Perspective

Vinay Couto Kevin Dehoff Vikas Sehgal Jim Weinberg

The Five Fallacies Of Automotive Offshoring Overcoming the Lingering Obstacles to Offshoring BPO and Engineering Services

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CONTACT INFORMATION
Chicago
Vinay Couto Vikas Sehgal

Florham Park
Kevin Dehoff
Partner 973-410-7625 kevin.dehoff@booz.com

McLean

Senior Partner 312-578-4617 vinay.couto@booz.com

Partner 312-578-4828 vikas.seghal@booz.com

Jim Weinberg

Partner 703-902-3844 jim.weinberg@booz.com

Originally published as: The Five Fallacies of Automotive Offshoring: Overcoming the Lingering Obstacles to Offshoring BPO and Engineering Services, by Vinay Couto, Kevin Dehoff, Vikas Sehgal, and Jim Weinberg, Booz Allen Hamilton, 2006.

The Five Fallacies of Automotive Offshoring

Overcoming the Lingering Obstacles to Offshoring BPO and Engineering Services
The automotive industry is no stranger to offshoring. Offshoring practices, which began with the global sourcing of parts and components more than a decade ago, have expanded to include IT offshoring and are increasingly encompassing more and more of the value chain (see Exhibit 1). Still, the offshoring of business processes and engineering services is a relatively nascent phenomenon in the automotive industry, lagging behind other sectors such as financial services, travel, high-tech, and pharmaceuticals. Our experience in the auto industry indicates this reluctance to offshore higher-end functions is due to persistent misconceptions about the benefits and
Exhibit 1
The Automotive Industry Is Offshoring More and More of Its Value Chain

risks. Our goal is to debunk the myths and expose the current realities of offshoring automotive business processes and engineering services.
Never has the impetus to offshore been stronger in the automotive sector, compelled by severe and growing pressures on both the supply side (e.g., downward volume pressures, aggressive competition, legacy costs, and low capacity utilization) and the demand side (e.g., proliferation of product, employee pricing, shortening product lifecycles, and more exacting consumers). In response, automotive original equipment manufacturers (OEMs) such as General Motors, Volkswagen, and Ford have eagerly sought ways to cut costs while improving effectiveness and efficiencyand they have passed this sense of urgency onto their suppliers.

DaimlerChrysler Customer service Customer Tier 1 support Advanced technical support Complaint resolution Customer ful llment Dispatch support Collections consumer and B2B

Visteon Marketing and sales Customer analytics Market research Outbound telemarketing Sales graphic design Loyalty program assessment

Order ful lment Contract and quote administration Technical support Dealer support Product support

General Motors DaimlerChrysler Delphi CAE FEMA Simulations EBom/PDM Graphics Vehicle build plans support Prototype development

Product Development/ Engineering

Inbound Supply Chain

Operations IT

Outbound Supply Chain

Sales and Marketing

Customer Care

Financing and Accounting HR HR services Payroll processing Employee contact center Bene ts administrator Recruiting administration Employee data maintenance General Motors Dana Finance and accounting Accounts payable General ledger accounting Fixed asset accounting Accounts receivable Cash management

General Motors

Federal Mogul

Technology services Software development Hosting and maintenance Customer technology support Packages/enterprise applications support and installation Network-infrastructure management General Motors Visteon

Source: Booz Allen Hamilton

Still, most cost-pressured OEMs and Tier 1 suppliers have looked first to other obvious cost-saving targets, such as health-care benefits, discretionary marketing, and ad spend. They have limited their offshoring activities for a number of valid reasons, including high severance costs, intellectual property risks, and the unionization of professional labor, such as engineers. As these barriers have gradually subsided, the automotive offshoring market has grown substantially, but there is tremendous unexplored potential. IT offshoring (ITO), the largest and most mature segment of this market, is today a well-established industry with a large vendor base and an established set of rules and processes. In fact, many auto companies, such as Nissan and Mercedes, are already coming to the close of their first-generation ITO contracts and are actively looking to re-source. Others, such as GM, have already resourced their IT deals. However, the offshoring of business processes in administrative functions such as finance, HR, sales administration, procurement, and customer service is still in the incipient stages. The offshoring of technical functions such as engineering lags still further. Based on our extensive work advising automotive industry clients on outsourcing and offshoring, Booz Allen estimates that BPO is today four to five years behind the ITO market, and engineering is probably eight to 10 years behind. Winning companies around the world recognize where these markets are headed, however, and are already placing strategic bets. Increasingly, they see offshoring as more than Exhibit 2
Offshoring Value Creators and Destroyers

just an opportunistic cost play and are using it as a lever to tap into a global pool of skilled talent. They have moved beyond manufacturing and non-core process areas and are marching down the path toward offshoring core engineering and product-development processes. Offshoring is becoming an essential arrow in automotive companies quiver as they negotiate turnarounds and restructurings in their search for value. Still, several widely held misconceptions continue to dog the industrys progress in offshoring these services. We consistently come up against five myths in our work with clients. Myth 1: The Prize Isnt Worth the Trip It is true that the benefits of offshoring are often overhypedat least for companies that are expecting coststructure reductions of 50 percent or more. To those who claim that offshoring has not delivered the generous returns they expected, or, alternatively, that its too much upfront work for too little reward, we have two responses. First, these companies have likely overestimated their expectations for a return; second, they underestimated the upfront planning and ongoing governance required. More important, they also underestimated the substantial intangible benefits of offshoring. These benefits include increased flexibility and the ability to scale up rapidly to respond to new business needs. In our experience, the offshoring prize is definitely worth the trip, but auto companies need to invest the requisite upfront time and attention to minimize value leakage once the deal closes (see Exhibit 2).

Business Process Offshoring Benets Business process offshoring can generate value of up to 35% of baseline cost... 100 35 70 Labor 40 Vendor Cost 10
Process efficiency Client Baseline
(1) (2)

...but often nearly half of this value is eroded post-deal 35 Potential Value 8 5 2 20

Potential Value

65

Inefficient Demand and SLA(2) Management

Inability to Unwillingness Standardize to Transform Processes

Leftover Value

Client retained org for governance and PMO(1) Ongoing Costs Net Baseline

Gross Bene ts

PMO = Program-Management Organization SLA = Sevice-Level Agreement Source: Booz Allen Hamilton

With the appropriate amount of due diligence and a robust, ongoing governance model, most outsourcing relationships can be highly successful if companies institute the following 10 best practices: 1) Start with a firm understanding of your business requirements, based on both internal and external customer needs; 2) Know your own processestheir performance and their stabilitybefore deciding which ones to outsource; 3) Establish internally a logical, fact-driven business case for outsourcing; 4) Secure executive consensus and advocacy; 5) Think large, start small, and then scale up rapidly; 6) Set up a healthy, competitive supplier-selection process, one that accommodates more flexibility than the standard, template-ridden, RFP beauty contest; 7) Pick suppliers whose cultures, capabilities, and philosophies are aligned with your own; 8) Negotiate contracts that include service-level agreements, penalties and credits, and gain-sharing mechanisms; 9) Build internal vendor-management capabilities to manage the transition and support the governance of the relationship moving forward; and 10) Define an effective measurement system that holds both the outsourcing team and the supplier accountable for results. Myth 2: Fix It Before You Ship It

Naturally, this assistance comes at a price, and the most successful partnerships devise an appropriate way to compensate the offshore service provider and fairly apportion the value extracted through this transformation process. Progressive companies that opt to ship before they fix recognize the trade-offs involved in leapfrogging to an outsourcing solution: They leave some value upside on the table, but if they take time to understand upfront where their processes are broken and what it will cost to fix them, and then select the right partner with the requisite capabilities, they can negotiate a competitively advantaged and mutually beneficial deal, in which gains are shared by both sides.
Myth 3: Offshore Markets Wont Stay Competitive

Every six months or so, a spate of headlines proclaims that offshore destinations of choice, such as India, are losing their appeal because of rising labor costs. Salaries for Indian IT workers, as an example, are climbing an average of 12 percent a year. As large U.S. companies, such as IBM, Accenture, and EDS, expand operations overseas, this wage creep will only intensify. What we have here is really a two-pronged issue. First, will wage inflation really wipe out the labor arbitrage that has fueled offshoring any time soon? Second, will offshoring markets still be competitive even in the absence of labor arbitrage? While wage creep in traditional offshore centers is real, it does not warrant the level of scrutiny or alarm it has generated. Companies looking to offshore should first keep in mind that salaries are increasing everywhere in their headquarters country as well as in offshore destinations. Second, this much-hyped wage inflation is largely limited to the hot spots in India such as Bangalore and Chennai. Most Indian service providers, anticipating the impact of wage inflation in these traditional centers, have shifted the more routine, administrative aspects of their delivery processes to less expensive second-tier cities such as Jaipur, Kolkata, and Kochi. Moreover, there are new competitive offshoring markets emerging in China, the Philippines, Vietnam, and Eastern Europe. Furthermore, smart players in business-process offshoring are minimizing the impact of wage inflation at the lower levels by holding the line on entry-level salaries, while establishing career paths and attractive campus environments to stem attrition at the middle and upper levels. Taking all of this into account, we conclude that there will still be a substantial wage differential even 15 years from now (see Exhibit 3, page 4).

There is a widely held view in offshoring circles that companies should consolidate and/or reengineer business processes before they ship them overseas. In an ideal world, such an approach would indeed result in maximum value capture, but auto OEMs and Tier 1s do not operate in an ideal world. Given the myriad external challenges they face, they do not have the time, the capital, or the qualified resources to effect the transformation necessary to fix processes they intend to offshore: It is simply not a strategic priority for cash-strapped companies. On the other hand, it is the top priority for the external service providers taking over these processes; ruthless standardization and continuous improvement are their raison detre. Moreover, these providers have matured enough to drive the process transformation required. In fact, with sophisticated technologies, deep domain expertise, Six-Sigma discipline, and years of global experience, they can often fix processes and achieve cost efficiency faster and more reliably.

Exhibit 3
The Wage Gap with India Is Gradually Closing
Projected Wage Rate Differentials Between India and the United States U.S. Wages Wage Rate for High-End Services India Range Wage Rate for Low-End Services Gap: 10%40%

100% 80%

Wage Rates 60% (Percent of U.S. Wage 40% Rates)

20% 0% 2005
Source: Booz Allen Hamilton

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

2019

2020

The public sector is also addressing the talent shortage issue. For example, Indias National Association of Software and Service Companies (NASSCOM) has recently launched a pilot program to train potential employees in business-process outsourcing (BPO), an industry that is expected to employ more than a million 1 people by 2009. Programs such as these will not only expand the talent pipeline; they will improve the ongoing quality of the workforce. The Indian government is supporting these efforts by defining enhanced certification procedures, promoting higher college-quality standards, and encouraging collaboration between industry and educational institutions. There is no denying that, in time, wages will creep up in offshoring destinations, but so will the complexity and strategic importance of the tasks being performed. In our view, the competitiveness of offshoring markets is sustainable, not because wages will remain so much lower in these countries, but because productivity, even quality in some cases, will become so much higher. Countries like India have already established a global reputation for IT quality and competency. By investing in automation, Lean and/or Six-Sigma business-process reengineering, and code reuse, some service providers are able to generate 10 percent gains in productivity to offset wage inflation. In short, the offshoring value proposition is evolving from do it cheaper to do it better and cheaper.
Myth 4: Companies Cant Offshore Too Close to the Core

core of what they do. As such, the argument goes, innovation cant be offshored. Yet, automotive companies today are incredibly cash-constrained. The only way not to undermine investment in new-product development is to leverage low-cost R&D centers in offshore locations. The offshoring of this core work to low-cost countries is just the latest step in the ongoing globalization of automotive design and engineering (see Exhibit 4, page 5). This transition is driven as much by the quest for skilled talent as it is by the eternal search for lowest-cost solutions. Furthermore, as the electronic content of automobiles increases, the offshoring of work to electronic strongholds in Taiwan (design) and China (production) is increasing. Another trend driving innovation and engineering work to India and China is their emergence as major consumer markets in their own right. Automotive Tier 1s, followed by OEMs, have realized that they want to be where their customers are. Leading players are offshoring or will offshore as much as 50 percent of their workload and workforce 2 to lower-cost locations around the world. As an example, Toyotas Thailand operations already support truck platforms for the entire world outside of the United States. A real risk that attends offshoring innovation is the prevalence of intellectual-property piracy in some of these offshore locations. The key to navigating this risk is successfully structuring the right offshoring model for high-value processes and technologies. Typically, these premium services should be offshored to a captive center or, at least, to a center where the auto company can exercise strong management control (e.g., through a stake in the offshore provider). Johnson Controls, for example,

Automotive companies rely on innovation; it is the very

1 National Association of Software Service Companies (NASSCOM) 2 Booz Allen Hamilton

Exhibit 4
Automotive Offshoring Moves Closer to the Core
Roadmap for Offshoring Engineering Services to Vendor (20012005)
Manufacturing Support Design Design Design Support Modeling, detailing and legacy conversion Technical publications

Manufacturing Support Design

Increasing Complexity

PLM

Development, implementation and deployment

Casting design Harness design Hydraulic design Tool and xture design

Design and Validation Meshing Static and dynamic analysis Vibration analysis Fatigue analysis CETOL analysis

Digital simulation of assembly lines and factory simulation Of ine robot programming NC programming Weld procedure manuals Of ce CMM programming

Weld procedure manuals Of ine CMM programming

Engineering Applications
Engineering application development and customization KBE tools development

Manufacturing Support Process planning PFMEA Time management Process sheet preparation

Engineering Applications Engineering application development and customization KBE tools development

2001
Source: Booz Allen Hamilton research and interviews

2002

2003

2004

2005

Increasing Time

chooses from among a range of governance models for the work it offshores to India, depending on the nature and the sensitivity of the process involved.
Myth 5: Go With a One-Stop Shop to Reduce Vendor Management

Bundled, long-term mega-deals, in which multiple functions are outsourced/offshored to a single provider, are a remnant of the past. While single sourcing supposedly enables companies to capture cross-functional synergies, these scale economies have always been vague at best. Meanwhile, these bundled deals constrain companies flexibility and their ability to exploit technology innovation. Increasingly, companies are adopting a best-of-breed approach to global sourcing and engaging multiple vendors that specialize in select processes or services. Not only do companies enjoy the best-of-breed benefit across functions, but multi-sourcing also reduces outsourcing risk. Businesses can hedge their bets by retaining a number of smaller expert suppliers, rather than a single large provider. They can more easily address failures in specific areas (i.e., by replacing that particular vendor), and multi-sourcing enables more competitive pricingboth before selection and once service commences. While the emerging best-of-breed model requires more upfront due diligence and greater management complexity on an ongoing basis, it invariably results in an outsourcing arrangement that is more relevant and tailored to the needs and characteristics of the customer company. GMs ITO deal, announced in February 2006, is a good

example. In re-sourcing its IT services contract, the automaker opted to spread its $15 billion budget across a number of providersEDS, HP IBM, CapGemini, Covisint, , and Wiproto reduce its own risk exposure, encourage a healthy rivalry among vendors, and take advantage of offshore pure plays for discrete activities. At the same time, GM also slashed the contract term from 10 to five years. By engaging in multi-sourcing, GM gets the best of both worlds: world-class, value-added, strategic IT support, as well access to low-cost and efficient non-core services provision (see Exhibit 5).
Exhibit 5
General Motors Takes Advantage of the Best-of-Breed Approach
GMs Third-Generation IT Multi-Sourcing Deal HP ($700M*) Maintenance, monitoring, testing, deployment, user support Covisint ($100M*) B2B supply-chain collaboration Wipro ($300M*) Middleware systems and IS&S software integration IBM ($500M*) Apps support, integration management of IT computing infrastructure CapGemini ($200M*) Enterprise apps integration management
Note: *5-Year TOV Source: Booz Allen Hamilton

EDS ($3,800M*) Mission critical systems (servers, desktops, LAN, mainframes)

Managing these multiple contracts without running over budget or creating a stifling bureaucracy is a challenge, but companies today are becoming far more adept at managing disparate delivery models, pricing structures, and business metrics. They are instituting centralized vendor-management functions to monitor vendor performance, ensure compliance with service-level agreements, and apprise vendors of important company developments. They have also created a disciplined governance structure that oversees how the organization handles vendor selection, contract negotiation and oversight, and service-level management. In mature offshoring areas such as ITO, multi-sourcing has moved to the next level with the emergence of the prime/ sub model, in which a primary provider assumes responsibility for offshored efforts across all IT towers, but must engage other, smaller players that specialize in certain critical areas. The prime/sub model enables companies to achieve the dual objective of capturing the benefits of a best-of-breed approach, while reducing the complexity of multiple-vendor management.

Conclusion

Offshoring is here to stay. As cash-strapped auto companies search for cost savings to sustain their investment in new-product development, their attention is naturally turning to offshoring, and the range of valuechain activities they consider offshoring is expanding. The question auto companies increasingly ask is not Should I do it? but What more can I do? The offshoring myths that have caused many OEMs and Tier 1 suppliers to hesitate are being dispelled, and we are confident that the industry as a whole will globally source business processes and technologies more aggressively in the coming years. However, auto companies need to keep in mind that there is, unfortunately, no standard formula for success in offshoring, no universally accepted set of commandments. As companies explore offshoring and global sourcing opportunities, they need to adapt their approach, business models, and governance structures to their own unique circumstances to ensure that the benefits of offshoring accrue to them for years to come.

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20060092 10/06 Printed in USA 2006 Booz & Company Inc.