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Two Pathways to Low Cost

There are two pathways to low cost: Focus on particular customers and their product needs; or create economies of scale. When you combine both, you have a powerful low-cost engine that is also attractive to customers.

Several years ago, I consulted for a high tech company. This company sold components for a much larger technology system. The company’s customers were many times the size of my client. Most of the technology system companies who could have been my client’s customers produced their own component rather than purchasing from a merchant outside supplier like my client.

I asked my client CEO how he expected to out-perform the in-house competitors he faced in the marketplace. He had to be at least as good, if not better, in Function, while being lower in Cost and Price. His answer was focus. His company did nothing else but produce this component. Everyone in his company focused their attention on improving the component and reducing its cost. He argued that his in-house competition did not have the same advantages of focus that he had. His focus would produce lower costs and prices, which would be visible to these larger companies over time. Then his business would grow very rapidly.

I was reminded of this story while reading of a study done by Forrester Research. This study explains some of the changes happening in the outsourcing market.

Several Western companies who had opened centers in India to perform back office work in a cost-saving move have now sold these operations. Several of these companies had decided early-on that they could save the 15 to 20% profit margin that Indian outsourcers typically charge by building their own centers. In many cases, this has proven to be a false economy.

The Forrester Research study estimated that it cost about 25% more for a company to operate a captive center in India rather than to have an outside company provide the same services. In other words, the outsourcing company is able to create a profit for itself that allows it to finance and grow its business, and still charge prices 25% below the costs of the captive center. (See Audio Tip #182: Productivity as a Measure of Physical Costs on StrategyStreet.com.)

How can this be? The answer comes in noting the buyers of these centers. (See Diagnose/Costs/Quantifying Cost Reduction Objectives on StrategyStreet.com.) In virtually every case, the buyer of these centers, which western companies are closing, are large Indian outsourcing firms, such as Wipro Ltd. (See Audio Tip #196: Why Economies of Scale Exist on StrategyStreet.com.) As these Indian outsourcers purchase the centers from the western companies, they gain two important benefits. They acquire experienced employees and guaranteed contracts from the western companies extending for a period of years. These Indian acquiring companies then have the benefit of both focus and economies of scale. This combination will make them an even stronger presence in the market.

Posted 6/29/09