Get to what matters.
The Issue: Assessing the Role of Captive Operations in
Global Service Delivery Models
by: Cliff Justice, Managing Director, Globalization
Stan Lepeak, Managing Director, Research
Aparna Sundaram, Research Associate
Offshore outsourcing is moving beyond point-to-
point outsourcing (e.g., from the West to India)
toward multi-point, multi-provider global delivery
models. Services are simultaneously climbing the
value chain from transaction to more strategic,
knowledge-based processes (e.g., R&D, financial
analysis, marketing, market research). In response,
many buyers are seeking to establish offshore
captive operations, while others are divesting their
captive centers, and still others are leveraging
theirs to support partnerships with third-party
outsourcing service providers. Most buyers will
require a combination of service delivery options,
from internal distributed delivery to domestic
shared services, offshore captive operations,
and third-party outsourcing, to achieve their
performance, productivity and cost-reduction
objectives. This Perspective presents the pros and
cons of captives, a pulse-check on captive center
performance, and strategies to generate maximum
value from business process outsourcing (BPO) and
knowledge process outsourcing (KPO).
The Details
Drivers of global outsourcing are shifting from denominator-
focused (e.g., cost reduction) to numerator-focused factors
(e.g., performance improvement, revenue enhancement,
capital productivity improvement, and risk mitigation.
See Figure 1). Concurrently, the functions and processes
that buyers are seeking to outsource are moving up the
value chain. Service delivery units – whether third-party
partner or captive subsidiary – consequently, have greater
influence over a buyer’s core activities. For example, an
offshore service delivery unit can affect service quality
and stability, development and protection of intellectual
property, or the cost, timeliness, or method of exploiting
opportunities in the offshore country. Alternatively, offshore
partners can contribute intellectual property (IP), created in
hyper-competitive and resource-poor environments, to create
fundamentally new advantages in quality, speed, efficiency
and even innovation. This increased interdependency is
necessitating new relationships between buyers and suppliers.
How are Buyers Responding?
EquaTerra has found, through market research and client
experience, that buyers are eager to exploit global service
delivery to bolster competitive advantage; however, they
often fail to create realistic and thorough global sourcing
strategies. Some buyers, for example, view a captive center as
a lower-cost and lower-risk alternative than using third-party
outsourcing. Whether this is the case, however, depends on a
variety of specific circumstances.
Figure 1 – The Changing Face of Global
Service Delivery
A strategy created yesterday may not have the flexibility
to support today’s goals of revenue enhancement
or capital productivity improvement. Relationships
predicated on cost reduction during the first stage of
offshore outsourcing employed robust contracts and
service level agreements. Those based on performance
enhancements and cost reductions during the second
phase focused more on governance and communication
processes atop contracts. Now, as global services
become increasingly strategic, buyers are seeking ways
to gain greater control, for example, through risk-sharing
mechanisms and more precise contracts. Detailed
contracts may provide more comfort but decrease
flexibility and are costly to enforce. The key is to balance
control and flexibility in the context of a buyer’s risk
profile.
An EquaTerra Perspective
Captives currently account for $9 billion, or 30 percent
of total offshore outsourcing in India, the world’s largest
market for global service delivery. BPO services are often
housed in captive centers where they are perceived to be
lower risk: in 2005, 60 percent of BPO in India was done in
captive centers (as opposed to 25 percent of ITO). Buyers
establishing captive centers must ensure that they assess
operational requirements and future service needs as
thoroughly as if they were outsourcing to third parties or
they risk consequently underutilizing their centers.
An underutilized captive center is likely more expensive than
using a third-party outsourcing provider, despite the 15 to
20 percent premium that a buyer typically pays to a service
provider. A factor exacerbating costs is that buyers and their
captives lack a service provider’s institutional knowledge,
brand and facilities. For example, an inexperienced buyer
may organize captive operations as an internal local cost
center and will under-perform relative to a third party
that delivers services as a revenue-generating business.
Furthermore, operational inefficiencies can lengthen captive
start-up times and expenses. In India, EquaTerra finds that
organizations can easily add up to six months to start-up
time to understand the local business environment, legal
infrastructure, and taxation regulations – important issues
that a local service provider typically understands.
Below are facts buyers must consider when evaluating their
captive operations. While much of the data pertains to
the Indian market, the points hold true across many other
offshore markets.
Costs
• Captives often spend more on buildings and furnishings
than third-party providers, rent in better locations and
neglect to bargain adequately with property developers
and managers. Increased demand for real estate in
cities where offshore outsourcing is centered – BPO
companies are responsible for occupying 50 percent
of new commercial real estate in India in the last three
years – and regulations favoring local companies
amplify the costs to captives. For example, in India, the
government allocates land for free or at nominal prices
to providers building significant facilities.
• After investing in the development of facilities, buyers
face increasing labor costs, a lack of institutional
knowledge, and an absence of local name recognition.
Various market estimates predict that the Indian BPO
labor market will fall short by 500,000 or more full-
time equivalent (FTE) employees in the next three to
2
Get to what matters.
Figure 2 – Defining an Offshore Captive
Operational Model
Offshore captive operations are quite simply buyers’
internal shared services center operations, established
or extended to a lower cost, a.k.a. “offshore” market.
EquaTerra defines shared – or enterprise – services as
follows:
1. A collection of activities that cross various
functional boundaries and can individually or
collectively be provided to internal operating
groups by a common service organization.
2. A service enterprise that creates and sells common,
measurable and scaleable services to business
entities within the same corporate structure for
a fee.
3. A passion to transform end-to-end business process
through scale, automation, standardization,
aggressive performance management, customer
orientation and wage arbitrage via a global network
of captive or outsourced service centers.
Organizations deploying captive operations have
similar goals as those deploying traditional enterprise
or shared services operations. For companies that are
not yet global, captives lower costs primarily through
labor arbitrage – though EquaTerra is increasingly
finding that buyers are seeking skilled, not just
cheaper, labor in offshore markets. For those that are
already global, captive centers often present gains
through process improvements. In both cases, captive
operations also present similar challenges to offshore
outsourcing, such as language and cultural barriers,
time zone differences, and legal and regulatory
complexity.
five years. While this number is disputed – particularly
by India-based service providers – the trend toward a
tighter and more expensive labor market is clear. Third-
party service providers are able to recruit employees
and control attrition by offering clearer career paths in
entrepreneurial environments. Additionally, providers are
able to access labor arbitrage opportunities in an ever-
expanding number of different geographic locations.
Providers in multiple locations can employ flexible
models that allow for work transfer across international
locations to mitigate dynamic risks and hedge against
any exposure to currency risk.
An EquaTerra Perspective
• Parent companies typically send top managers to the
offshore outsourcing locations to set up captives. Travel
and opportunity costs for these managers increase
start-up costs by 60 to 70 percent over third-party
providers. Expatriate salaries keep operating costs up
during steady state. Long-staying managers also expose
the organization to additional taxes, at least in India. A
recent court decision stated that profit taxes would be
applied to centers that had foreign employees working
in-country for more than 90 days. While BPO firms
had previously been exempt from corporate taxes in
India, corporate taxes of 34 percent or at the minimum
alternate tax rate of 11 percent (whichever is higher) are
levied if the center is deemed to operate at less than an
arm’s length from the parent. The 90-day clause is one
measure of estimating “arm’s length.”
Attrition
• Attrition rates at captives are often 10 to 20 percent
higher than at larger service provider companies,
where the average rate is approximately 20 percent.
Captives must, consequently, spend more on
advertising, recruitment, training and retention fees.
Local service providers can better control these
expenses with corporate performance-linked pay
schemes, professional development programs, and flat
organizational structures that encourage collaboration.
• Buyers typically pay a 30 percent premium to recruit
employees in knowledge-based services from the open
market; providers with established local presence can
limit exposure to these costs.
Scale
The scope and complexity of services must be compared
with size and scale in order to justify the overhead costs of
a small captive center. An R&D captive center, for example,
with higher-value resources can justify a smaller scale than a
customer-care captive.
• Achieving economies of scale is critical for captives
that perform high-volume transactions or mundane
tasks, such as application development and testing,
claims processing, or accounts payable/receivable.
Captives executing these services often cannot achieve
economies of scale and operate efficiently, because
they are unable to seek volume from third-party buyers
and parent companies often send low volumes of
work. McKinsey & Company finds, for example, that
the average captive’s costs are 30 percent higher than
those of third-party outsourcing providers, largely due
to less effective operating practices.
3
Get to what matters.
• Knowledge process outsourcing (KPO) captives
performing R&D, analytical analysis and other strategic
functions can operate on reduced scales. KPO services
are typically more rewarding (monetarily and personally)
and more integrated with headquarters operations;
consequently, professionals in the local market desire
positions in KPO establishments. KPO firms still need to
address scale: KPO firm Evalueserve cites inefficiencies
in captive KPO centers on the order of 7 percent, due
to lower staff-to-billable professionals ratios (a smaller
captive with 50 FTEs would likely operate in the 1:4
to 5 range, at best, as opposed to 1:8 for third-party
providers). Inadequate scale added inefficiencies of 10 to
15 percent during start up and 3 to 5 percent in steady
state, according to the same report.
• Lack of scale can cause even shutting down to become
expensive irrespective of the type of service. If no
buyer can be found for a small or under-utilized captive,
processing paperwork, transfer contracts and divesting
facilities to shut down a facility can take up to two years.
As organizations seek to send offshore more strategic
functions, EquaTerra expects the number of captive centers
to grow approximately 30 percent in India alone over the
next two to three years. Organizations establishing these
captives may be new entrants to the market with inadequate
experience to pursue opportunities beyond labor arbitrage.
These captives will risk following the poor performance of
some of their predecessors and may quickly see a need to
re-examine their outsourcing choices.
How are Outsourcing Service Providers
Responding?
Multinational and domestic third-party service providers
continue to build out their own delivery capabilities in India
and other lower-cost markets. This pressures captives to
compete for increasingly scarce and expensive resources,
as explained above. While some service providers offer
“build/operate/transfer” services to Western buyers, leading
providers increasingly offer outsourcing services only.
EquaTerra finds buyer interest in completing transfers to be
waning. Buyers with captives find themselves competing with
service providers for talent and resources, simultaneously
purchasing services in other operational areas from the same
providers.
An EquaTerra Perspective
Service providers also are expanding their offerings to
include KPO services. As the range of services available
through third-party providers expands, the advantages
of captives diminish, though there are still industry- and
buyer-specific services that are not readily available on the
open market. One way service providers are expanding their
offerings is through partnerships with captive centers. In the
most popular model, providers take over non-core functions
from captive centers, enabling the centers to focus more
exclusively on strategic services. More innovative models
involve service providers and captives contributing valuable
intellectual property (IP) to execute strategic services.
Partnership and hybrid models are further detailed below.
Service providers are expanding their service delivery
footprint globally. This is, in part, out of the necessity to
support workforce needs, address costs, diversify and target
new markets. Expansion can also make the service provider
more competitive relative to a single-country captive given
the expanded access to a diverse and potentially more cost-
competitive global resource pool. Global diversification has
required providers to develop expertise in disaggregating
services – even knowledge-based ones – distributing the
components in a way that leverages skill sets, time zones
and cost savings, while hedging against risk. Few buyers will
have the resources, expertise or desire to build out a multi-
country captive model with the speed, efficiency or scale of
a global service provider. India-based service providers are
building out their Western operations, putting them closer
to buyers and enabling them to deliver services that require
a local presence to facilitate remote execution.
Service providers continue to make acquisitions of captive
operations (Infosys recently acquired Philips’ Electronic
captive F&A shared services centers and Citigroup’s captive
is being pursued) to increase their services and global
footprints. Some captives have consequently been sold
or become successful service providers (e.g. GE’s is now
Genpact, British Air’s is WNS). A purchase is the exception,
however, not the rule. Buyers should validate whether or not
this is a realistic exit strategy.
The Advisor Perspective – Critical Points
to Consider
Buyers must consider factors such as their individual
circumstances, as well as those related to their industry
and competitive landscape, when creating a global service
delivery strategy. Organizations often fail to adequately
incorporate these factors in their outsourcing strategies
– particularly when establishing captive centers. Frequently,
4
Get to what matters.
captive centers become catch-alls for non-essential work sent
piecemeal by managers with short-lived interest in using the
center. Operating without a strategic goal, the captive center
itself fails to cultivate a culture of continuous improvement.
Employees at the captive center are unmotivated to
learn about or adopt process improvement methods or
certifications, such as CMMI and Six Sigma.
Buyers that currently deploy, or are rolling out, captive
operations need to focus on ways to evaluate and drive
performance. Ways to improve performance include aligning
or realigning the headquarters organization with the captive,
focusing the captive and outsourcing endogenous activities,
and creating hybrid partnerships or “virtual captives.” If none
of these options are appropriate, there is an opportunity for
outright sale.
Realignment: Buyers often fail to redesign their global
processes when establishing a captive. When starting a
captive, organizations sometimes extend existing processes
and their inefficiencies to the new office. They should seek to
improve performance by realigning the organization to better
use the captive center.
• Advertising or re-introducing the center to business unit
managers, requiring that these managers recommend
ways to leverage the center, and formulating a transition
plan can enable the captive unit to gain scale, increase
resource utilization and staff size, and optimize marginal
costs.
• Creating or re-framing a transfer pricing system and
articulating revenue goals can motivate management at
the captive center to seek additional work from these
same or new business units within the organization.
Revenue goals are only relevant, however, if the captive
center has strong local management, an understanding
of firm-wide operations, and authority to suggest
initiatives to the headquarters or its business units.
• Evaluating the captive center’s financial performance
in terms of the organization as a whole can expose
opportunities to exploit local tax regulations. For
example, the Indian BPO tax ruling mentioned earlier
allows a captive center to charge an above-market rate
(e.g. the U.S. cost price) and gain exemption from taxes,
or to charge a market rate (e.g. a premium Indian price,
which is in line with the prices that a third-party provider
would charge) and pay profit taxes. Upon examination, it
may prove beneficial to do the latter, particularly if this
drives captive center managers to better control costs or
improve processes, or if the center can be used as a
tax shelter.
An EquaTerra Perspective
Partnership: A partnership with a third-party service
provider can create opportunities for both product or
service innovation that are beyond what many captives
can achieve independently given skills or cost constraints.
Partnerships can enhance overall process performance,
better utilize assets, and create a better risk profile. Ideally,
a partnership can both drive innovation while keeping
costs low and efficiency high. There are many types of
partnerships open to buyers. At one end of the spectrum,
captives and partners perform separate but complementary
activities as part of an overall service chain. In the hybrid
partnerships or virtual captive models discussed below,
partners are brought in to perform some or all of the
activities within the captive center itself. In these models,
the buyer maintains control and ownership of the captive
center but does not directly perform all of the work in the
center. The nature and depth of a partnership depend on
various specific buyer factors, including needs, sophistication
and risk profile.
• Offshore partnerships in locations like Russia, India and
China must innovate ways to gain leverage in extremely
competitive environments despite a lack of access to
robust infrastructure, laws, financial markets and other
resources that buyers take for granted. As a result,
buyers involved in these partnerships have been able
to develop and leverage IP – in terms of processes,
technologies, products, disaster recovery systems and
more – more effectively than they would have been
able to do independently. Boeing provides a successful
example of this. The company maintained control of its
own IP while leveraging over 40 partnerships for their
IP. The Boeing R&D captive, together with its third-party
partners, designed parts of the 787 Dreamliner. The
partnership enabled Boeing to introduce a fuel-efficient,
mid-sized aircraft to the market bucking the industry
trend toward larger aircrafts and earning $100 billion in
a single day.
• Third-party providers are experienced in distributing
non-core activities to global locations. Consequently,
they are skilled at disaggregating and modularizing
business processes, managing stable global delivery,
and shifting work from one country to another to hedge
against natural, regulatory and financial risk. Partnership
can increase flexibility by enabling the captive center
and the headquarters organization to make better use
of resources, speed up response times and reduce
financial burdens. Finally, the current appreciation of
the Indian rupee is highlighting the advantages of multi-
country operations.
5
Get to what matters.
• A third party could make use of a captive’s excess facilities,
particularly if the captive is in a location that the provider
is not or if the work requires specialized technology or
equipment. Partnership with a third party could also gain
the organization and/or captive access to the institutional
resources of, and/or financial incentives targeted to, the
former.
• For any of the above benefits to accrue, additional
measures are required, such as realigning the parent
company around an offshore outsourcing strategy. The
primary shortcomings of a partnership are heightened
risk and complexity. A buyer could end up with numerous
partnerships that lack a unified goal. Captives, including
those already in partnerships with third parties, will need
to develop governance processes to manage third parties.
For this success to be replicated by other companies, a
strong understanding of the offshore outsourcing market,
KPO performance drivers and metrics, relationship
management processes, and governance mechanisms,
are critical.
Hybrid Partnership: In this version of a partnership, the
captive center partners with one or more third-party service
provider that offers some of the captive center activities (e.g.,
infrastructure, HR services, process management) to enhance
the center’s performance. The partner is brought directly into
the captive’s operations as opposed to providing separate
but complementary services externally. Specialization in
high-value services, coupled with partnership with a third-
party provider, can improve the captive’s balance sheet.
Captives can create agreements with third-party providers
to handoff non-core activities and focus specifically on
services that must remain in-house. The scope of a hybrid
relationship can range from infrastructure managed services
to tactical staff augmentation to full-scope outsourcing
of key functions within the center. The buyer keeps overall
ownership and control of the center, along with the business
unit relationships, though the third-party provider may assume
more strategic roles over time. By leveraging the local brand
and core capabilities of third-party providers, this approach
can potentially make recruiting new staff easier, improve
productivity and drive ongoing savings from the center.
Virtual Captive: In this more expansive version of the hybrid
partnership, the buyer partners with a service provider that
will provide nearly all of the captive center operations. The
buyer typically retains ownership of key personnel and
processes, though this is not always the case. The result is a
third-party operated captive center or “virtual captive.” This
approach is particularly effective when internal policy or
regulations preclude an approach that releases control of
processes to a third party.
An EquaTerra Perspective
Divestiture: There are situations where realignment of the
organization, specialization in the captive, or partnership
with a third party will lead to insufficient improvement.
Buyers in industries exposed to extreme cost pressures could
be better served to sell their captives. While realignment or
specialization can boost performance, the costs to do either
and the time before benefits are seen could prove to be
too costly, particularly if there is the opportunity to sell the
center. Many providers are seeking to bolster their credibility
in order to gain competitive advantage and win KPO
contracts. A captive center may give a provider specialized
knowledge and skills, credibility and added capacity.
Occasionally, selling off some or all of a captive can prove
lucrative to the buyer. General Electric, for example, sold
60 percent of its Indian captive to General Atlantic Partners
and Oak Hill Capital Partners. The now renamed Genpact
is a 20,000 employee, $500 million company with GE as a
primary customer. Captive owners should recognize that the
Genpact scenario is unique in terms of the captive center’s
capabilities and the price premium it commanded.
New entrants and those with existing captive centers should
thoroughly examine their offshore outsourcing strategy and
business case, inclusive of the following factors: existing
market environments, management thinking, overall
business strategies and business processes. Second to this,
they should create or redesign their offshore outsourcing
strategies – not the other way around. Companies must
then define their primary offshore outsourcing
objectives – cost reduction alone, in addition to
performance enhancement, or in addition to revenue
enhancement, capital productivity improvement, and risk
mitigation. If the goals are numerous, the best strategy may
be multi-sourcing. Finally, companies should analyze local
market conditions to decide on an appropriate outsourcing
strategy.
6
Get to what matters.
Both captive centers and third-party providers bring unique
advantages to a buyer: the former brings greater control
and local presence, and the latter, cost reduction, global
delivery and potentially innovative IP. If a buyer is already
operating globally, labor arbitrage becomes less significant
to the business case. The services a buyer is outsourcing also
are crucial: if they are more mundane non-core services, a
captive would need scale to achieve cost reduction. Third-
party providers have economies of scale in their areas
of specialization, as well as a global footprint and flexible
delivery model – and IP that can spur disruptive innovation.
Scale, global locations and flexible delivery can reduce costs
and risks and increase productivity significantly, while IP and
innovation can open new markets.
Simply outsourcing to a third-party provider, however,
separates a buyer from the human resources function. The
buyer loses ability to motivate managers with non-monetary
incentives, such as the award of greater responsibility
or authority – measures that could prove significant in
competitive labor markets. Moreover, by outsourcing alone,
buyers lose a certain degree of opportunity – both to drive
process improvements and to develop local institutional
capacity. Captive centers can create or expand a company’s
local presence, develop and maintain assets in diverse
markets, control critical business processes, and improve
overall financial performance. As each model brings unique
advantages, thorough analysis and possibly a multi-sourcing
model is necessary.
An EquaTerra Perspective
Conclusion
As global outsourcing focuses more on revenue
enhancement and capital productivity, in complement
with cost reduction, companies have more opportunity
and greater risk in global sourcing strategies. Increased
interdependence between external service delivery
options and core business performance has necessitated
new relationships – particularly multi-point global services
delivery. Re-examination of an organization’s offshore
outsourcing performance will enable a company to
proactively manage multiple third parties, internal and
captive delivery models to drive an organization’s overall
strategic goals. The best combination of models, locations
and global services will depend on the objectives, practices
and process of the organization in question and its
outsourcing objectives, plus a good plan to integrate the
two. Organizations that have deployed or are considering
deploying offshore captive operations need to clearly
define what services those centers can best perform and
whether they can perform those services more efficiently
and effectively than a third party. This bundle of services
will change over time, and, in some cases, outsourcing may
become preferable for more routine activities as captives
handle specialized services (e.g., regulatory requirements,
IP concerns). In other cases, outsourcing can contribute
valuable IP and drive innovation while captive centers can
focus on project management. Buyers should examine or
re-examine their offshore outsourcing strategies in the
heightened context of BPO/KPO opportunities to determine
the route to maximum value.
Copyright © EquaTerra 2007. All rights reserved. The prior written permission of EquaTerra is required to reproduce all or any part of this document, in any
form whether physical or electronic, for any purpose. 3005_082007
7
Get to what matters.
About EquaTerra
EquaTerra sourcing advisors help clients achieve sustainable
value in their IT and business processes. With an average
of more than 20 years of experience in over 600 global
transformation and outsourcing projects, our advisors offer
unmatched industry expertise. EquaTerra has in-depth
functional knowledge in Finance and Accounting, HR, IT,
Procurement and other critical business processes with
advisors throughout North America, Europe and Asia Pacific.
Our people are passionate about providing objective, conflict-
free advice to our clients, which has fueled our exponential
growth over the past four years. We help clients achieve
significant cost savings and process improvements with
outsourcing, internal transformation and shared services
solutions. It is all we do.
If you have questions about this report or would like to learn
more about how EquaTerra can help your organization address
the points and opportunities discussed, please contact
Cliff Justice at Cliff.Justice@EquaTerra.com or +1 925 918 0142.
For additional information on EquaTerra, please contact
Lee Ann Moore at LeeAnn.Moore@EquaTerra.com or
+1 713 669 9292.
For more information on EquaTerra’s research efforts, contact
Stan Lepeak at Stan.Lepeak@EquaTerra.com or
+1 203 458 0677.