P.

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