There's reason to smile: The Indian BPO industry is clipping at 40 per cent, and by 2010 could fetch $30 billion

These are heady times for the Indian BPO industry. Last fiscal, according to NASSCOM, the industry grew 44 per cent to rack up $5.2 billion (Rs 23,400 crore) in revenues, and this financial year it will grow another 40 per cent to clock $7.3 billion (Rs 32,120 crore) in revenues. At last count, there were some 300 BPO firms in the country, with 350,000 people on their payrolls. By 2010, the industry is expected to be $30-billion (Rs 1,32,000-crore) big. No wonder, many people in the industry believe that the BPO gold rush has just begun. But has it? Fierce price competition, high employee attrition and a shortage of skilled manpower are beginning to tell on the industry. Although revenues are growing, margins are under pressure, and it's getting harder to enter more value-added activities. In fact, according to a recent Gartner report, the Indian BPO industry could lose as much as 30 per cent of its market share by 2007 to emerging BPO destinations such as the Philippines, Malaysia, Vietnam and Poland.

Recently, Bala V. Balachandran, distinguished professor of accounting at the Kellogg School of Management, and Vijay Nallan Chakravarthi, a 2005 graduate of the school, undertook a study of the Indian BPO industry as part of their consulting assignment at a Hyderabad-based BPO. Based on their analysis, Balachandran and Nallan Chakravarthi have come up with five managerial strategies that will help executives at BPO firms create and sustain value.

But first, a quick word about VNC Inc., (not the Hyderabad BPO's real name) and its dilemma. A healthcare administrative service provider, VNC recently underwent a change in leadership. It has five major product lines, with revenues of $18 million (Rs 79 crore) and an operating profit of 12 per cent. However, with increasing competition and more demanding client needs, VNC's new CEO is facing a dilemma typical of other BPO CEOs. Since VNC's employees and processes share responsibilities across product lines, the CEO does not have a clear understanding of the profitability of his different products. He is not clear whether he should focus on revenue increase or cost decrease in order to increase the profitability of the company. Further, the new CEO would like to craft a strategy to elevate VNC to the next level of growth.

Now, a look at the five strategies:

1 UNDERSTAND PROFITABILITY OF
INDIVIDUAL ENTITIES

As BPO firms start providing a wider variety of functional services, sharing of resources and employees across products, functions and clients increases. Therefore, determining the individual profitability of different products or client accounts becomes more complex. For example, if the same employee works on two client products or if the same computer is used for two products, it is not easy to allocate the costs related to the employee or computer to a specific client or product. While the overall profitability of the firm might be increasing, managers lose transparency of individual product/client profit structures. The best way to resolve this issue is to implement an Activity Based Costing (ABC) system. This involves three main steps. First, detailed process maps of all the processes in the firm are drafted and these are sub-divided into discrete process steps. Second step is to identify the activity based driver for each process step. For example, in a call centre, attending a customer service call can be defined as a process step. The primary cost of performing this activity is the salary paid to the employee attending the call. Since employees are usually paid based on time, the activity driver in this case will be the number of customer service calls. If the same employee attends many types of calls each with different average durations, then the activity driver would be the number of customer service calls weighted based on the time. The last and final step is to quantify the cost for each product or client by allocating costs based on the activity driver.

Implementing an ABC costing system will provide the BPO service provider the transparency needed to make important strategic decisions, despite the complexity created by multiple product lines or clients. For example, the firm can either expand or discontinue a product line based on its profit structure. Also, the firm will know how to price the product to different clients based on its profitability. Therefore, an activity based costing system will help create a cost matrix that can act as a tool in making strategic decisions as indicated in the chart on the previous page, which shows the cost matrix for VNC Inc. This matrix will allow the manager to dissect the costs by different products and also processes involved with each product. For example, it is clear from the chart that Product B costs the company the most and SG&A costs are the most prominent at 22 per cent of the revenues. The manager will, therefore, obtain the transparency needed to focus his/her energies on these important areas.

2 WHERE TO FOCUS-REVENUE
GROWTH OR COST MANAGEMENT?

The resources of the company would be drained by focussing on both revenue growth and cost management simultaneously. Therefore, it is important for the manager of a BPO service provider to focus on the right lever to maximise value creation. Consider two companies, A and B. For the sake of simplicity, let us assume that the cost structures of both companies are 100 per cent variable. Both companies have sales of $100 (Rs 4,400) each. However, while company A has costs of $80 (Rs 3,520), company B has a cost of $40 (Rs 1,760). The management of both companies would like to understand which lever to impact in order to maximise value creation. Option 1 is to increase sales by 5 per cent and option 2 is to reduce cost by 5 per cent (5 per cent was chosen arbitrarily to illustrate the point). By concentrating on sales, both companies would increase their profits by 5 per cent. This is because, while revenues increase by 5 per cent, so do costs, which are 100 per cent variable. Alternatively, by reducing the cost by 5 per cent, company A would increase profitability by 20 per cent, while company B would only increase profits by 3.33 per cent. The options are summarised in the table above. Therefore, while company B would benefit more through revenue growth, company A would be better off by focussing on cost management. In general, the rule of thumb is that if costs are less than 50 per cent of the revenue, revenue growth will yield higher returns and if costs are greater than 50 per cent of the revenue, cost management will be a better option. The BPO manager needs to understand the dynamic relationship between cost management and revenue growth. This helps him use cost management as an operational decision-making tool and choose the right lever to influence in order to optimise value creation.

VNC's costs constitute 88 per cent of its revenues. Therefore, a decrease in cost will yield the company greater returns than an increase in revenues. A 5 per cent (chosen arbitrarily) increase in revenue will result in a 12 per cent increase in profits, while a 5 per cent decrease in costs will fetch a 26 per cent increase in profitability. Therefore, cost management will yield greater returns for VNC. However, this analysis should be integrated with the opportunities available and other external factors that are explained in recommendations 3 through 5.

3 EXPLORE GROWTH THROUGH
SPATIAL ADJACENCIES

Growth at many BPO service providers in India is slowing down. This could be due to saturation of their market or intense competition. The first instinct in such a situation is to capture volume by reducing price. However, this only results in sub-optimal economic rents that can be extracted out of the market both for the BPO service provider and its competition.

Instead the BPO firm should aim to exploit spatial adjacencies that exist in its business. One way to do this is to explore functional commonalities that exist between the BPO's current services and other services. For example, a BPO providing customer service to the desktop computer market through call centres will have acquired the domain expertise in that functional area. It can, therefore, explore opportunities for expansion by extending its customer service to similar markets such as servers, PDAs or other technology markets that require similar skills.

Another way to grow is to expand by increasing the range of services provided in the same market. For example VNC Inc., which is currently providing healthcare administrative services, can provide other services in the value chain that include hr administrative services, payroll services etc. VNC will need to upgrade its level of knowledge and technical competencies in order to expand its areas of service. The company can also explore forming strategic alliances or acquiring other firms in order to obtain the domain expertise required for such growth.

4 IDENTIFY THE CASHEW NUTS AND WALNUTS

When given a bowl full of mixed nuts in a bar most people tend to cherry pick the biggest nuts, namely walnuts and cashew nuts before they go after the peanuts. BPO managers would benefit from following this analogy while deciding on the right issues to go after. They need to spend significant amount of time in prioritising key issues and improvement opportunities that would give them the maximum bang for their buck. By following the process described below, managers can ensure that they spend as much time on issue identification and prioritisation as they do on improvement and implementation.

Step 1: Identify Activity Drivers

a) Map out high-level process maps

b) Draft detailed process maps for each sub-process

c) Divide each sub-process into process steps

d) Identify the activity drivers for each process step

Step 2: Determine the Cost for Each Process Step

a) Determine the number of transactions in each activity

b) Determine weighted average time for each transaction (for example, a transaction that takes one minute of work is not the same as another that takes, say, five minutes. By weighting each transaction based on the amount of resources it needs, we can measure them based on the same scale)

c) Calculate the cost involved with each process based on the activity driver

Step 3: Calculate the Profitability of Each Entity

a) Allocate costs across each product/client based on process costs

b) Calculate profitability for each product/client

Step 4: Identify the Cashew nuts and Walnuts

a) Quantify the size of each opportunity

b) Rack and Stack opportunities based on return on investment of resources

Step 5: Implement Improvement Plan

a) Design improvement plan for each opportunity

b) Implement plan

The chart alongside indicates the process of prioritisation of opportunities for VNC Inc. The percentages indicate the proportion of revenue each cost component consists of. Products A and B together constitute costs equal to 77 per cent of VNC's revenues. Also, SG&A comprises 22 per cent of VNC's revenues. Hence, these are VNC's walnuts and cashew nuts. VNC would obtain higher returns by focussing on products A and B and SG&A costs before impacting other areas.

5 ABOUT RISK OF CONSTRUCTIVE
DISRUPTION AND VALUE MIGRATION

In today's fast changing world, businesses are constantly evolving, which results in continuous transformation of the services required of BPO service providers. Therefore, BPO firms need to design operating mechanisms to think systematically about risk while crafting their long-term business plans.

There are two kinds of risks that BPO service providers need to think about. First is the risk of constructive disruption. For example, medical transcription services will soon be a thing of the past with the installation of healthcare it systems and Picture Archive Systems that store and integrate patient data across hospitals. In such situations, firms will have to continually monitor the changes taking place in technology and the marketplace. This will help them expand to other related service areas.

The second kind of risk is the risk of value migration. As customer needs and technology evolve, the value provided by BPO firms will also need to transform with it. For example, BPO firms that are currently providing data processing services are experiencing value migration towards data analytics, as computerisation and automation make traditional data processing redundant. In such cases, BPO firms will have to constantly climb up the value chain and innovate in terms of the services they provide.

In VNC's case, as the cost of providing healthcare becomes more significant for large corporations, the value of providing healthcare administrative services will migrate towards flexible healthcare accounts. These accounts place more of the responsibility for healthcare in the hands of the employees while providing them greater flexibility to take care of their health needs. VNC will, therefore, need to modify its existing services to encompass this transformation in healthcare services.

As the BPO industry is moving towards the stage of maturity in its life cycle, firms need to look not only within their business to create value, but also consider the entire ecosystem. By considering both internal and external factors, a BPO service provider can not only create maximum value, but also sustain this value over the long-term.

Bala V. Balachandran is the distinguished professor of accounting at the Kellogg school of management, and Vijay Nallan Chakravarthi is a 2005 graduate of the school