Outsourcing vs. Captive Operations – Which Model is the Best Fit For Your Business?

While feasibility of using offshore/nearshore resources for the delivery of certain activities or business processes has been already established, long term strategic feasibility and appropriateness of various engagement models are still under scrutiny.

The most common approaches nowadays are either working with a third-party outsourcing provider or establishing captive operations in lower cost locations. Engagement models can be differentiated based upon customer organization’s need for management control, costs of operation, risks and other factors.

Third-party Outsourcing

Third-party outsourcing is classic client-vendor relationship governed by contractual obligations and service level agreements. It is mostly driven by tactical reasons such as short-term cost savings and staffing flexibility. Non-core or non-critical activities are typical candidates for outsourcing.

Traditional third-party outsourcing comes in two main forms:

  • Project-based outsourcing is considered to be the most appropriate for development of software with well-defined requirements and deliverables. It is suitable for irregular but on-going or one-off projects. On-site presence may be required to facilitate estimating, specification and relationship management. Typical pricing models are Time and Materials (T&M) and Fixed Price.
  • Dedicated development center model caters for software with changing requirements, maintenance and support of large systems, research and development, testing as well as other types of complex ongoing medium- or long-term tasks. In this type of engagement vendor provides necessary facilities and allocates a team that works only on account’s projects and is managed by customer representative. This option is usually preferred when resource requirements are low. The customer is charged fixed monthly fee per full-time employee (FTE).

Captive Operations

When considering how to organize the remote delivery of software development services, captive subsidiary option often does not receive full consideration in comparison to outsourcing. While it is generally accepted to outsource certain non-crucial activities, in certain cases this approach is inappropriate for core functions and critical activities. Decision to take work offshore/nearshore doesn’t necessarily mean that you have to outsource it. Use of remote resources for the delivery of functions close to core business while retaining operational control and benefiting from real cost advantages can be achieved by means of setting up captive facility, thus keeping work within the company.

Captive model means that customer organization makes strategic decision to create its presence in the lower cost location and conduct work there as a part of its own operations. The activities are performed remotely, but they are not outsourced to the vendor. Thus the customer is able to retain full control and mitigate respective risks associated with intellectual property and other sensitive business information.

Organizations that want to establish captive centers have similar goals as those deploying traditional enterprise or shared services operations. In the first place captives are supposed to lower cost through labor arbitrage. But recent research shows that buyers are seeking not only cheaper but skilled labor at offshore/nearshore locations. They want to obtain competitive advantage and gains from process improvements. In order to avoid risks of underutilizing captive capacities, organizations must thoroughly assess their long-term operational requirements and predict service needs that may arise in the future.

The most common approaches to setting up captive operations are the following:

  • Creating captive center from scratch (do-it-yourself captive) can be successful when customer organization has necessary resources, local expertise and market knowledge. Decision to set up own captive center may evolve organically through growth. Organization can either perform extensive due diligence on its own or buy existing company with operations in the chosen location.
  • Build-Operate-Transfer (BOT) approach means partnering with third-party vendor to establish and stabilize center. Vendor is responsible for initial setup, staffing and operations of the captive center during the predefined period of time. At the end of the contract period the ownership is transferred to the customer. Thus organization takes over the turnkey captive center tailored to its specific needs. BOT option best suits organizations that do not have local expertise or extensive resources available. In this type of engagement only logistics associated with setup of the captive center is outsourced. Build-Operate-Transfer optimally combines control element of the pure captive model with flexibility of outsourcing. Essentially it provides maximum control at minimal risk.

Main benefits of having own captive center:

  • Ongoing realization of real cost savings
  • Full operational control and monitoring
  • Full ownership after the transfer
  • Minimization of intellectual property and data security risks
  • Retained knowledge of industry, specific business processes and techniques
  • Improved communications by continual reinforcement and experience
  • Easy replication of parent organization’s processes
  • Captive center can be commercialized at some point in the future

Both outsourcing and captive operations have similar driving forces (cost reductions and competitive pressures in the first place) and particular advantages, but main factors for choosing one or another vary.

Both approaches will deliver benefits in terms of improved focus, optimization of processes, reduction of operational costs, faster time-to-market etc. But companies must thoroughly evaluate each option to identify one that represents the best fit for their specific requirements, business culture and strategic goals.

The approach selected will depend on whether the primary driver is short-term cost savings or whether the company has long-term vision for offshoring/nearshoring and wishes to retain control over processes and intellectual property.

Establishing nearshore captive center in Ukraine through BOT model

If software development is a core competency of your company and you have long term specialized resource requirements, it makes sense to build your own capability in order to support the full software life-cycle, secure intellectual property and build up specific know-how. Nowadays this process is not as difficult as it used to be. The key to success is finding a trusted partner that already operates in the environment of country. By doing this you will benefit from:

  • Clearly defined setup methodology and timeline
  • Planned step-by-step implementation
  • Responsibility for all logistics associated with establishing a captive center
  • Practical knowledge of establishing IT business and dealing with related legal and contractual issues
  • Deep comprehension of cost and effort components associated with setting up and running a software development center in offshore/nearshore country
  • Hands-on experience in software engineering, generally recognized methodologies, processes and quality assurance that can be adapted to captive center
  • Established HR practices, experience in recruiting qualified IT staff
  • Attention to addressing security and business continuity issues
  • Consulting and support throughout the setup process
  • High level of business commitment and responsiveness
  • Flexible client-specific approach

Captive Insurance

Most accountants and small business owners are unfamiliar with a great way to reduce taxes and expenses. By either creating or sharing “a captive insurance company”, substantial tax and cost savings will benefit the small business owner. Over 80% of Fortune 500 companies take advantage of some kind of captive insurance company arrangement. They set up their own insurance companies to provide coverage when they think outside insurers are charging too much, or coverage is simply unavailable. The parent company creates a captive so that it has a self-financing option for buying insurance. The captive then either retains the risk of providing insurance or pays reinsurers (companies that reinsure insurers) to take the risk.

If you buy insurance from a standard insurance company, your money buys a service, but the money is spent and gone forever. When you utilize or “rent a captive”, your money buys a service but it is invested with a good possibility of a return.

In the event of a claim, the company pay claims from its captive or from its reinsurer. To keep costs down, captives are often based in places where there is favorable tax treatment and less onerous regulation (i.e. Vermont, South Carolina, and Bermuda).

Optimum utilization of a captive by a small business, medical practice, or professional

The best way for a small business, medical practice, etc., to take advantage of captive benefits is to share or rent a large captive. You can significantly decrease your costs of insurance and obtain tax deductions at the same time. There are, as well, significant tax advantages to renting a large captive as opposed to owning a captive.

The advantages of “renting a captive” become apparent when you consider that the single parent captive may be forced to use less than adequate standards or marginal service so they can meet the financial requirements associated with the initial general licensing and administrative costs of establishment. Additionally, when renting a large captive, the captive bears the burden of initial capital commitment and protects reinsurers from runaway claims and unnecessary losses through their underwriting protocols and claims management practices, all at significant savings to the small business owner.

Other advantages include low policy fees and no capital responsibilities to meet solvency requirements or annual management and maintenance costs. By renting a large captive, you only pay a pro rata fee to cover all administrative expenses for the captive insurance company. Another significant advantage of renting a large captive is the ability to take a loan. It is illegal for an individual captive to make loans to subscribers. When renting a large captive, however, the individual subscriber has no ownership interest, and this difference makes it legal for a rented captive to make loans to individual subscribers. So you can make a tax deductible contribution, and then take back money tax free. Operation of an individual stand alone captive insurance company may not achieve the type of cost savings that a small business could obtain by renting a large captive. To rent a large captive, your company simply fills out some forms. Renting a captive requires no significant financial commitment beyond the payment of premiums.

Buyer Beware

As with many strategies to enjoy tax savings and advantages, you must to do this correctly. IRS and other problems have happened, in the past, to those that have done this improperly or abusively. You probably want to work with a large captive that already has over fifty million in assets and is being rented by at least 200 different companies. Also, you’ll not want to own or control any part of the captive. As an unrelated party, you can more likely significantly decrease your cost of insurance, eliminate capital requirements, and minimize maintenance costs.

You want to deal with a large captive that meets the risk shifting requirements of IRS Revenue Ruling 2005-40. Be cautious about setting up your own small captive. In addition to all the costs, a small captive may find that the expense of defending itself from regulatory oversight is much greater than any benefits received.

How Effective Are Captive Services?

Captive Services have been a popular means of business process outsourcing for some companies. In this, companies wholly own their BPO units rather than using a third party outsourcing firm. Companies opt for captive services to have complete control on the operations of their business processes in other countries. Again, the main driver is cost effectiveness. Companies tend to shell out more than they would have to pay a third party vendor however a lot less than what they would have to pay in their own country.

Most financial and telecommunication companies prefer having parts of their business processes outsourced in this manner. For example 3 Global services have their captive contact centre in Mumbai, India. Lehman Brothers also had their captive unit in India. The objective of having a captive unit is just to have tighter control and better regulation and functioning of the unit. There are a lot of long drawn legalities around liaising with a third party vendor.

The quality of work can be controlled only to a certain level and the framework of vendor may not be compatible with the company. Hence, using captive services has been an option for companies wanting to outsource since the 1980’s. Some of the companies who spearheaded this movement are British Airways (Captive later known as WNS Global), General Electric (captive later known as GECIS /GENPACT) and AMEX who have their captive units in Delhi and surrounding regions in India. The service arms of Dell, HP, IBM and Accenture have also set up shop in India.

On the other hand, the employees of the captive centres stand to benefit from this sort of a setup. When an employee is working for a BPO, they are indirectly employed by companies that have outsourced their work to them. They may be doing exactly the same work, putting in the same hours and producing the same kind of end product, however they are paid a lot lesser than their counterparts in the west. In a captive service, people are directly employed by the companies and get the same kind of benefits the employees of the company may get in the west. There may be minor differences in their pay scales as compared to the employees in the west; however they pay much better than third party vendors.

The global economic meltdown has not helped these captive setups. Companies like Citibank, Merrill Lynch, BT, Lehman Brothers etc have been forced to shut shop, face bankruptcy and cut down on jobs in many of their captive units. Others have been forced to sell their captives. For example, TCS bought out Citigroup Global Services. In the recent years companies have been forced to rethink their outsourcing strategies as the rising costs have diminished their returns on investments. With most captives attaining maturity and cost effectiveness being a challenge in the face of increasing competition, the future of captive services doesn’t look promising.