The next generation of in-house software development - How leading-edge companies are streamlining applications development.

Most companies recognize the many advantages of buying software applications off the shelf rather than developing them in-house. By purchasing packaged applications (such as those from Microsoft, Oracle, SAP, and other vendors) or by using applications that vendors create, host, and make available over the Web (for example, those from SalesForce.com), companies can acquire effective business solutions with the benefits of standardization. In this way, they can keep up with of the innovations created by focused specialists.

In spite of those advantages, custom-built applications are still very much a part of the IT landscape. Companies in many sectors spend well over half their applications budgets on custom software, used largely to enhance, support, and operate customized systems. For large companies in competitive, fast-moving industries such as telecommunications, financial services, high tech, pharmaceuticals, and media, those outlays can run into hundreds of millions of dollars. Banks, for instance, frequently build custom applications to support new financial products or to manage risk. Pharmaceutical companies regularly build custom applications to support R&D and marketing activities.

Even when a company uses off-the-shelf applications, it frequently customizes them, typically by adding modules that provide a distinctive capability. A high-tech company, for example, installed a suite of packaged enterprise-resource-planning applications but also built a customized cash-management application to supplement the ERP product's plain-vanilla finance functionality. Unfortunately, even a little customization here and there quickly adds up. Worse, when companies must revise systems to meet new business needs, changing interconnected, customized applications can be difficult and costly, and upgrades to customized applications usually cost more than those to packaged software.

Nevertheless, some pioneering companies have found a way to capture the benefits of packaged software in a customized-applications environment. They have adopted the approach of software vendors, which package and sell applications aimed at the common needs of many customers rather than of individuals, by writing an application once and then selling it many times. In this way, pioneering banks and media and pharmaceutical companies have reduced the complexity and cost of managing applications and speeded up the deployment of new or updated ones.

An approach some companies have used to turn elements of custom-applications support into packaged activities involves standardizing the maintenance, support, and software-management activities that groups of applications share. Applications that support field service work, for instance, may undertake similar functions (such as call planning) or incorporate similar types of tools (such as calculators, diagnostics, or checklists for customers). A company can define the management of common elements among applications as standardized "products" designed to provide for the needs of many applications rather than one. Similarly, it can assemble new, custom-built applications from common, internally built modules of functionality and then reuse services developed by its teams to undertake common tasks such as authenticating users or accessing attributes of customers or products. Like software vendors, such a company writes the code once but uses it frequently—a tactic made possible by creating application interfaces that incorporate broadly accepted standards such as those from the Web Services Interoperability Organization.

The upside of this approach is now quite clear. One company that adopted these support and maintenance principles reduced spending on applications maintenance by 30 percent—amounting to 60 percent of the entire applications budget—and speeded up the deployment of new applications, thereby completing in two to three weeks what once took two to three months.

Focusing in-house applications management on such products can be challenging and clearly isn't right for all companies. The payback will be greatest in fast-moving sectors. Companies prepared to try will be tempted to seek solutions for the problems of today's applications portfolios rather than those of tomorrow's—problems that are inevitably harder to pinpoint and understand. But treating support services as products is all about building for the future. Companies will need to change how they organize support resources, perhaps even overhauling IT governance structures to ensure the appropriate funding, oversight, and accountability of a very different applications environment.

Turning applications management into a product

To understand what the leading companies are doing, it's worth dividing the expenditures for custom-made applications into two parts, each requiring a different strategy. One part is identifying and codifying into software the business rules that give a company its competitive edge—rules like "If a physician is unaware of our product, give her the benefits message" or "If patient compliance is an issue, discuss tools for improving compliance." This is a development task.

The second part of spending on custom applications—accounting for 50 to 70 percent of their total costs—involves managing them over their lifetime. This task includes selecting the applications tools to use, determining the service levels users require, rolling out applications, operating them at target service levels, maintaining them, providing ongoing user support for them, and eventually retiring them.

In most companies today, the IT and business teams involved in developing a custom application decide independently on the type and version of the applications tools and deployment environment it will use—the server, the database, the portal, and so on. Decisions about service levels (such as availability) and policies on data storage also are made ad hoc. Such applications end up as complex beasts to manage, typically requiring a host of maintenance and support processes as customized as the applications themselves. There will be differences—sometimes major—in how they meet the demand for split-second response times or what must be done to change the reports that they produce.

More companies are setting standard levels for infrastructure services—including standards for server availability, storage capacity, and network performance. Yet the way teams manage end-user enhancements, maintenance, and support for applications still varies widely. These variations lead to spotty utilization, reduce productivity, delay the rollout of new applications, and impair the ability to meet user expectations consistently.

In response to such problems, companies have tried to reduce labor costs by, for instance, offshoring the maintenance of applications and consolidating them in shared service centers. Consolidation improves utilization (fewer machines and people are needed) but rarely raises the productivity of IT maintenance, because the diversity of maintenance and support activities doesn't go away. Similarly, offshoring can reduce per-hour labor costs, but companies (either in their captive offshore centers or their outsourcing vendors) typically do little to reduce the underlying diversity in the maintenance processes for applications. Indeed, without investment in a level of on-site support or strict adherence to processes, geographic separation may only exacerbate the problem.

But these processes can be standardized, as some leading companies are demonstrating. A company may have thousands of applications, but we've found that, for most organizations, they can be clustered into fewer than a dozen archetypes—our term for applications grouped by their key commonalities. Archetypes naturally vary by company, but broadly speaking they can include applications that support a large number of customers primarily on the Web, provide data-intensive analytical support, track performance and provide dashboard summaries for senior executives, or offer highly regulated transaction support.

The important point is that, within these archetypes, the requirements for applications management are strikingly similar, so maintenance and support can be standardized. All "road warrior" applications, for example, need tools that support offline work, the offline-online synchronization of data, PDA form factors, and early-morning and late-evening technical assistance. Companies essentially need to standardize these processes into products, designed once and then used over and over again for different applications, within a particular archetype. When a company needs a new customized application, the team that develops it chooses a product that determines how it will be deployed, maintained, operated, supported, and even priced for internal users. This approach draws on the model used by software vendors and application service providers such as SalesForce.com.

Considerable standardization may be involved. One company, for instance, defined five such products that address the management challenges of each application archetype and are designed to derive the maximum benefit from standardization (exhibit). Together, the five addressed 60 percent of the company's applications, accounting for 80 percent of its applications budget. This company didn't attempt to squeeze all existing applications into the new model. Instead, it has looked forward: IT managers estimate that over 90 percent of all its new applications-development projects will take advantage of one of the five models from the beginning.

Companies that took this path have found several benefits of standardizing applications-management activities as products:

• Reduced work for application "owners" (such as business units) and developers in sorting through management issues
• Reduced costs and enhanced cost transparency derived from per-seat, per-application prices
• Standardized, fine-tuned processes for applications of the same archetype
• Dramatically higher resource utilization
• Increased manageability of service levels
• Concentration of skills around fewer technologies, leading to better training and development
• Full value for companies that consolidate applications in shared services¹

Turning business functionality into products

Several leading companies are at the stage of defining archetypes to reduce spending on applications management. Some of these companies have begun to experiment with applying the lessons of packaged software—write once, sell to many—to the development of customized applications as well (see sidebar, "The development and delivery process").

In essence, such companies have taken the writing of reusable code, an idea as old as computing, into a new era. The task is to create software that performs a particular function—calculating an interest rate or targeting a customer, say—and then to reuse it in any new application that might need this functionality. In the past, locating such code and deciding how best to use it were difficult because this knowledge could be shared effectively only within a tightly knit team.

Today companies bring some order and standardization to the process by using Internet-based service-oriented-architecture (SOA) standards.² These IT advances help companies to codify business functionality in ready-to-use software building blocks much more easily and quickly, to scale up the kinds of functionality suitable for reuse in applications, and to ensure that such building blocks are employed more effectively across project teams and organizations—and maintained in a more standard fashion after an application has been deployed.

Consider the problem these companies are solving: because the applications that support old ways of working are difficult to change, many companies have found it hard to adapt their business capabilities to keep up with market developments. One health insurance company, for example, has a different claims engine for each of its three lines of business. When the applications were developed, making each one unique was logical because these businesses had very different needs. But that uniqueness has become a drag on innovation. When the insurer began to introduce more consumer-directed health plans, it had to change all three systems—and alter them again when it later introduced a new marketing approach that involved different methods for tracking customers and promotions. Each change was difficult, expensive, and time consuming.

In a company with reusable components of business functionality, such changes are a lot easier. A major bank created a library of reusable modules—essentially off-the-shelf products—that codified business functions for analytic modeling. The bank uses these products repeatedly in applications that support the trading of a wide range of financial instruments, such as equities, bonds, derivatives, and foreign exchange.

Other companies are following suit. A leading media business defined ways to codify elements (including customer profiles, lifetime value analyses, promotions, and campaign management) so that the software for them could be built once and reused. Naturally, this approach saves time and therefore money. For early adopters, the benefit that really counts is a reduction in the time needed to develop an application: they are finding that they can roll one out 20 to 40 percent faster when they use common applications products. Furthermore, the reduced expense could eventually allow companies to leverage the advantages by using easy-to-assemble applications to test new business strategies. If the strategies work, the companies can scale up the applications; if they don't, little has been lost, because such applications are inexpensive to build and easy to discard.

It is still early to make definitive predictions. But internal, off-the-shelf components of business functionality might allow IT to deliver its true promise: promoting business innovations instead of being the boat anchor holding them back.

Lessons from early adopters

As we noted earlier, this approach isn't suitable for all companies. Those that must roll out new applications quickly and constantly—banks and media companies, for instance—will benefit from it. But those in slow-moving sectors may have little need. If applications don't have to change much, writing them once is good enough—it's not worth all the work required to standardize custom activities. For businesses that can benefit from product-oriented approaches, we offer the following lessons from early adopters:

• Build the products "prospectively," mindful not just of the existing base of applications but also of future needs.
• Organize groups to deliver products effectively against business needs and not just technology outcomes.
• Pay attention to organizational factors that will ensure proper governance and realize the business benefits.

Build the right products prospectively

Defining the right products to manage applications begins with analyzing how they cluster according to common needs. It is then more fruitful to focus on applications in the pipeline rather than those already in place. In fast-moving sectors, the useful shelf life of most applications is typically less than five years. By focusing on the future, companies in these sectors avoid putting effort into applications near retirement; thus, within three years, as much as 90 percent of the portfolio of custom applications can be standardized.

Admittedly, it is possible to standardize the support and maintenance of existing applications so as to reduce costs. Further, it is easier for a company to see concrete ways of reengineering existing support processes (a remediation project) than to plan the organization of support and maintenance for new applications that haven't yet been clearly defined, because budgets, risks, and organizing principles are unclear. Nevertheless, our analyses suggest that it isn't worth recalibrating the management of most existing applications. Significant effort is necessary to reengineer processes and to help people accept and abide by new standards. Since the applications portfolio turns over quickly, the costs of reengineering are barely recovered, if at all. Reengineering applications with a longer life cycle can make sense, but only a few of them exist in the portfolios of companies in fast-moving businesses.

Similarly, the best way to identify the components of common business functionality is to look at requirements prospectively rather than retrospectively. In particular, companies should focus on specific areas (such as the way prospective customers are valued) where there is a strong business interest in standardizing operations or rules across groups. This approach not only helps a company get to the truly reusable business rules but also piques the business's interest in using these products, thereby making it easier to secure ongoing support for standardizing such processes.

Organize to deliver products effectively

To define and deliver applications-management products, early adopters are carving out a single, separate applications organization from the multiple existing ones. As this delivery organization proves itself, companies mandate adherence to the new, standardized approach. Typically, the organization is global, focused on standardizing activities of the applications that support products globally. After all, there are more common elements within product groupings than in applications that are grouped geographically.

The pioneers are also forming groups to manage business functionality products, organizing them in close relation to business domains—that is, end-to-end business processes (such as order to cash or R&D). The developers become steeped in the business groups' activities and can see more clearly how to capture functionality in code. Also, business leaders can act as sponsors of these product groups, an approach that can put them on an equal footing with traditional applications-development teams. In some cases, these groups can even provide leadership in driving business process standards—leaving traditional teams to assemble solutions from the reusable code.

Pay attention to organizational factors

Turning support and maintenance into standardized applications-management products is one thing; getting the organizational elements right to make the most of those products is another. Companies must pay attention to three immediate constituencies: vendors, internal "buyers," and those who finance the budget for applications development.

Vendors have to understand what the company is trying to accomplish by standardizing support and maintenance, development, or both. A vendor's specialized software offerings or hardware should be incorporated appropriately into a prospective customized application. These technologies must therefore comply with the standards chosen for the management product supporting the application or be compatible with the modules assembled to make a new application. To achieve this goal, one company uses an architecture review process—looking at an application's technical design before launching development—as a way of forcing vendors to comply with its standardization efforts. Another company encourages compliance by certifying vendors, providing awareness education, and offering price incentives and vendor performance reviews.

A company must also persuade those who own an application internally (and across the global business) to look for and use off-the-shelf business functionality, captured in code either inside or outside the company. One way to do so is to create markets for these products. Goldman Sachs, for example, built a Web portal that allows developers around the world to share software components and documentation, both internally and with certified systems integration vendors.

Finally, those financing new applications must favor standardized business functionality products (on the development side) and management products (on the support side). People should be held accountable for moving toward these new, common approaches. Costs for developing functionality and management products are ascribed to a single applications project, but subsequent applications can reuse them, and this possibility has implications for the way projects are measured and their performance is graded. Companies may find it necessary to finance standardization efforts separately from other development projects and to establish pricing mechanisms for recouping the investment from business users of the applications. Funding must take into account both efficiency and relevance, and pricing should balance recovering the investment with encouraging greater use.

Companies that live or die by how quickly they can roll out new, innovative business capabilities to their customers can benefit from making their customized applications more like products.

The development and delivery process

Old

• The infrastructure staff and development vendor must design an infrastructure platform for every application.

• Dealing with exceptions to current processes (such as the needs of machines, remote access, and root privileges for the vendor) creates unnecessary overhead.

• Delays caused by procurement snags or infrastructure configuration issues typically run five to six weeks.

• Because the company has to pay vendors on a time-and-materials basis—and scale is limited—expenses mount.

• External resources are needed for routine operations such as database administration support.

• Time and attention are wasted on coordinating activities such as reboots and updates with other groups sharing infrastructure.

• Ad hoc systems upgrades and reboots often cause unplanned application downtime.

New

• Predefined product options greatly reduce the time spent designing the infrastructure for the most common applications.

• A standardized process that can also handle exceptions creates a single point of ownership and accountability.

• An inventory of infrastructure options that comply with the reference architecture eliminates procurement delays.

• Leveraging vendor contracts gives the company a pool of resources at attractive rates.

• Routine tasks that were formerly undertaken by the vendor are coordinated, eliminating redundancy in the process.

• Applications operations are managed, freeing time to focus on more critical business tasks.

• Accountability for service levels helps the company identify key areas to improve processes.

Return to reference

About the Authors

Sam Marwaha and Ranjit Tinaikar are principals in McKinsey's global IT practice. Sam is a coleader of the IT governance and organization practice and leads the US pharmaceutical-IT practice. Ranjit, a coleader of the IT strategy practice, specializes in retail-banking and consumer credit operations. Samir Patil, an associate principal, is a leader in the IT governance and organization practice. All three are based in New York.

This article was first published in the Spring 2006 issue of McKinsey on IT.

Notes

¹Managing applications support in this way is very similar to the approach other companies are taking to manage their infrastructure more efficiently and effectively. For more on this topic, see James M. Kaplan, Markus Löffler, and Roger P. Roberts, "Managing next-generation IT infrastructure," McKinsey on IT, Number 3, Winter 2004, pp. 2-9.

²Service-oriented architectures allow applications to be highly interoperable across a network by making it possible to access standardized computing or application services in a standardized way.

Ten trends to watch in 2006

Web exclusive, January 2006

Those who say that business success is all about execution are wrong. The right product markets, technology, and geography are critical components of long-term economic performance. Bad industries usually trump good management, however: in sectors such as banking, telecommunications, and technology, almost two-thirds of the organic growth of listed Western companies can be attributed to being in the right markets and geographies. Companies that ride the currents succeed; those that swim against them usually struggle. Identifying these currents and developing strategies to navigate them are vital to corporate success.

What are the currents that will make the world of 2015 a very different place to do business from the world of today? Predicting short-term changes or shocks is often a fool's errand. But forecasting long-term directional change is possible by identifying trends through an analysis of deep history rather than of the shallow past. Even the Internet took more than 30 years to become an overnight phenomenon.

Macroeconomic trends

We would highlight ten trends that will change the business landscape. First, we have identified three macroeconomic trends that will deeply transform the underlying global economy.

1. Centers of economic activity will shift profoundly, not just globally, but also regionally. As a consequence of economic liberalization, technological advances, capital market developments, and demographic shifts, the world has embarked on a massive realignment of economic activity. Although there will undoubtedly be shocks and setbacks, this realignment will persist. Today, Asia (excluding Japan) accounts for 13 percent of world GDP, while Western Europe accounts for more than 30 percent. Within the next 20 years the two will nearly converge. Some industries and functions—manufacturing and IT services, for example—will shift even more dramatically. The story is not simply the march to Asia. Shifts within regions are as significant as those occurring across regions. The United States will still account for the largest share of absolute economic growth in the next two decades.

Further reading:
China and India: The race to growth
Mapping the global capital markets

2. Public-sector activities will balloon, making productivity gains essential. The unprecedented aging of populations across the developed world will call for new levels of efficiency and creativity from the public sector. Without clear productivity gains, the pension and health care burden will drive taxes to stifling proportions.

Nor is the problem confined to the developed economies. Many emerging-market governments will have to decide what level of social services to provide to citizens who increasingly demand state-provided protections such as health care and retirement security. The adoption of proven private-sector approaches will likely become pervasive in the provision of social services in both the developed and the developing worlds.

Further reading:
The demographic deficit: How aging will reduce global wealth
Boosting government productivity

3. The consumer landscape will change and expand significantly. Almost a billion new consumers will enter the global marketplace in the next decade as economic growth in emerging markets pushes them beyond the threshold level of $5,000 in annual household income—a point when people generally begin to spend on discretionary goods. From now to 2015, the consumer's spending power in emerging economies will increase from $4 trillion to more than $9 trillion—nearly the current spending power of Western Europe.

Shifts within consumer segments in developed economies will also be profound. Populations are not only aging, of course, but changing in other ways too: for example, by 2015 the Hispanic population in the United States will have spending power equivalent to that of 60 percent of all Chinese consumers. And consumers, wherever they live, will increasingly have information about and access to the same products and brands.

Further reading:
Premium marketing to the masses: An interview with LG Electronics India's managing director
New strategies for consumer goods

Social and environmental trends

Next, we have identified four social and environmental trends. Although they are less predictable and their impact on the business world is less certain, they will fundamentally change how we live and work.

4. Technological connectivity will transform the way people live and interact. The technology revolution has been just that. Yet we are at the early, not mature, stage of this revolution. Individuals, public sectors, and businesses are learning how to make the best use of IT in designing processes and in developing and accessing knowledge. New developments in fields such as biotechnology, laser technology, and nanotechnology are moving well beyond the realm of products and services.

More transformational than technology itself is the shift in behavior that it enables. We work not just globally but also instantaneously. We are forming communities and relationships in new ways (indeed, 12 percent of US newlyweds last year met online). More than two billion people now use cell phones. We send nine trillion e-mails a year. We do a billion Google searches a day, more than half in languages other than English. For perhaps the first time in history, geography is not the primary constraint on the limits of social and economic organization.

Further reading:
The next revolution in interactions
The McKinsey Global Survey of Business Executives, July 2005

5. The battlefield for talent will shift. Ongoing shifts in labor and talent will be far more profound than the widely observed migration of jobs to low-wage countries. The shift to knowledge-intensive industries highlights the importance and scarcity of well-trained talent. The increasing integration of global labor markets, however, is opening up vast new talent sources. The 33 million university-educated young professionals in developing countries is more than double the number in developed ones. For many companies and governments, global labor and talent strategies will become as important as global sourcing and manufacturing strategies.

Further reading:
China's looming talent shortage
Sizing the emerging global labor market

6. The role and behavior of big business will come under increasingly sharp scrutiny. As businesses expand their global reach, and as the economic demands on the environment intensify, the level of societal suspicion about big business is likely to increase. The tenets of current global business ideology—for example, shareholder value, free trade, intellectual-property rights, and profit repatriation—are not understood, let alone accepted, in many parts of the world. Scandals and environmental mishaps seem as inevitable as the likelihood that these incidents will be subsequently blown out of proportion, thereby fueling resentment and creating a political and regulatory backlash. This trend is not just of the past 5 years but of the past 250 years. The increasing pace and extent of global business, and the emergence of truly giant global corporations, will exacerbate the pressures over the next 10 years.

Business, particularly big business, will never be loved. It can, however, be more appreciated. Business leaders need to argue and demonstrate more forcefully the intellectual, social, and economic case for business in society and the massive contributions business makes to social welfare.

Further reading:
What is the business of business?
The role of regulation in strategy

7. Demand for natural resources will grow, as will the strain on the environment. As economic growth accelerates—particularly in emerging markets—we are using natural resources at unprecedented rates. Oil demand is projected to grow by 50 percent in the next two decades, and without large new discoveries or radical innovations supply is unlikely to keep up. We are seeing similar surges in demand across a broad range of commodities. In China, for example, demand for copper, steel, and aluminum has nearly tripled in the past decade.

The world's resources are increasingly constrained. Water shortages will be the key constraint to growth in many countries. And one of our scarcest natural resources—the atmosphere—will require dramatic shifts in human behavior to keep it from being depleted further. Innovation in technology, regulation, and the use of resources will be central to creating a world that can both drive robust economic growth and sustain environmental demands.

Further reading:
Preparing for a low-carbon future
What's next for Big Oil?

Business and industry trends

Finally, we have identified a third set of trends: business and industry trends, which are driving change at the company level.

8. New global industry structures are emerging. In response to changing market regulation and the advent of new technologies, nontraditional business models are flourishing, often coexisting in the same market and sector space.

In many industries, a barbell-like structure is appearing, with a few giants on top, a narrow middle, and then a flourish of smaller, fast-moving players on the bottom. Similarly, corporate borders are becoming blurrier as interlinked "ecosystems" of suppliers, producers, and customers emerge. Even basic structural assumptions are being upended: for example, the emergence of robust private equity financing is changing corporate ownership, life cycles, and performance expectations. Winning companies, using efficiencies gained by new structural possibilities, will capitalize on these transformations.

Further reading:
Strategy in an era of global giants
Loosening up: How process networks unlock the power of specialization

9. Management will go from art to science. Bigger, more complex companies demand new tools to run and manage them. Indeed, improved technology and statistical-control tools have given rise to new management approaches that make even mega-institutions viable.

Long gone is the day of the "gut instinct" management style. Today's business leaders are adopting algorithmic decision-making techniques and using highly sophisticated software to run their organizations. Scientific management is moving from a skill that creates competitive advantage to an ante that gives companies the right to play the game.

Further reading:
Do you know who your experts are?
Matching people and jobs

10. Ubiquitous access to information is changing the economics of knowledge. Knowledge is increasingly available and, at the same time, increasingly specialized. The most obvious manifestation of this trend is the rise of search engines (such as Google), which make an almost infinite amount of information available instantaneously. Access to knowledge has become almost universal. Yet the transformation is much more profound than simply broad access.

New models of knowledge production, access, distribution, and ownership are emerging. We are seeing the rise of open-source approaches to knowledge development as communities, not individuals, become responsible for innovations. Knowledge production itself is growing: worldwide patent applications, for example, rose from 1990 to 2004 at a rate of 20 percent annually. Companies will need to learn how to leverage this new knowledge universe—or risk drowning in a flood of too much information.

Further reading:
The 21st-century organization
Making a market in knowledge

Companies need to understand the implications of these trends alongside customer needs and competitive developments. Executives who align their company's strategy with these factors will be the best placed to succeed. Reflecting on these trends will be time well spent.

About the Authors

Ian Davis is worldwide managing director of McKinsey & Company and Elizabeth Stephenson is a consultant in McKinsey's San Francisco office. A shorter version of this article was published in the Financial Times on January 13, 2006.

Moving IT infrastructure labor offshore

Moving IT infrastructure labor offshore

The offshoring of IT infrastructure—machines and networks and the people who manage them—has been relatively slow to develop. But this is changing as leaders show how to offshore it effectively and vendors step up to meet a growing opportunity.

Kishore Kanakamedala, James M. Kaplan, and Gary L. Moe

Web exclusive, June 2006

Half of the people in corporate IT departments manage and support infrastructure rather than develop and maintain applications, yet infrastructure represents only a tiny percentage of the IT labor offshored to low-cost locations so far. One reason is that managers have been hesitant to send such mission-critical operations too far from home. If an application-development project bogs down in Budapest or Bangalore, the roll out of a new feature may be delayed; if a server crashes or a network goes down, the business consequences can be far more serious. These concerns—as well as the cost and unreliability of telecommunications in some developing markets, the limited availability of key infrastructure skills there, and a history of locating hardware and labor at end-user sites—have made CIOs reluctant to pull the offshoring lever to reduce infrastructure costs.

In the past two years, however, constraints on the offshoring of infrastructure have started to ease, and the market appears poised to follow the growth trajectory of other IT-offshoring segments (Exhibit 1). Offshore vendors have started to invest aggressively both in infrastructure talent and redundant networks from the United States and Western Europe. From 2003 to 2005, the number of offshore vendors (the global talent pool of people who can handle infrastructure tasks) tripled, to 15,000, from 5,000. At the same time, automation tools, more effective processes, and onshore consolidation efforts have made corporate IT departments increasingly comfortable with locating more of their infrastructure labor remotely from assets and users.

Most senior IT executives have already learned valuable lessons from offshoring their application-development projects, but they will have to learn new skills to offshore infrastructure successfully. The split between onshore and offshore resources requires a careful design based on the need for proximity to application developers, end users, and infrastructure assets. The necessary skills imply that different mixes of locations and commercial models (vendor or captive) will be required, and the real-time nature of infrastructure typically calls for substantial changes to key processes and organizational structures.

Leading-edge companies that began moving labor to India two to three years ago have already achieved savings of as much as 60 percent

The benefits of offshoring labor

IT departments send their infrastructure labor offshore primarily to take advantage of lower labor costs, but there are other advantages too. The offshoring of infrastructure labor can spur operational improvements and the implementation of a global operating model that provides far more uniform support to applications and users, no matter where they work.

Hiring people with the necessary skills is getting easier in places such as India, Malaysia, the Philippines, and Eastern Europe. Some IT infrastructure technologies are easier to offshore than others: depending on the task, companies may be able to offshore from 40 to 50 percent of the staff in certain areas (Exhibit 2). Leading-edge companies that began moving their internal IT help desk operations and UNIX server monitoring, management, and support work to India two to three years ago have already achieved savings in unit labor costs of as much as 60 percent—though 20 percent is more typical—after an initial investment period (Exhibit 3). Seeing this opportunity, vendors and captives have ramped up their skills, and a lot of them now offer a broad range of network, help desk, distribution, and application integration capabilities.

Many companies house their infrastructure in local or regional operations. For this reason, technologies, processes, and services are scattered around the world, so it is hard for infrastructure organizations to support increasingly global business processes and applications. The opportunity to consolidate labor in a low-cost offshore center can act as a forcing mechanism to consolidate infrastructure operations and thus raise service levels for applications and users—for example, by providing affordable 24/7 support.

In addition, some companies that have already moved some of their application-development and business operations offshore find that moving their infrastructure staffs as well offers economies of scale for facilities, data communications, and training. One manufacturer offshored all of its server support and help desk work to the Indian vendor that already developed its applications. Thanks to shared facilities, administration, and training, it achieved savings of 10 to 30 percent on those infrastructure tasks.

Assessing the opportunity

Most IT executives already understand some of the basic planning requirements for offshoring the development of applications. Deciding which infrastructure activities can be offshored is a bit different, partly because the reliability of infrastructure affects business operations directly (and often immediately) and because people who play infrastructure roles work so closely with other functions (such as operations) and third-party vendors. Given these constraints, managers planning a move must evaluate whether the jobs under consideration require proximity to senior management, application designers, vendors, or machines. Obviously, any function requiring close access to any of these onshore resources is a poor candidate for offshoring. What's more, in some countries and industries, regulations limit cross-border access to customer data, so any role requiring such access would not be wholly transferable.

Moving infrastructure labor offshore is just one way to make better use of IT resources. See "Managing next-generation IT infrastructure."

Companies that view offshoring from this perspective report that about half of all infrastructure labor can be offshored, depending on how well grooved their IT processes are. A retailer with thoroughly understood business processes, stable IT budgets, a conservative stance on introducing new applications and technologies, and very limited regulatory requirements, for example, might offshore more than half of its infrastructure labor, because those roles are easy to standardize and manage remotely. By contrast, an investment bank, which could have a very different IT environment, might be able to offshore slightly less, because more of its roles require closer management or greater flexibility.

Planning the move

As with application development, the right place, time, and model are key decisions. Reengineering roles, transferring knowledge, and monitoring operations in real time are even more critical.

Location

Labor skills and costs vary by region. Singapore, given its political stability, advanced skills, pervasive use of English, robust infrastructure, and (for many IT organizations) existing footprint, is the least risky labor-offshoring option. Singapore's labor costs are several times India's, however, and with a population of only four million its labor market is shallow.

India (followed by Eastern Europe, Malaysia, and possibly China) is on the rise as an offshore provider of infrastructure services. While infrastructure offshoring is still relatively new to India, it has vast amounts of low-cost, English-speaking labor in almost every infrastructure area except mainframes. As labor costs rise there, however, many IT organizations will look to Malaysia as an alternative source of English-speaking infrastructure labor or to several Eastern European countries that can provide support in French and German. Although China is not a realistic option for companies that need English-language support, several IT organizations are looking at the region around the Chinese city of Dalian as a location for Japanese infrastructure operations.

Captive or vendor?

Captives and contractors are among the range of available options. Almost all full-service Indian offshore vendors are investing heavily in infrastructure capabilities, though most of the deals these companies have signed to date are relatively small. In infrastructure as in other services, they plan to leverage their proven advantages over captive operations in recruiting and retaining personnel. But very early data indicate that the offshoring of infrastructure may involve a more even balance between captive and sourced operations than application development did, because companies want to retain more control over what are largely real-time processes.

Sequencing and prioritization

When companies offshore infrastructure labor, tasks that involve the least interaction with the onshore business should be moved first if the talent pools in the offshore location can supply the right staff—mainframe operators, for example, are still hard to find offshore. A typical strategy would be to move monitoring and some problem resolution responsibilities first, followed by more sophisticated roles, such as system and database administration.

Remote management and automation

If only jobs (and not machines) are moving offshore, remote monitoring and administration become critical. Engineers in Asia or Eastern Europe may be keeping an eye on machines in North America or Western Europe and performing necessary services, such as rebooting servers, backing up data, balancing loads, and tuning performance.

During the past few years, tools to perform these tasks have advanced significantly. The remote-monitoring and -diagnostic capabilities of the leading system-management tools have improved; remote system updates, patch management, and automated server provisioning have become more common. In addition, the troubleshooting capabilities of network-management tools are more robust; end-to-end trouble-ticket generation, routing, and management are now widespread.

To capture the full potential of infrastructure offshoring, IT managers must determine which roles can be undertaken at a distance

Role and process redesign

Even with such substantial advances in remote management and automation, many onshore infrastructure workers still perform a mix of activities. Some tasks require these workers to be physically close to machines, developers, and top managers; others don't. Looking only at roles in the current model will probably mean that fewer of them can be offshored than might be the case if they were reengineered. To capture the full potential of infrastructure offshoring, IT managers must determine which roles can be undertaken at a distance from onshore machines and personnel and then have roles and processes redesigned to segregate such functions from those that need proximity.

This is a substantial process of change. Several organizations that have undertaken it concluded that they had to augment their traditional, technology-centric processes and structures with functionally aligned processes and structures. One organization, for example, ifs transferring a number of operational responsibilities from its onshore server, storage, and end-user organizations to offshore centers of excellence aligned by function.

Training and knowledge transfer

Every company's IT setup is unique. New offshore workers must be trained to understand the legacy systems, service requirements, and businesses they will support. Ongoing exchanges are needed to transfer knowledge in both directions; a leading manufacturer, for instance, rotates its offshore staff through its US back-office and IT operations. That approach gives these employees enough hands-on experience to understand the company's unique needs (such as the way a proprietary manufacturing process affects procurement, now partly undertaken offshore), as well as the performance tuning and optimization required by its server configuration. Good training and professional development are also valuable tools for recruitment and retention in low-cost regions that experience an offshoring boom. This manufacturer reports that it has a much lower attrition rate among offshore workers than peer companies do.

Unique governance challenges

The real-time nature of IT infrastructure means that it can't be governed in the same way as the offshoring of application development. Companies must clearly determine who has the authority to resolve conflicts and processes, since engineers and managers may have to react in minutes rather than hours or days. In addition, it's common to have employees with similar titles and tasks sitting in a number of locations—a recipe for confusion unless roles and responsibilities are plainly defined. In view of these greater risks, it would be a mistake to leave the details of governance to data center managers. CIOs and senior business executives must take a direct interest in setting up the proper governance, for the success of the venture will depend on it.

In addition to all the usual benchmarks of good governance—clearly delineated reporting structures and decision-making rights, as well as processes for approving projects, resolving conflicts, and handling exceptions—three governance principles are essential for offshoring infrastructure. First, to reduce the chance of miscommunication, offshore teams must be aligned with the onshore organization at all levels, from senior managers through engineers and operators.

Second, because onshore and offshore teams work together more closely in running the IT infrastructure, it's critical to establish a good relationship between them by encouraging informal collaboration and camaraderie. It helps if the offshore leader has strong credibility with the onshore leadership, but even managers at more junior levels should come together periodically through training events and regular job rotations.

Third, companies should align their performance metrics for managers with the new offshore strategy. A common mistake is to set performance targets for offshore operations without giving onshore managers incentives to send more work their way. An electronics company trying to ramp up its offshore data center operations, for example, was still asking the head of its onshore center to keep it running with 99.99 percent uptime for all applications. There were no incentives for cost savings. The offshore operation was staffed up, but its utilization remained low because the onshore manager received no encouragement to send it work. As a result, the company saw no benefit from its offshore data center investment until IT and business managers gave the head of the onshore data center an incentive to cut costs through offshoring.

CIOs are just beginning to discover the large value creation opportunity that IT infrastructure offshoring affords. First movers will not only cut costs but also get the first pick of the talent pool, develop better innovations thanks to the new global business and operating models, and gain a deeper understanding of the offshore services landscape.

About the Authors

Kishore Kanakamedala, James Kaplan, and Gary Moe are members of McKinsey's global IT practice. Kishore, a consultant, is an expert in IT management and is the practice manager for IT infrastructure. He is based in Silicon Valley. James, a principal, leads the IT infrastructure practice. He is based in New York. Gary, a principal, is among the leaders of the outsourcing and offshoring practice. He is based in Silicon Valley.

The authors wish to acknowledge the contributions of Asen Angelov, Jeff Cohen, Abhijit Dubey, William Forrest, Kevin Gu, Michael Rosenthal, and Allen Weinberg.

This article was first published in the Summer 2006 issue of McKinsey on IT.

Measuring performance in services

Measuring performance in services

Services are more difficult to measure and monitor than manufacturing processes are, but executives can rein in variance and boost productivity—if they implement rigorous metrics.

Eric Harmon, Scott C. Hensel, and Timothy E. Lukes

2006 Number 1

Faced with stiffening competition, increasingly demanding customers, high labor costs, and, in some markets, slowing growth, service businesses around the world are trying to boost their productivity. But whereas manufacturing businesses can raise it by monitoring and reducing waste and variance in their relatively homogeneous production and distribution processes, service businesses find that improving performance is trickier: their customers, activities, and deals vary too widely. Moreover, services are highly customizable, and people—the basic unit of productivity in services—bring unpredictable differences in experience, skills, and motivation to the job.

Such seemingly uncontrollable factors cause many executives to accept a high level of variance—and a great deal of waste and inefficiency—in service costs. Executives may be hiring more staff than they need to support the widest degree of variance and also forgoing opportunities to write and price service contracts more effectively and to deliver services more productively.

As with any task or operation, to improve the productivity of services, you must apply the lessons of experience. Consequently, measuring and monitoring performance (and its variance) is a fundamental prerequisite for identifying efficiencies and best practices and for spreading them throughout the organization. Although some variance in services is inescapable, much of what executives consider unmanageable can be controlled if companies properly account for differences in the size and type of customers they serve and in the service agreements they reach with those customers and then define and collect data uniformly across different service environments. To do so, it is necessary to bear in mind a few essential principles of service measurement.

• First, service companies need to compare themselves against their own performance rather than against poorly defined external measures. Using external benchmarks only compounds the difficulties that service companies face in getting comparable measurements from different parts of the organization.
• Service companies must look deeper than their financial costs in order to discover and monitor the root causes of those expenses. This point may seem self-evident, yet many companies fail to understand these causes fully.
• Finally, service companies must set up broad cost-measurement systems to report and compare all expenses across the functional silos common to service delivery organizations. The goal is to improve the service companies' grasp of the cross-functional trade-offs that must be made to rein in total costs.

None of these principles is easy to implement. Top executives are likely to face resistance from managers and frontline personnel who insist that services are inherently random and that service situations are unique. Managers who have grown used to the protection that lax measurement affords may be reluctant to view their operations through a more powerful lens. But only by adopting these principles and implementing rigorous measurement systems throughout the organization can service executives begin to identify reducible variance and take the first steps toward bringing down costs and improving the pricing and delivery of services.

Why variance is difficult to measure

Executives who launch variance-measurement programs in a service business are often surprised at the level of difference they discover among similar sites and groups within their own organization, let alone when they compare one company with another. In general, a company's metrics are not uniform across its business units, so that, for example, one group in a call center may regard all calls on a given issue as a single case, while another logs every call separately. A top executive with a background in consumer goods (where items are similar and thus comparable) assumed control of a service business and was shocked to find that the variance of key metrics among similar sites ranged from a factor of 2 to 30. Site managers explained this vast range by asserting that every site was different—and, according to their metrics, they were right.

Services are different

To make meaningful comparisons, companies have to identify the sources of difference in their businesses and devise metrics that compare these businesses meaningfully. The considerations that show up frequently include the most obvious differences among jobs and groups, such as regional variations in labor costs, local geographies and difficulties in reaching accounts, the workload mix (for example, repairs versus installation), and differences in the use of capital (whether equipment is owned or leased by the company or owned by the customer). Several other major issues come into play as well.

Service-level agreements. The more types of services a business offers, the more variability it can expect in its agreements. The metrics for a help desk that provides customer support for 5,000 users in a 9-to-5 office are very different from those for a help desk that supports logistics in a round-the-clock industrial environment. Even when offerings are similar, variance can be introduced locally through the way contracts are interpreted. In one IT-outsourcing company, two desktop support accounts with service-level agreements that specified an eight-hour response time had very different cost metrics. When asked why, the manager of the poorly performing account said that, despite the contract's limits, "If we don't answer within the hour, our client goes ballistic." The written service-level agreement had been trumped by an unwritten one that was costing real money.

Environment, equipment, and infrastructure. Each customer's environment has unique aspects that are difficult to measure. A logistics provider will see huge differences between managing a big, automated warehouse and a small, simple one. Field services that support industrial systems must contend with many generations of equipment and upgrades at customer sites. Some clients have their own on-site staff to support service, while others may be difficult even to reach. Given the range of possibilities, it's usually not very helpful simply to measure the average cost of a service call.

Work volume. Size is a major reason for the wide variance among accounts and business units. Interestingly, managers of both small and large accounts claim that size makes their particular metrics worse. Both have a point: large accounts should benefit from scale, but in general they are also more complex, and that drives costs back up. Volume needs to be considered, but only in tandem with other patterns (including scale benefits and the breadth of work) that help explain costs.

The data problem

Underlying all of these problems is an inability to identify what must be measured and how to normalize data across different environments. Even when companies know what to measure, they struggle to achieve accuracy. Data are rarely defined or collected uniformly across an organization's environments. A service call involving the installation of two elevators, for example, could be measured as a single installation in one part of a company and as two in another.

Contributing to this ambiguity is the fact that data collection is usually driven by the requirements of financial cost reporting, which often fails to shed light on ways of boosting performance. Accountants for an IT services company may need to know the cost of each server, for instance, but an executive looking to reduce variance would also need to know the number of service incidents by server type and the time spent on each incident. Variance in demand drivers is also important: did the number of calls to a help desk rise because more users bought a product, for example, or because it changed? Financial metrics might fail to detect this important distinction.

Principles of service measurement

Many executives don't understand how to measure and manage what appear to be unique activities, and they confuse correctable performance variance with irreducible environmental variance. Embracing three principles that identify variance and allow for meaningful comparisons can help executives overcome these difficulties.

Use internal benchmarks

While a company must know what its peers are achieving, it's a mistake to measure its performance against the competition: these benchmarks are typically just samples of data with little explanation behind them. Companies that use external benchmarks are often frustrated to find themselves off by a factor of five to ten, positively or negatively.

Using external benchmarks compounds the internal difficulties that service companies face in normalizing activities and the data that define them. Consider a measure such as costs per unit of information processed: some companies include allocated costs, such as corporate overhead and salaries; others don't.

Internal benchmarks deliver more detailed metrics, allowing a company to find its own best practices and to see where and how they are achieved. It can then have access to all relevant information to assess differences among business units and accounts. In defining internal benchmarks, for example, a company can determine which costs are included or how asset costs are allocated—details that get lost in external benchmarking. A company can see what's really possible within the organization by using its own benchmarks.

A cost tree with detailed metrics is an important tool to help companies define internal benchmarks (exhibit below). External metrics might deliver numbers on the top level of the tree, but only by developing internal trees for each service line can a company begin to understand its true cost drivers. A tree allows a manager to compare the performance of different accounts against similar metrics and also to calculate which improvements will have the most impact on the top-level figure. Once a team has gathered cost data throughout the tree, for example, it could target opportunities to cut costs and calculate which efforts would have the most impact on the bottom line. Creating cost trees can also help companies write better service agreements that exclude unprofitable activities or generate more revenue where service costs warrant it.

Measure cost drivers

Even after service companies begin to define and capture the detail that lies beneath the top level of the cost tree, they still need to discover the underlying cause of each expense. Measuring only the cost of repair calls, for instance, probably wouldn't reveal whether they all stem from a single poorly built product, which could be improved or sourced differently for less than the cost of the repairs, or from factors such as variability in the performance of repair teams. Better measurements look at cost drivers, such as cost per employee (a resource metric), incidents per employee per day (a productivity metric), or—in a product-based service business—the number of incidents per product (a volume metric).

Of course, companies must also omit allocated costs, which can confuse the issue. A business unit's support infrastructure, for example, could include human resources, physical plant, and product engineering, all of which must be considered from a financial point of view. But such costs do little to determine productivity and are something of an obstruction when companies try to spot variance and waste. Once these obstacles are removed, managers can stop trying to cut costs that may be beyond their control and instead address the drivers they can improve. Before measuring the financial costs, it's often helpful to measure the items and events that drive costs, such as people, machines, incidents, service calls, and change orders.

Measure deep and broad

When service companies try to measure only their selected costs—rather than taking a comprehensive approach—they are often surprised to see that their teams hit every budget target while still losing money. That's because services are fungible, and it's easy to measure the wrong things or to shift costs, intentionally or not, to unmeasured areas.

Consider the case of a cable company that was trying to reduce the resolution times of its help desk and service calls. After setting goals, managers saw resolution times shrink, but total service costs were rising. In this case, help desk representatives, eager to meet their goals, spent less time trying to resolve problems remotely. After asking only a few questions, these employees referred cases to field service reps, who were happy to have a series of fast and easy calls to boost their own metrics. Unfortunately, the number of field service calls, which are far more expensive than help desk calls, rose dramatically. To resolve this problem, management combined call centers and field services into a single cost tree and monitored the percentage of calls passed from the one to the other, as well as the time spent on each type of call. Managers then encouraged the call center reps to spend more time trying to resolve difficult calls before passing them along to field services, thereby increasing the average call time but helping to reduce total costs. Thus a critical purpose of any cost tree is to yield insights about how better (or worse) performance in one area of the tree might affect another.

Setting up measurement systems

With these principles in mind, executives can begin to define their metrics, collect data, and implement processes that will drive their efforts forward.

Build the tree and choose your metrics

Cost trees should be detailed enough to spot efficiency problems and broad enough to be comparable across operating units. Once companies have identified the allocated costs and cost drivers, they can begin to build the cost tree. Broad input from the field (line managers, engineers, field and service reps) is vital, along with input from senior executives, who are generally better able to focus on the total costs required to deliver a service to customers. In this way, the tree captures all the costs of (and details on) the most important cost drivers. The tree should also be constructed to compare key metrics across a range of environments—for example, all call centers, whether they operate 24 hours a day or 9.

As the data arrive, management will want to monitor the top level of the tree as well as the key metrics below. In most cases, we find, three to five metrics monitor 80 percent of the variance in costs.

Collect with care

Without clearly defined metrics and knowledgeable people to support the gathering of data throughout the organization, companies can spend too much time cleaning up messy data. Training and improved processes can alleviate this problem.

Managers should review the data collection rules and templates with the people who develop them—usually employees from different regions or accounts. Even with new procedures in place, however, there will be much room for interpretation. It's therefore helpful to show not only how data should be collected and entered but also how users occasionally misinterpreted these processes in the past—an approach that sheds light on gray areas the rules might not address. Guidelines for identifying problems early on can save time later. It's also important to establish boundaries beyond which suspect metrics should be investigated. One service company, whose teams handled from two to five service calls a day, wondered why one of its teams was reporting an average of only a single call. It found a good reason: the account belonged to a prison system, where security procedures made each visit a daylong affair.

Reviewing data collection in the early stages of implementation can help to ensure that procedures are followed. Equally, sharing reports with regional and account leaders gives them an early view of their standing and can help identify unusual patterns in the data.

Institutionalize measurement

Managers accustomed to tracking costs in accordance with accounting needs will have to understand these new metrics and make them consistent throughout all levels of the organization. Periodic reviews, whose frequency should be based on the availability and shelf life of data, are essential for individuals and work groups. Visible interest from senior management—such as sending an executive vice president to attend a regional metrics review—promotes a strong message to everyone that a company is intent on identifying variance and improving service performance. Compensation should be tied to these metrics.

What's measured can be managed

For tools managers can use to price and manage service contracts, see "How to make after-sales services pay off."

Once executives have learned to measure the variance inherent in service companies, they can begin to manage processes to eliminate waste, to improve the delivery of services, to price services more accurately, and to write better contracts. Although a company can do many things to control the variance of its service delivery, most of them fall into three main areas: managing demand, standardizing environments, and applying appropriate resources to tasks.

Managing demand offers the biggest potential for improvement. Cost trees help managers identify the sources of demand for services—sources that might include faulty products, poorly performing service units, or any number of other causes. Some fixes must be made within the organization (better training, better products, automated-response systems); others depend on shaping the behavior of customers (for instance, by offering tools and guidance to help them resolve problems themselves).

Standardizing operating environments requires the most discipline, since salespeople are strongly tempted to sell as much customization as a client wants. Standardization can yield enormous results: in addition to raising productivity, it helps the workforce become more flexible because people can transfer with less retraining. Where possible, companies should standardize not only service product lines and tasks but also the work environments of employees and the equipment they use to deliver services. Scripted routines help eliminate errors and allow employees to emulate high performers. Furthermore, clearly defined programs limit overdelivery, a common problem in service companies.

What's more, identifying cost variances can help companies allocate their human resources more effectively. In general, it's more productive to handle problems with the least expensive resources that can resolve them: calling in experts or sending out field technicians increases costs and slows response times—and therefore makes customers less satisfied. Metrics on costs per call or device demonstrate the benefits of using less expensive labor, thus encouraging companies to keep requests upstream and to place first responders (often a call center) in less costly regions to further increase savings and productivity.

Finally, companies that have a better picture of where costs are incurred can price services more accurately to avoid losing revenue on unprofitable activities. They can write better contracts that take into account cost drivers hitherto written off as inescapable variance.

As services become an ever larger part of the global economy, managers are rightly looking for ways to improve productivity and efficiency. Services may be more difficult to measure and standardize than the manufacture of products, but executives should not abandon hope. Adopting the principles set forth in this article will help companies improve the delivery, pricing, and sales and marketing of services.

About the Authors

Eric Harmon is an associate principal in McKinsey's Dallas office, Scott Hensel is an associate principal in the Stamford office, and Tim Lukes is a consultant in the Miami office.

The authors would like to thank Byron Auguste, Ken Davis, Travis Fagan, Ozan Gursel, and Greg Neubecker for their contributions to this article.

The untapped market for offshore services

The untapped market for offshore services

Business processes and traditionally outsourced—but not offshored—IT services will be the main drivers of offshoring growth in the near future.

Sujit K. Chakrabarty, Prashant Gandhi, and Noshir Kaka

2006 Number 2

The global market for offshored IT services and business processes has nearly tripled since 2001. However, a study finds that service providers have so far captured only 10 percent of a $300 billion opportunity. Over the next five years, the market will grow by an additional $80 billion.

Our study, which includes a comprehensive analysis of the addressable market for offshoring, also highlights ways in which this market may yet evolve.¹ It found that the drivers of future growth are likely to shift somewhat in IT-outsourcing services but will remain largely the same in business processes. Despite a significant slowdown in IT spending, the global offshoring market for IT services has grown by 21 percent a year since 2001. To date, this growth has come largely from applications development and maintenance and from R&D services—segments where we estimate that offshoring has reached about 30 percent of its potential. In R&D, new growth opportunities are opening up in increasingly advanced services. The John F. Welch Technology Centre, in Bangalore, for example, is conducting R&D in technologies such as propulsion systems for aircraft engines and in this way contributing significantly to the design of GE's latest jet engine. Nevertheless, our analysis suggests that, during the next five years, more traditionally outsourced—though not offshored—IT services, such as hardware and software maintenance, network administration, and help desk services, will account for 47 percent of the addressable market for offshored IT services (Exhibit 1).²

The global market for business process offshoring has grown by 49 percent a year since 2001 and appears likely to continue outpacing the market for offshored IT services. Banking and insurance account for nearly half of the addressable business process market, but companies have captured less than 10 percent of it thus far (Exhibit 2). In the next five years, the lion's share of growth is likely to come from these two industries: there are opportunities worth $23 billion to $25 billion, for example, in the offshoring of retail-banking activities associated with deposits and lending, $9 billion to $11 billion in credit card processing, and $3 billion to $4 billion in mortgage processing. Among cross-industry functions, human resources (HR) and finance and accounting appear set to fuel growth.

While the global addressable market for offshoring is a stunning $300 billion, the pace of adoption will be shaped by the interplay of three forces: supply (the capacity and quality of offshore locations), demand (the rate at which companies adopt offshoring), and the actions of industry players. We built a model to study this interplay and to evaluate various scenarios for different industries. Our analysis indicates that approximately 35 percent of the work that could potentially be offshored, worth $110 billion and divided equally between IT services and business processes, actually will be offshored by 2010. We believe that India's offshoring industry, which has captured two-thirds of the current global market for offshored IT services and almost half of the global market for offshored business processes, can maintain its leadership position. But to do so the industry, together with India's central and state governments, must address a few key issues, such as bridging a potential shortfall of nearly half a million qualified workers and improving the country's infrastructure.

The potential expansion of the markets that offshoring can address—say, through new models that go beyond the simple replication of onshore activities—is hard to forecast, since precedents are few and the potential varies greatly among industries. Still, companies can start by looking for ways in which offshoring would allow them to increase their revenues, to avoid or reduce costs, and to improve their utilization of capital.

One leading US bank, for instance, saved $100 million by using offshore staff to detect fraud in low-value transactions that could not be scrutinized profitably onshore. Lower processing costs have even allowed banks to create new products, such as subprime lending to previously unviable customer segments. As for the pharmaceutical industry, it could double the value it creates from offshoring (Exhibit 3), through new or redesigned processes and services that would improve compliance and the quality of its trial data, enhance its analytical capabilities, and help it develop products for consumer microsegments.

About the Authors

Sujit Chakrabarty is a consultant and Noshir Kaka is a principal in McKinsey's Mumbai office; Prashant Gandhi is an associate principal in the Delhi office.

Notes

¹ The study—Extending India's Leadership in the Global IT and BPO Industries, published in December 2005—was conducted jointly by India's National Association of Software and Service Companies (Nasscom) and McKinsey, and is available for purchase at Nasscom's Web site. The markets discussed in this article are those we consider "addressable," meaning that they can be served using a delivery model based primarily on offshore work. (Indian IT companies typically perform 25 to 30 percent of their work in the client's country and the rest offshore.) Our market estimates are limited to industries that are currently offshoring on a significant scale.

² The size of the addressable offshore IT market was determined using a three-step methodology. First, we examined spending on IT services in developed countries. Then, in a detailed analysis involving primary as well as secondary research, we applied to each service the six key factors (including labor intensity, business risk, and the complexity of interactions) that affect the decision to offshore tasks. Finally, we estimated the offshore cost savings for individual activities.