When the world?s largest chip equipment maker, Applied Materials hit a slump, its IT department was forced to cut costs. It wasn?t easy as CIO Ron Kifer had already slashed IT costs by 35% and reduced service providers to three in the last two years. Renegotiations with the three service providers?IBM, TCS and Wirpo?slashed the costs further but this was not enough. The nano-manufacturing firm decided to get creative and eased service-level agreements with its suppliers and demanded lower costs in return.
The key to bigger savings here was the flexibility in the managed services model. Managed services optimisation was one of the three tracks they had identified, according to Applied Materials India director, Global Information Services, Nagraj Bhat. ?This model helped us to scale up and down based on business needs and better manage our cost structure,? he explains.
Applied Materials is not alone. Economic downturn has forced IT departments of several multinational majors to experiment with new models while outsourcing their IT operations. And offshore service providers are joining in the re-engineering exercise of their clients. HCL Technologies, for one, has helped a large aerospace and logistics company in consolidating a diverse set of IT applications during the last six months. This exercise has made them a ?closer partner of the client?s CIO?, claim HCL officials. The trick, insiders say, is to find cost saving options that don?t punish the vendors. Analysts are also working out new models to cut further costs after the current round of renegotiations in such a way that vendors are not squeezed further.
These changes might have been forced by the economic slowdown but are far from temporary and might change the way IT is bought and sold forever. The paradigm shift in the outsourcing models seems to be irreversible, especially since this is a win-win situation for suppliers as well as buyers. ?The entire notion of offshoring is changing,? says Forrester Research principal analyst Paul Roehrig.
Buyers and suppliers are now constrained to deliver cost savings through long term improvement initiatives, economies of scale, optimised service delivery and relationship management. Forrester is predicting a fundamental restructuring of the economy, IT spending and the supplier landscape in another survey of North American and European technology decision makers. It expects firms to have the desperation as well as the courage to rationalise the application portfolio as dust settles in 2010.
Tumbling growth rates and margins have taken a big toll on the offshoring industry, used to a breakneck pace of growth. But the renegotiation of contracts is creating a bigger shift by accelerating the move to new models like managed services, outcome-based pricing and fixed price projects. Regardless of who?s their outsourcing services provider, companies are re-evaluating their contracts and re-negotiating arrangements.
Right now, flexibility in the project size and deal structure seems to be the key. ?A flexible cost structure is a given in this environment. Since no one is willing to give a long term commitment and budgets have lost their sanctity,? says Infosys CFO V Balakrishnan. Many clients are looking at pay per use model and want to adopt rollover minutes model popularised by mobile phone operators. Outsourcing firms have to revamp their pricing models to accommodate these demands.
Interestingly, the shift is more marked at a time when outsourcing deal pipeline is again showing signs of revival after an almost freeze for the last six to nine months. And the revival seems to be helping growth in the non-mega deals category. Average contract value of non-mega deals increased to $8.5 billion in last three quarters from $7.6 billion in the previous three quarters, according to deal advisory firm, TPI.
In sharp contrast, average contract value of mega deals declined to $3.3 billion in the last three quarters from $8.5 billion in the previous three quarters.
Transactions picked up in the deals sized between $25-50 million in the quarter ending March 2009, even as total value of deals signed in the first quarter of the calendar year 2009 was down 21% sequentially and 22% compared to the same period last year. Indian vendors could gain as most of the big deals coming to Indian offshoring companies fall in the range of $25-50 million.
Other deal tracking firms like Black Book of Outsourcing agree. More than half the companies that outsource say they expect their spending on technology to come back to the levels before they made cutbacks, according to its latest survey of 3,00,000 companies. Industry leaders confirm that request for proposals are being floated once again but the new ones are nothing similar to the ones signed a year back. And the changes in contract structure are more marked in companies that are under a slump. As Balakrishnan points out, large companies going through pain are the first ones who have changed the way they structure their deals.
As outsourcing picks up again, the deals will be much shorter and simpler, according to the Black Book of Outsourcing survey. As they want quicker returns, outsourcers will ask for a more thorough and quicker return on investments. No one in the industry expects this demand to die out as environment brightens. In a recent survey of North American and European technology decision makers, Forrester Research found that 29% will put their projects and new initiatives through a more thorough ROI in the next 12 months. Majority of companies are now looking for an almost immediate payback and want returns on investments within four to five months. Insiders expect the higher level of scrutiny and demand for quicker returns to continue for offshoring deals.
Analysts and vendors agree that when the slowdown ends and the growth returns, it will come in a different shape. The biggest change will come in the form of selective sourcing; smaller number of service providers; move from a time and materials to a fixed price model and increase of output-based pricing.
Most vendors have already sensed this dramatic change in what buyers are looking for. Most requests for proposals till a year back were quite cost and capability oriented, but buyers are now looking for partners to optimise their processes and deliver savings.
Analysts confirm that their clients are reporting intense discussions with their vendors and renegotiation of contracts for terms and conditions, service-level agreements, fees, volumes and low-cost offshoring delivery locations.
The nature of the deals has also changed to a great extent. ?There is a dramatic change in what people are asking for. Typically, CIOs used to outsource asking for a rate card to manage a bunch of applications. Now, they show us a set of applications and say our salesforce productivity is low and costs are high. How can you help us solve these problems,? says Krishnan Chatterjee, head of global business marketing, HCL Technologies.
A major consequence of the current economic climate will be a shift towards more tactical initiatives in the short term. CIOs are typically looking at converting capital expenses (capex) into operating expenses (opex). The new sourcing paradigm revolves around more fixed price projects, to a great extent.
Wipro executive director and joint CEO (IT business), Suresh Vaswani explained in a recent analyst call, ?Having fixed price projects or larger percentage of fixed price projects, you are able to achieve two things?one is you have more flexibility in terms of giving better cost to the customer and two, you have more flexibility in terms of driving your operational efficiency.?
Wipro has seen a shift in fixed price projects by as much as 650 basis points for the year. According to him, that has been one of the key reasons that they have been able to show significant price realisation this year over the previous year?3% onsite and 3% offshore.
The new sourcing paradigm is also expected to accelerate adoption of several emerging technology models. A closer scrutiny of sourcing options is widely expected to benefit software-as-a-service (SaaS). Cloud approach could also gain quicker acceptance as cash conservation gains momentum.
As most CIOs look for return on investment quickly, more projects are expected to see virtualistion and server consolidation. Analysts like Gartner expect revamp in IT governance methods to have a tighter focus on the role IT plays in the business.
As outsourcers reduce their IT spends, they are likely to consolidate vendors. Analysts in touch with large US and European tech decision makers have been seen asking for vendor assessment in preparation for consolidation. About half of the companies surveyed recently by Forrester had plans to consolidate to a smaller number of service providers either on top or middle of their agenda.
Clearly, recession has done nothing more than wipe out the inefficiencies of the outsourcing processes. But many of these changes have unfolded new models that can change the way IT is bought and sold. The new models promise to continue even as outlook for outsourcing starts to brighten and are not likely to fade even when the recession eases.