FSN: Cost conscious companies are turning to DIY outsourcing “Captives” and offshoring. But what are the risks?

Cost conscious companies are turning to DIY outsourcing “Captives” and offshoring. But what are the risks?

30th July 2007
Demand for outsourcing in Europe has increased dramatically in the first half of 2007, as companies of all sizes grow more confident about offshoring and the economic, technical and operational barriers become less daunting. However, there are significant pitfalls for the unwary and for example, legal considerations around employment, data protection, and industry specific regulations should not be overlooked. Gary Simon , FSN's managing editor considers the trends and some of the pitfalls.

Demand for outsourcing in Europe has increased dramatically in the first half of 2007, compared with the same period last year, according to the latest Quarterly Index from sourcing advisers TPI. The total value of new (as opposed to renewed or restructured) outsourcing contracts in the €40 million plus bracket - where most significant outsourcing activity occurs - is up 78% on 2006 .

This €12.3 billion of new business in Europe represents a significant recovery from the relatively soft outsourcing market experienced in Europe last year, and is a 23% increase on an average €10 billion of new contracts added in each of the previous five years. So impressive is Europe's record on new deals this year that it accounts for over half (54%) of new outsourcing contracts signed globally, against 32% last year and a five-year average of 38%.

Duncan Aitchison, Managing Director of TPI, explained: “Continental European countries have been relatively slow to adopt outsourcing, which makes it a market with huge growth potential. Five years ago, the region accounted for only twelve per cent of global outsourcing deal activity, and only Germany , France and the Netherlands managed to achieve above a one per cent share. Now, Continental Europe has nearly trebled its share to thirty per cent, with Belgium , Denmark , Norway , Finland , Switzerland and Italy each representing over one per cent of the global market.”

Peter Moller, leader of Outsourcing Advisory in the UK at Deloitte told FSN he is also seeing an up-tick in European outsourcing. “In an increasingly global economy there is only so long any organisation can wait to adopt a more cost effective business model if its competitors have already done so. The move to outsourcing, and especially outsourcing with a significant offshore component, represents such a shift and Continental European firms are way behind their Anglo Saxon competitors. This is why we are now seeing them make a move,” says Moller.

But the nature of outsourcing itself appears to be changing shape. Duncan Aitchison, Managing Director of TPI, explained: “We believe the slowing of growth in the global outsourcing market is driven by the fact that offshoring to a wholly-owned captive operation, or tactical out-tasking of small, discrete processes, is currently considered an alternative to outsourcing by some client organisations looking for short-term cost savings. Other clients are going beyond a focus on cost savings to seek innovative outsourcing relationships and competitive advantage. The challenge for service providers is to add value in the labour arbitrage game and/or to offer the kind of transformation that will deliver far wider-reaching benefits.”

Deloitte's Moller believes that the cloak of mystery surrounding off-shoring is disappearing tempting companies into going it alone with Captives. He told FSN, “Five years ago the thought of building a back office in India to support internal operations and tap into lower labour costs would have too scary for all but the most enlightened and bold executives. But increasingly companies are seeing that it is achievable and that they can save the 15-25% margin that outsourcers are after and thereby save well in excess of 50% of affected costs. Companies that have a brand identity in India , have some operations there already and/or are seeking to penetrate the increasingly important and expanding Indian middle class are the prime candidates to go it alone and build a captive back office offshore.”

Despite TPI's observation of an increase in offshoring through captives, the use of offshore service delivery within the scope of outsourcing also continues to expand. In the first six months of this year, 59% of the deals on which TPI advised entailed at least partial delivery offshore - the highest percentage ever.

But there are risks for the unwary, according to Nelu Abeygunasekera, who specialises in employment law at Pritchard Englefield. She told FSN, “Whilst there are obvious advantages, to offshoring - when work is transferred overseas, usually to low cost countries such as India , the hidden costs and potential liabilities to the organisation seeking to delegate its business activity should be borne in mind.”

“In the UK , offshoring will often trigger the application of the Transfer of Undertaking (Protection of Employees) Regulations 2006 (“TUPE”). If TUPE applies to an outsourcing, the parties involved in the outsourcing will need to consider a number of employee-related issues, which includes the automatic transfer of the contracts of employees who are employed by the organisation seeking to delegate its business activity (transferor) immediately before the outsourcing to the new service provider (transferee) on the same terms as applied between the employees and the transferor. This means that following the outsourcing, the transferee would become responsible for any costs relating to those employees.”

“This does not necessarily mean the employees would automatically transfer to the off-shore location where the transferee is, for example India , but their contracts of employment on their existing terms would transfer. Consequently the employees would then be employed by a foreign employer, but remain based in the UK ,” adds Abeygunasekera.

In practice, if the foreign transferee does not wish to retain employees in the UK, it could make the employees redundant and offer them alternative employment overseas on local terms and conditions.

However, employees that have been employed for more than one year and who are dismissed, (including redundancy), by reason of a TUPE transfer can claim automatic unfair dismissal, unless the dismissal was for a reason connected with the TUPE transfer (as distinct from the transfer itself) and the transferor or transferee has an economic, technical or organisational reason for the termination entailing changes in the workforce. Currently the maximum compensation for unfair dismissal is £60,600.

“As well as a potential claim for unfair dismissal other potential employee-related liabilities, include for failure to consult under TUPE and failure to provide employee liability information – both of which attract financial penalties,” says Abeygunasekera.

According to Helen Clifford, who specialises in Intellectual Property at Pritchard Englefield, other issues to consider include ownership of intellectual property and data protection particularly where personal data is to be transferred outside the European Economic Area. Such transfers are possible but in very limited circumstances and stringent conditions for such transfers apply.

“There may also be sectoral requirements, for example certain regulated sectors such as utilities and aviation have specific requirements on companies wishing to offshore their functions; obtaining specialist tax advice, for example, to find out whether double taxation treaties exist between the proposed jurisdiction of the off-shore entity and the UK; local employment and tax laws.,” says Abeygunasekera.

Few companies want to think about how to exit their outsourcing arrangements when they embark on outsourcing but the lawyers recommend companies consider how to claw their way back before signing on the dotted line.

“It is essential to have a well planned exit strategy formulated at the outset,” Abeygunasekera told FSN “It should deal with such matters as, the continuity of service between the out-going and new supplier (including if services go back in-house), the welfare of employees, the return of assets and software and the ownership of confidential information, know how and intellectual property rights,” she adds.

Whilst the financial rewards of outsourcing can be alluring it seems that economic considerations and legal considerations need to be taken together. However all the signs are that European companies are growing in confidence and, despite the pitfalls, offshoring seems to be on a roll.

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