Captive or Outsourcing - What suits your business?

Captive is basically a service model (a type of Business Process Outsourcing) where an organization invests and develops its own subsidiary rather than investing in a Third Party vendor. The benefit of such an arrangement is that organizations are able to leverage the cost savings of offshore resources, while having complete authority over the center. It also allows them to build domain/knowledge capital over time. However, running a captive data center involves huge infrastructure cost in terms of land, buildings, servers and networking equipment, security personal, power and generators cost, electronic surveillance. Apart from these, complexity costs like installation, maintenance and monitoring requires highly skilled technical professionals, data protection and software experts, data warehouse and storage experts, etc.  On the other hand you have Third party vendors who have all the infrastructure set up and can provide you the required service efficiently at a much lower cost. Citigroup, Unilever, Deutsche Bank, Dell etc. are few of the Fortune 500 companies who have shut down their captives in recent years. Some 60 per cent of all such captives fail to meet expectations. Third party offshore outsourcing industry, particularly in India, has reached a maturity level that one wonders why a company would take the hassle of setting up their own shop abroad.

And yet the Captive Center lives on. According to NASSCOM there are more than 750 multi-national companies with captive centers in India. The captive centre market has grown to $11.1 billion in annual revenue, which represents a 300% plus growth since 2003. According to international Data Corporation (IDC) India, Captive Centers are expected to grow at CAGR 16% in next two years. MNCs like MetLife Inc. started its captive center in India three years back and currently employs close to 2500 employees. Indian banks like SBI, ICICI Bank, PSB and Bank of Baroda have their own data centers. BSNL, Bharti Airtel, Reliance Communications and Tata Communications are the leading telecom operators that have captive data centers. How have the captive centers managed to survive when it makes absolutely no business sense to invest in one? What are the driving forces that make a company opt for a captive delivery center rather than outsourcing? 

Captive Model

Drivers:

Control over operations

Companies prefer to keep a very tight control over the sensitive matters of their business, like new product launches, product costing data, engineering data, etc. Since captive center model enables them to have complete operational control and transparency, it is preferred over other models.

Reduce Cost

When companies have ambitious and aggressive plans for offshoring and would like to do it on a large scale, they would like to retain the 'economies of scale' and set up their own centers. Companies already having an existing set up in the low cost region would prefer to extend these centers to support engineering activities as well.

Knowledge Transfer and Retention

Some companies believe that best knowledge repositories are their own people who have worked in the organization for several years and have been part of multiple product launches. So companies prefer captive centres where they can leverage the knowledge of their employees to train new employees and thus retain the knowledgw within their organization.

Strengthen their presence in local market

Companies want to establish a strong foothold in emerging markets like that of China and India. local presence will enable these companies to understand customer prefernces well and they can leverage the local resources to bring products faster and cheaper to the market.

Data Security

Insurance and banking companies are extremely sensitive about customer data. These companies deal with account details, social security numbers etc. of their customers which if leaked can result in severe penalties and lawsuits. Naturally, companies would prefer having their own captive centers.

Challenges:

Lack of Scale

Scale of operations is the most important parameter determining the success of the company.

Higher than anticipated costs

Many companies don't pay premium salaries to attract top talent in their captive units.Desperate to scale up, captives often pay well above market rates throwing the entire cost model out of order. This is a serious demerit of the captive model especially hurting the start-up units which operate on a shoe-string budget.

High Attrition

High attrition is a major deterrent which kills productivity and at the same time destroys morale of the resources. Industry statistics show attrition at captive centers is almost twice as high as the average rate for the third-part providers. There are several factors that drive attrition. 

There is sense of lacking as far as career path opportunity is concerned, especially at smaller captives

Second-class-citizen status

In many cases off-shore teams at the captives are considered as second class employees doing uninteresting work that is not important to the main function of the organization

Managing Attention Wanes

The management team is initially excited about the captives. But it is generally observed that the management support and the enthusiasm are very short-lived. It is highly essential for the captive model to be experts in managing their operations without diverting attention from the core focus of the company.

Poor Development Process and Integration

Many captives face a lot of difficulty in establishing strong development processes. Ability to integrate rigorous procedures like CMMi, Six Sigma and other measures into practice are seldom found in the captives. Further they often lack proven processes for knowledge transfer and collaboration.

Perception Change

Due to heavy startup costsand the lead-times involved in showing the ROI and tangible results, captive centres develop an image of a cost center in an organization. To change perception within the parent organization from being a 'Cost center' to a 'Profit center' would be a challenge.

Key Reasons for failure:

• Lack of vision and focus from the parent company
• Thrust on short term goals and to show quick benefits
• Inability to attract, develop and retain talent in local markets
• Trying to maximize benefits from labour arbitrage rather than focus on building a value chain in these centres.

Outsourcing Model

Drivers:

Shorter lead time to get started and to get results

Since vendors have an established setup they can provide a quick start and have the ability to ramp up operations quickly

Companies have the option of doing a pilot execution before any large scale operation

Upon successful piloting, companies can choose to strengthen the vendor-partner relationship to support the large scale operation or set their own captive operations

No large upfront investments required

No wind-up hassles/costs involved

Challenges:

Domain Skills and Knowledge Transfer

For engineering companies finding vendors with core domain and technical expertise is very difficult. under such circumstances, companies would have to invest a lot of time and money to ramp up the knowledge levels of their vendor partner

IP Protection

Companies believe that it is risky to carryout core engineering activities with vendor partners due to fear of losing IP.

Data Security

Companies in insurance and banking sector are very sensitive about their customer's data. Any misuse of such data can lead to heavy penalties and lawsuits.

Having seen the drivers and challenges of both service models, a company should choose the model that fits their short-term and long-term plan best. The decision to select an off-shore model should be based on the Total Cost of Ownership. If a company is opting for Captive Service Model, it should assess its strengths and weaknesses w.r.t. the country where it is planning to establish the center. Management support, Infrastructural facilities, Government policies etc. are some of the key points to be taken note of.

On the other hand if a company is opting for a Third Party Vendor, it needs to assess its partner from various perspectives and narrow down to the best choice. However, going ahead I believe that a blend of these two service models is what will suit the business best - a hybrid model where service providers complement the operations of the company. For example, a service provider can help in setting up the captive center initially using its own resources. Once it is setup, the service provider along with the parent company can start recruiting talent and train them. Once the processes are established and the center is stable, ownership can be transferred to the parent organization. The service provider can take the role of a consulting partner after transfer of ownership. There can also be a scenario where a company opts for a service provider and within the Third party's premises sets up its own personal space to handle sensitive data and key processes. In fact this is something that is already in practice e.g. Microsoft has Offshore Development Centers (ODCs) within Infosys premises. The costs of operating the ODC like electricity, maintenance, employees etc. is borne by Microsoft.

According to Eric Simonson, managing principal of the Everest Research Institute, an independent research and analysis organization on taking a sample of captives, you might find that a fairly high number are struggling. But if you weight it and look at the larger and more mature organizations, the number that are struggling is dramatically less. Many of them that are struggling are less experienced companies that have come to the market more recently. So some are in the early stages and experiencing growing pains, others might have been late adopters to begin with and maybe not as adept in understanding offshoring or the culture in which they are operating. So yes, it's right that a fair number of captives are struggling. But if you look at where the work is occurring, the mass will tell you a different story.

(you can read the complete interview at http://www.itbusinessedge.com/cm/community/features/interviews/blog/captives-vs-outsourcing-combining-approaches-may-be-best-answer/?cs=22760)

References:

Offshore Models for Engineering Product Development: Captive Center vs Vendor Partner - Vijay Machigad, KNS Acharya (White Paper)

http://www.cio.com/article/149154/Total_Cost_of_Ownership_Comparison_of_Outsourced_Versus_Captive_Solutions_for_Capturing_Outsourcing_Value

http://community.forrester.com/thread/3993

http://articles.economictimes.indiatimes.com/2011-04-21/news/29459331_1_captive-centre-captive-units-offshore-vendors

http://www.iit-nearshore.com/captive-vs-outsourcing.html

-Rahul Mukherjee

MDI 2011-13