In a recent ComputerWorld article, Gerry Clark of TPI offered his perspective on outsourcing trends. One of the most interesting things that Mr. Clark highlighted was the increasing effort provider markets take to distinguish themselves from other markets. He says:

Differentiation seems to be the direction that most are taking. The big attraction offshore used to be lower cost. Today, that is not good enough because they themselves are facing increased inflation in labor, real estate and infrastructure cost. Even countries like India have to think about what else they can do to be successful.

While I tend to agree – participants in crowded marketplaces always look for differentiation – I wonder what the effect such differentiation and segmentation will have on the marketplace in general. After all is said and done, the effort involved in entering into and managing an outsourcing relationship can be costly, and requires distinct, measurable benefits over non-outsourced environments.

Generally, benefits tend to align themselves in three broad areas: costs, scalability and capability. While many, including this author, have suggested that focusing on areas aside from cost is imperative for a successful relationship, one can also make the argument that, without cost benefits, the outsourcing model contains some serious flaws.

Why? First, analysts often fail to consider transactions costs. However, transactions costs are both real dollars (in the case of advisors and lawyers) and lost productivity (in the case of analysis and management), and can adversely affect the cost-benefit analysis. As deals get shorter and smaller, transactions costs eat up a larger portion of the deal value. Put simply, if a company invests the same time and money in building its own staff that it would in building an outsourced relationship, it may be able to secure excellent results within its own four walls. Without a significant cost benefit, offshoring can become a less attractive option.

Second, if one takes cost out of the equation, it is possible to address scalability and capability in most domestic markets without changing the delivery model. While there may be specific labor shortages in specific markets, many needs can be met through hiring and training in local markets. Furthermore, popular offshoring destinations are experiencing labor issues (including shortages and turnover) themselves. Such issues adversely affect markets ability to scale significantly. Without a significant cost benefit, offshoring again becomes less desirable.

By raising the internal governance costs, differentiation and market segmentation also work to make offshoring less attractive. It is cheaper (although perhaps not more successful) for a company to manage one or two large, long-term deals than it is for that same company to manage ten specialized, short term deals. As a customer’s transactions costs and governance costs increase, the cost-benefit of offshoring, by their nature, decrease.

Finally, developing a market based on capability is no easy task. Unlike cost and scalability, a capability-based market is a reputation-based market. For a variety of reasons, executives tend to believe that outsourcing – particularly offshoring – is inferior to, but cheaper than, domestic services. Like many back-office services, executives are far more likely to notice and talk about failures than they are about successes – and the successes often do little to polish the public reputation of an outsourcing vendor. This is not a good foundation for a capability-based market. Furthermore, the nature of offshoring deals – and most customers’ desire to keep them from public view – does not tend to offer the type of repeated positive customer contact and press necessary to build a good reputation.

“Top-ten” lists (and there seem to be many) do little to ameliorate this problem. They are simply not believable measures of how Vendor X will handle your problem. Advisors and lawyers can offer some assistance, but all too often, such parties are only involved in the deal-making and dispute resolution processes, not the governance process, and their knowledge of Vendor’s actual capabilities are, in fact, limited.

Cost, on the other hand, is easily estimated and believable – even though cost estimates have proven remarkably inaccurate and deal value has proven elusive. The often-false objectivity offered by a set of number on a spreadsheet – and the many gates generally provided by a customer’s finance and legal organizations offer security to the outsourcing executive that is not offered by claims of scalability and capability. In addition, one could make the argument (and I will in a later article) that outsourcing reduces the cost risk to an organization (even if it increases the process risk) by reducing the size of the domestic workforce and, therefore, the risks of benefit mandates and accelerating benefit costs.

Like domestic companies looking to offshore, offshore vendors are going to have to look into ways to make their organizations leaner and more efficient. Ultimately, cost will remain a key differentiator – and one that is facially more objective than other measures.