Not too long ago, many CEOs were grappling with the question of whether to outsource part of their business processes to countries like India. Fast forward a few years, and the key decision morphed: Businesses pondered whether to keep the outsourcing operation in-house as a captive center or allow a third party provider to handle it.

Today, even that question is becoming largely moot as companies are pursuing ever-newer hybrid models of managing outsourced processes – and discovering that a host of other issues has cropped up to keep their executives awake at night. Headlines have only reflected the pace of news: IBM Global Services announced its acquisition of New Delhi-based call-center firm Daksh in April, and GE sold a big stake in its GE Capital International Services (Gecis) unit to U.S. investors in November.

In an effort to explore the latest developments in this fast-changing industry, Knowledge at Wharton tapped into the experience of several experts, including executives who spoke at a panel on IT and offshoring at the Wharton India Economic Forum held last month in Philadelphia. While they differ on the details, they all agree that the next few years will see some major changes in how outsourcing will take place.

Command and Control

Instead of relying solely on captive centers or third party providers for their outsourcing needs, companies are increasingly turning to hybrid structures, says Ravi Aron, a professor of operations and information management at Wharton. “The debate over one or the other is really fading away, and firms are going toward what’s called an ‘extended organizational form’ which brings together the strengths of the two models. It gives companies a way to say what they want done but also say how they want it done.” Essentially, the client firm’s managers act as very senior managers of a third-party provider.

For instance, New York-based Office Tiger, a BPO solutions provider that has set up operations in Chennai, India, has a system through which companies can make day-to-day changes to processes, adding in verification layers. “I call this ‘virtual prowling,'” says Aron. “In most captives, you are able to have a senior manager prowl the floor. So when a third-party provider gives you fine-grain analysis capability, you can still monitor all of these things.” Thus, the client firm can see which teams are excelling at which processes – and start picking the composition of new teams based on that knowledge.

The system also allows for real-time collaboration. “Suppose an investment banker in New York is working on a merger – he can work on the cash flow and revenue projections on a spreadsheet and send it abroad to Office Tiger,” says Aron. “They can look at the document to verify accuracy, make corrections and perform necessary research, and send it back. The key is that each party can see what the other is doing at all times and make suggestions. With these hybrid models, you get both control and cost efficiency.”

Even firms that swear by captive centers acknowledge that there is scope for more outsourcing. Peter Nag, vice president and head of the global program management office at Lehman Brothers, notes that Wall Street firms often go to captive sites in part because there’s a disconnect in domain knowledge between the young managers in India and their older counterparts in the U.S. “We were able to offshore about 20% of our technology within the first year. But we couldn’t get beyond that, because we had project managers in their 40s working with people in their 20s. Our projects were complex and proprietary, and we needed a high degree of control. But captive doesn’t equal not outsourcing – they both do work and outsource, and it can open the way for more outsourcing once high quality work is proven.” Lehman made headlines when it withdrew some of its help desk outsourcing from Wipro in India and moved those operations back to the U.S., but according to news reports, the company continues to outsource other aspects of IT work to India.

Client control even extends as far as strategic acquisition decisions. “With consolidation [among players] increasing, customers are wondering how to handle it,” says Nagi Palle, a principal in A.T. Kearney’s New Delhi office. “Companies select third parties based on their supplier selection processes, but if the suppliers they choose are in turn acquired by a less-than-optimal supplier, it does not go down well. I believe that, especially with large outsourcing contracts, customers will require suppliers to get approval before deciding to get acquired. This trend has begun.”

Metric System

Ask companies why they outsource, and no matter what they say, their answers can largely be summed up in two words: cheap labor. But therein lies the problem, says Aron. “A lot of companies look at their potential gains from going to India and salivate over the labor arbitrage opportunities. What they should do is architect their plans backwards from the interface of the market.” In other words, says Aron, companies should look at the ultimate destination of the process they’re outsourcing and align workflows to integrate with actual customer needs. “They’re beginning to understand that it’s important to have discipline in knowing what to measure and why. Several firms have achieved operational flexibility through outsourcing – in other words, if their work volume suddenly goes up, they can look to their Indian operations to staff up cheaply – but very few have really been able to leverage outsourcing for true business impact – ability to price products at a premium, enter new markets, build in switching costs, etc.”

The myth, says Aron, is that companies with spaghetti-like, poorly managed processes in the U.S. and elsewhere are those that get the most out of outsourcing. “Firms that get the greatest value from outsourcing aren’t those whose operations shops can’t deliver in America; it’s the ones that already run a lean op shop here and know how to calibrate incentives to customer needs and reap gains from going to India. They achieve shorter times to market and can add on to existing product lines. It’s no accident that companies like American Express and GE have benefited – they have a culture of measurement and submitting themselves to numbers. On the Indian side, the BPO providers that have done best are those that share this culture of metrics and measurement.”

Tailor-Made Solutions

For their part, says Aron, the outsourcing majors in India aren’t looking at some of the key success indicators when it comes to making their businesses more robust. “Like any others, they have to look at their EBITDA and their burn rate, certainly. But because of the nature of their business, they should also look at other measures.” One such indicator, he notes, is revenue per full-time employee. But not all employees are relevant here, cautions Aron. “If you have 420 people actually working on a project for an overseas telecommunications company, and you have 80 people supporting the 420, then the number you should be focusing on is revenue per execution agent. The higher that number is, the more specialized and less commoditized the process, and the more you are customizing it for your client’s needs. That locks in the customer.”

Joe Sigelman, co-CEO of Office Tiger, agrees. “I want my employees to understand what it’s like to work in, say, a  London or New York investment bank. At first these companies were just interested in labor arbitrage, but we’re taking on increasingly specialized tasks and services and creating structures.”

Another key metric, notes Aron, is substitution of capital for labor. “If you have a certain number of agents working for a client this year, and you reduce that number the following year, you’re not just saving on salary costs. The more you automate processes, the less likely you are to have human driven errors and the easier it becomes to measure the work.” If your ratio of support staff to execution staff is rising, says Aron, it’s a red flag. “It often means you’re not automating as much as you should be.”

Outsourcing firms should always be trying to measure the extent to which they have customized processes for client needs, adds Aron. “The more you have calibrated it so that it fits the customer’s way of doing business, the more say you have in that company’s internal workings. You can start telling the client, ‘Here’s how we can bring more gains to you.’ That’s when you get more strategic, formulating and diagnosing issues instead of just executing them.” Right now, says Aron, most companies are positioning themselves in just one space – developing solutions or operating solutions. “They should be moving up into designing organizational processes and – at the very highest level — formulating and diagnostics work, typically done by a few people but with the highest revenue per FTE. Many firms made the jump from body shopping to applications development. The challenge is to move even higher.”

Sanjeev Aggarwal, CEO of Daksh-IBM, sums it up thus: “We’ve sold processing as a component; now we should begin to sell business transformation as a bundle.”

External Threats

Whether India can maintain its current standing in BPO is the million-dollar question. “The major issue is this: Is India willing to invest in infrastructure?” says Aron. “If the government because of an ideological orientation stops the flow of foreign capital, the bets are off. They should have no problem with allowing foreign investors to put money in immobile, solid assets that diminish in value over time – the risk lies completely with the investing firm. There’s not enough capital formation within India to sustain the infrastructure, and there’s a risk that the country won’t be able to keep up with its skilled population.”

Protectionist legislation abroad can be an issue, too – the domestic backlash against sending jobs abroad has already been felt. “India can counter by pointing out that it offers an enormous market in hospitality, airline, retail, and services,” says Aron. “That’s its greatest bargaining chip. But to do that it has to demonstrate the political will to open itself up to the outside. It’s definitely a complex sociopolitical situation.”