CONTRACTING FOR CAPABILITY: the future of outsourcing Reply

Outsourcing only works for vendors. It does not work for customers. Revenue curves for vendors show a slight increase since 2008 for global outsourcing growth but the picture is less clear for customers. When looking at the economic-value-added (EVA) for businesses before and after outsourcing deals most show a nett decrease, which is to say only that they are weaker after the deal but not necessarily because of it.

The reasons are myriad however there are a few standard reasons:

  1. outsourcing is usually part of cost reduction activities of panicking organisations.
  2. there is usually a nett decrease in headcount which wipes out the value-added aspects of reduced costs.
  3. the customer’s SG&A costs usually rise due to the increased management activity needed in finding and using information.

Due to these reasons there is a feeling in the market that outsourcing does not work despite the claims of vendors. Therefore, vendors have increasingly (certainly since 2007) seen themselves fighting for an ever shrinking slice of the economic pie. The greatest sources of competitive advantage have been reputations and economies of scale. All, however, have been scrambling for a differentiator that does not involve reducing their own profits.

MIDDLE-OFFICE OUTSOURCING

One large UK outsourcing outfit saw the writing on the wall. It felt that it would not be able to compete with the lower labour (and similar outputs) of India-based companies. It rationalised that eventually it would be squeezed out of the back-office (i.e. highly standardised financial processes) outsourcing and infrastructure hosting markets. It would, it rationalised, need to move into middle-office outsourcing. Front-office outsourcing, on the other hand, is largely fictional as it encompasses the customer-facing aspects of a business which is where the key differentiators are.

Middle-office outsourcing (such as a council planning approvals process) is unique because it involves less repetitive processes and sometimes ad hoc activities.  Success here is necessarily predicated on a flexible IT infrastructures (often service-based, i.e. SOA) and a sophisticated management which is able to choreograph technology-based processes and services.

COMMERCIAL CAPABILITIES

Being able to outsource the middle-office involves positioning the vendor into a customer’s capability. A capability is the ensemble of systems, processes, people and information/data necessary to do something. In business terms this means all the stuff that is necessary to perform a process. Technically, capabilities are specifications of an enterprise’s Value Chain, so in broad terms a business will have about 20-ish key capabilities. All capabilities are, necessarily, linked. The closer one gets to the front-office the more these capabilities need to (i) be performed and supported in real-time, and (ii) they also need to consume information and services from elsewhere in the business. For instance, in our planning approvals process example the vendor will have to (a) log approvals in real-time, (b) consume up to date information on structures and utilities, as well as (c) access information on business rules (i.e. council policy, governance, law etc). As with any outsourcing activity, more narrowly focused personnel on lower pay bands are used to perform tasks more ably supported by better technology. All these aspects not only add to the complexity (and therefore the price) but also to the potential liability. When offering low pay band workers to crank the handle on repetitive processes liability is something a vendor wishes assiduously to avoid.

DEFENCE CAPABILITIES

Capability is a term much abused but little understood in Defence circles. Much of this is because Defence does not use a standard value chain. Although there is a business model for most western Defence communities (Inform > Project > Operate etc) there is no need for a value chain because there is (i) no need to differentiate, and (ii) planning and financing is based on the use of ‘unlimited’ funds to confront external threats (i.e. Treasury tends to play second fiddle during war).

The military user will often class themselves as a ‘special’ customer. The defence industrial complex is a special environment for the simple reason that they are providing equipment which – if the enemy is successful – is useless to the customer by the time it enters service. Unlike the commercial enterprise, where such a situation would mean they lost some competitive advantage/margin, in the military such a situation is untenable. The purpose of a military capability is therefore to change quickly and radically over time in line with the threat. Corporate structures are notoriously incapable of maintaining the same tempo of development, even with lavish operational funding. The purpose of ‘Contracting for Capability’ is to solve the problem of commercial-lag whilst still providing a cost effective and commercially robust means of contracting.

THE CONTRACT: A COMPLEX ADAPTIVE SYSTEM

This is possible by viewing the capability environment as a complex evolving system which requires the commercial deal to be a complex adaptive system. This is not new to the law. Building and construction deals have been taking this approach for years and German franchising law has excellent precedents showing how risk may be judicially assessed throughout a large, distributed network of commercial entities – for a common purpose or effect.

Figure 1 – Shows how commercial deals fail to keep pace with and support military capabilities.

‘ROLES’ – The Key to Capability

The key difference between commercial and military capability is that in the military environment the vendor cannot own the people. In business, the customer will transfer the roles over to the vendor. In the military equivalents of the middle and front offices (i.e. front line and forward echelons) the vendor will never own the people. Soldiers will always perform critical tasks. This will remain a constant for some time to come as soldiers do not say (i) “the computer isn’t working”, or (ii) “do I get overtime?” etc.

Although a vendor cannot own the people it can own the ‘Role’ or the role specification, i.e. the processes, information and systems that a role uses. In this way, a vendor can support the core functions of a role without hindering the actual person’s ability to go outside the boundaries of that specification to ensure that something is done. For instance, a aeromedical evacuation must take place regardless of whether a computer is not working. The airman performing the tasking may have at their disposal a sophisticated orchestration of processes based on flight availabilities, supporting gunships, bed availability and surgeons on duty. However, if the network is down it is unacceptable to let a soldier die just because the computers are not working. That airman must now use their deep knowledge to work the radios and help save a life. On the other hand the military is largely incapable (and unwilling) to integrate the vast array of ICT necessary to develop the initial systems.

Figure 2 – ‘Contracting for Capability’ using commercial communities to support capability clusters.

COMPLEX CAPABILITY

The example of an aeromed evacuation is somewhat simplistic. The example above refers to the Deep Target Attack capability. This capability may be performed by submarine/ship-launched missile strike, aircraft or even Special Forces. The choice is a military judgement. In the case of a submarine launched method the enemy will try to prevent this through anti-submarine naval activity (ASW). The submarine needs to close to striking distance, reach launch depth and then withdraw safely. How is it possible to support such a process which involves very long and expensive R&D lead times, long into-service acceptance testing, new training and tight export controls as well as restrictions on the use and sharing of sensitive information?

The trick is to incentivise the commercial community to do some of the thinking for the military. Instead of having to wade through the commercial treacle of Defence procurement the following steps could be taken:

  1. Base contracts on Capability Increments. In this way, the vendor is obliged to keep pace with threat evolution and the development of capabilities.
  2. Outsource the Role Specification. This will ensure that the military community is forced to involve its commercial delivery partners (without being hamstrung by systems).
  3. Create Commercial Communities around the support to certain key systems/clusters of technology. This is similar to German franchise systems whereby all parties are legally obliged to discharge their contractual obligations in line with a common purpose. This will circumvent the horrific impasses usually experienced in alliance contracts.

Contracting For Capability is a logically sensible concept which simply builds upon the work already achieved in the Enterprise Architecture community (especially MoDAF, MoDEM and the IDEAS Group). It is not overly complex nor is it a step too far. Once again, the real question is whether Defence and industry have the sophistication and diligence to complete the task.

The Architectural Enterprise: financially lead capability development Reply

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There is one truism in the world of enterprise architecture, namely:  do not focus on developing the architecture first.  In other words, enterprises should focus on developing capability and not architecture.  Focusing on architecture can only ever gild the lilly. To focus on architecture first is to focus on systems first and not value.  To focus on architecture first is to focus on structures first rather than functions.

Enterprise architecture programs have received poor reviews in the past few years and most even struggle to leave the comfortable boundaries of the all-too-familiar systems rationalisation through data model interoperability.

Architecture, however, should not be the focus.  The focus should be value and the means to achieve this should be through organisational capability.

This bog is Part I in how to develop a comprehensive enterprise architecture program within an organisation, namely:  developing a capability portfolio.

STEP 1:  Value.

The best way to define value in an organisation or department is through variance analysis (so long as this is performed well and to at least 3 degrees of depth) in the relevant business unit.  In the Architectural Enterprise (the fictional enterprise built and run on EA guidelines) the specific variance would be referred to an Architectural Council to ensure that the variance was cross-referenced for dependencies and all the ‘noise’ was stripped away, i.e. personnel as opposed to role issues. The architectural team can now focus on supporting the process, service delivery or value activities.

Alliteratively, if the EA program needs to start more stealthily, then the ICT department may begin by cost-modelling the ICT budget.  The financial model needs to include 3-point estimates for all relevant costs.  Importantly, the higher bound is what the organisation does pay, the middle bound is what they should pay, and the lower bound (the 10% CI) is what they could pay.  This forces the team to not only to prep the model with uncertainty (for later simulation) but also to make sure that realistic stretch targets are imposed for projected cost reductions.

Once the model is run through a deep sensitivity analysis the team can then strip out all non-capability cost drivers, such as internal transfers, tax liabilities, interest and depreciation etc.

STEP 2:  Capability.

What is left are the most sensitive capability cost drivers.  The team now needs to make sure they focus on what is valuable and not just what is sensitive.  This is critical to ensure that the team doesn’t focus on low impact back-office ICT enabled capability but rather on high-impact, high-value operational capability.  The key is to ensure that an accurate value chain is used.

The best way to achieve an accurate value chain is to (a) develop a generic value chain based on industry baselines and then, (b) refine it using the firm’s consolidated financial returns.  The team should work with a management accountant to allocate costs amongst the various primary and supporting functions.  This will highlight exactly where the firm (i) derives its primary value, and (ii) along which lines it is differentiated.

Once the team understands these financial value-drivers and competitive subtleties they can now calibrate the capability-cost drivers with the value chain.

STEP 3:  Architecture.

Once the team has a short list of sensitive areas which are both architecturally weak and financially valuable they can then set about increasing the capability within defined parameters.

To do this, the team needs to create a parameterised architecture.  The architectural model has two facets: (a) it has capability components enabling it to encompass the dependencies of the area the team is focusing on, and (b) the capability components have attached values.

Determining values for model is oftentimes difficult.  Not all components of capability have easily defined financial parameters.  What value does the team place on information?  on processes? on services or even on task functions in certain roles?  Although this will be the subject of another blog the intangible aspects of capability must all affect the 100% of financial value.  For instance, a Role filled to 80% (due to shortfalls in the person filling the role) will not necessarily mean that the capability runs at 80%.  For a good set of capability coefficients the team can use the COSYSMO model elements. These coefficients allow the team to see how the overall cost is varied by differences in organisational capability.

Once the architectural model is built the team can adjust the parameters so that they achieve both the cost that they could deliver whilst making sure that they are also increasing overall capability, i.e. process output, software integration, role utilisation etc.

Whereas standard cost reduction programs reduce cost without accounting for the wider capability sensitivities, this methodology is able to model a capability financially yet cognisant of how intangible aspects support its overall enterprise value.

IN SUMM

Through this method the team is not only able to identify the areas requiring attention but they are also able to ensure that that costs are reduced without compromising overall business capability.  Moreover, the team will be able to do this whilst engaging with both the technical and the financial teams.

Most importantly, by focusing on capability and not architecture the organisation can hone in on not just on the hot-spots – because their will be too many to count – but on the valuable hot-spots.