As their enterprise clients move to digital business models, which are clearly superior in productivity, business alignment and speed, legacy service providers seek to shift their offerings to the new digital world too. Seems like a great match, right? So, what’s the problem? The problem is the service providers are accustomed to a very profitable offshore factory delivery model. Inconveniently, the new digital business models don’t align well with this old tried-and-true mainstay. Even more disturbing for the service providers is that the new delivery models look to be less profitable than the mature offshore talent factories. I foresee increasing pressures on margins and some potentially unrecognized consequences that will impact clients.
Two reasons for the margin paradox
As the services industry rotates from the old labor arbitrage model to digital business models, service providers expect to achieve higher margins than their typical 40 percent gross margins. Why? Because the digital models deliver a higher level of value. They are better aligned against clients’ business results and are delivered at a faster rate. So, why are providers shifting to digital not getting even close to maintaining the margins they enjoyed in the labor arbitrage space?
One reason is the price of digital talent. The skillsets for the disruptive technologies are rare and command a higher price. Plus, there is a scarcity of talent with skills and experience in implementing the new models.
A second factor is the difference in teams doing the work. The digital world requires persistent teams that remain over time and are located onshore; the arbitrage world depends on low-cost labor in offshore teams that churn over time.
Global rate cards
Service providers predicate their FTE-based global rate cards upon an offshore factory model, which is a cheaper model than digital. But clients seek to pay the same or similar prices for the new digital model services as they currently pay for offshore labor. Providers offering digital services push back heavily against this demand because they believe they are providing differentiated, high-value services that command more than commodity rates. But clients are unsympathetic.
The scarcity of skilled digital workers, together with the higher wages they command, exacerbates this problem. Although a rate card allows clients to believe they are getting those resources, providers are unable to attract and maintain that level of skills. Since they imposed the global rate card, it forces providers into the offshore factory model. That model is not suitable for the new tightly aligned, agile delivery with a rich talent base that the new digital models require.
Their own worst enemy
When it comes to pricing, service providers are their own worst enemies. They are desperate for growth and eager to build practices in the new digital area, so they heavily discount or prepare to discount the new growth areas to establish credibility and a footprint. This just results in creating further diminished headroom or a ceiling on their ability to raise prices.
Providers simply cannot attract talent in the FTE-based global rate card structure. Even though they attempt to deliver digital services in this structure, they end up delivering an offshore model with a less well-trained team. They simply cannot find the necessary digital talent at that price point onshore and certainly not when using a persistent team.
All this forecasts that service provider margins will come down, but the providers will increasingly need a more nuanced education. I’m not making the argument that they can or could achieve the high gross margins they enjoyed under the mature labor arbitrage model. I am, however, stating that a persistent team delivered onshore requires a different pricing structure than the global rate cards currently provided.
The solution to the dilemma
I’m calling for change. If service providers want to move to digital business models, they need to establish a different pricing structure and move away from the FTE-based global rate cards.
Service providers need to recognize what many of their clients are learning as they undertake digital transformation. Sure, pricing structures on a per-team unit basis may be higher than an FTE-based structure. But the internal cost basis is often a fraction of the total cost of the offshore FTE factory model because of the significant improvements in productivity, business alignment and speed.