iThink SSON – a Professor’s View on Outsourcing & Offshoring

What’s Your Captive Center Strategy?
Cost, growth and current market conditions as deciding factors

SSON is pleased to bring you a new column by Professor Ilan Oshri from the Rotterdam School of Management (Erasmus University) and Loughborough School of Business and Economics (Loughborough University): iThink SSON – a Professor’s View on Outsourcing and Offshoring

Say you have set up a captive center to provide back office support or IT support, or maybe even R&D support, from an offshore or nearshore location. Did you have a strategy for your captive center?

Most of you will probably say: sure, reduce operating costs by going offshore. Indeed, most of the IT and BPO captive centers, including customer support centers, were set up for this reason: to reduce operating costs. But the fact is that about 60% of the captives still struggle to meet such success criteria; so, what’s wrong with the captive sector?

My research shows that most of the parent firms did have a strategy for their captives! It was an emergent strategy, one that was reactive and in the form of crisis management rather than a thought through approach. But why is it important to have a long term strategy for your captive if the main objective is to reduce operating costs?

I would argue that the nature of the work allocated to captive centers may bring with it opportunities. For example, some captive centers have outsourced to a local vendor part of the work offshored to the captive, allowing them to free up resources to focus on value adding activities. Others have chosen to take on external clients expanding their range of services and turning the captive from a cost center to a profit center. In other cases yet, the parent firm has divested part of, or the entire, captive for various reasons, thereby improving cash flow as well as securing quality service from their former business unit. Now some parent firms are just lucky to stumble on such opportunities; but for the majority of firms a careful examination of the captive strategy is required in order to create such opportunities. So where do we go from here?

The first step is to understand the different captive strategies out there.

My classification for captive center strategies offers four types:

• Basic captive, which provides services to the parent firm;
• shared captive, which provides services to both parent and external firms;
• hybrid captive, which outsources part of the activities to a local vendor and;
• divested captive, where the parent firm divested part or the entire captive to a third party.

Other studies may claim that there are more captive models but my view is that any parent firm can strategize its captive investment based on the four options above. But executives should also be aware of the following: There is an evolutionary path and it is therefore imperative to figure out the parent firm’s strategic objective for the captive.

To understand the strategic objective, executives should ask one simple question: What is the strategic intent behind setting up this captive? I see two strategic intents here: cost advantage and growth opportunities.

At the same time, there is another aspect that executives should consider, which is local market conditions in the nearshore or offshore location. Local market conditions refer to the degree to which the local market in the captive location is either developed or underdeveloped in terms of the demand for the services that the captive center offers. Underdeveloped markets mean a low demand for the captive center’s services, and therefore we assume a small number of local vendors with little competition among them. A developed market in the captive location represents high demand by local firms and a high number of innovative competitors.

The combination of strategic intents and local market conditions creates the following figure:

So what should be your strategy?

If you are cost driven and the market is underdeveloped, I advise you to consider an outsourcing arrangement with a third-party service provider instead of setting up your own captive center. Underdeveloped markets for outsourcing services will lack skilled employees, a problem that will become a major challenge for the captive center when it needs to recruit the talent required to maintain service levels on par with the service provided onshore. Similarly, an underdeveloped market for outsourcing services in the captive location will limit the captive center opportunities to grow and set up partnerships with local vendors. However, if the parent firm decides to set up a captive center regardless of these challenges, due to the potential cost savings that a captive center can offer, I advise that the parent firm and the captive center maintain a basic captive center model.

If the strategic intent is to exploit growth opportunities and the captive location is in an underdeveloped local market, I advise executives not to invest in a captive center. The conditions within which the captive center will operate (lack of demand from external local clients, lack of skills, and lack of competition to drive innovation) will not support the center’s growth plans. Captive centers that operate in underdeveloped market conditions with the strategic intention to grow should be shut down.

A parent firm considering setting up a captive center in a developed market with a strategic growth intention should take advantage of the range of opportunities to improve captive center operations by moving from a basic to a hybrid and to a shared captive center over time. Considering that the local market is populated with numerous vendors, the captive center should exploit opportunities to outsource some of its activities in order to become more efficient and free up talent to focus on higher-level activities. At the same time, the captive center should attract external clients to increase scale, learn about markets and needs, and pursue innovation. The captive center can partner with local vendors and work closely with the parent firm to attract new clients.

A strategic intent focusing on achieving cost savings by setting up a captive center in a developed local market is another opportunity to exploit local market conditions. Over time, such a center should evolve into a hybrid captive center, having outsourced some of its noncore activities to local vendors. Developing scale should become a key objective for the captive center, and the parent firm should consider its strategic role in helping the captive to grow quickly. The parent firm can maintain full ownership of the captive center and benefit from the cost savings offered by the captive center as the scale of transactions processed offshore increases. Or the parent firm could consider divesting the captive center (the entire entity or portions of it) in order to focus on its core activities while becoming a client of the captive center after it is sold.

The Professor’s Verdict:
There is no one best method for pursuing a captive center strategy. A best-fit strategy depends on the strategic goals of the parent company, as well as the environment in which the captive center operates.

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