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Although the government outsourcing market is large and growing, changing market dynamics are likely to reshape the market landscape over the next few years. This raises issues as well as opportunities for governments and suppliers alike. Combining insights from market data and real life examples, this article suggests four ways to leverage the change and unlock the true potential of outsourcing in this segment.

What Does the Market Look Like Today?

Increasing fiscal pressures (which resulted in reduced capital budgets), growing citizen demands, and inevitable workforce attrition continue to trigger the need for outsourcing services to government departments. For these reasons, government outsourcing continues to grow at a significant pace, which should continue for the foreseeable future.

Government represents a significant portion of outsourcing across all the large markets. Our analysis reveals that government consistently ranks among the top two sectors across the major geographies, constituting around a third of total market activity in terms of number and deal value. This is especially true in the US, where government has been an early adopter of outsourcing and represents almost half the total market. The UK and Australia, and, to a lesser extent Canada and Sweden, are some of the other geographies where government has been a significant buyer of outsourcing services.

We expect to see even more outsourcing activity in these countries as governments explore more opportunities to implement their outsourcing strategies.

One point is clearly evident from our analysis: outsourcing drivers in the US and UK are equally relevant to governments in virtually all countries. We believe that it is only a matter of time before countries which have not yet adopted outsourcing decide to take the plunge. The global government outsourcing market growth should continue at a significant rate over the next few years.

Over half the market activity is in the US. The United States constitutes a significant portion of government market by geography, with around 70 percent of the total deal value globally and 60 percent of all the transactions from 1999 to 2004. For the same time frame, the UK is the second-largest contributor to government deals, with a share of around 20 percent of total deal value from just 13 percent of the number of transactions.

Defense-related transactions constitute the largest share overall. We found that the amount of transactions across the three major types of government agencies -- central/federal government, defense, and local government -- is almost equal, with central/federal government constituting a slightly larger share of the pie globally at 37 percent, followed closely by defense-related work at 35 percent, and then local government at 28 percent.

However, this changes dramatically when you look at the numbers through the TCV (total contract value) lens. Defense-related deals constitute over half the total TCV, with local government lagging behind at 10 percent. Federal government maintains a 35 percent share.

This tilt in favor of defense is slightly offset by the fact that average contract terms are around 10 percent longer on defense deals and 10 percent shorter on local government deals, thereby narrowing the gap in terms of annual revenue. That said, the average annual revenue at the aggregate level from a defense-related transaction is as much as $35 million, while local government deals generate annual revenues at 70 percent of that number.

Defense's position as the leading buyer of outsourcing services differs markedly in the US and the UK. In the US, defense deals constitute a majority in terms of value, whereas in the UK, central/federal government work takes the lion's share with half the total deal value and 40 percent of the number of transactions. Defense is a poor second in terms of TCV at 30 percent and just 10 percent of the total number of transactions.

BPO penetration is low. BPO penetration is quite low, at an overall average globally of 10 percent, both in terms of deal value and number of transactions. The penetration is much higher in the UK (at 18 percent) compared to the global average and US average of 10.5 percent.

The consortium model becomes the new paradigm. Interestingly, the statistics show some common characteristics of government outsourcing transactions. Almost three-quarters of all these deals have significant sub-contractor relationships among the suppliers responsible for the service. This shows that suppliers prefer an integrator/consortium model.

Government agencies negotiated half the deals with a fixed price, typically through a competitive bidding process and without any transfer of employees.

The top five deals were all ITO, with TCV $5-10 billion each range and deal length from 5-15 years. Four of those were in the US and were linked either to the central/federal government or to the Defense Department.

Changing Market Dynamics

What's changing are the dynamics within this market, with both buyers and suppliers becoming increasingly aggressive in their outsourcing aspirations and implementations. We are seeing heightened competition, large swings in market size from year to year, decreasing contract terms, and entry into new geographies and G&A (general and administrative costs) areas.

Increasing supplier fragmentation. The HHI (Herfindahl-Hirschman Index¹) for suppliers in the government outsourcing market has fallen from an average of 2,000 in the 1999-2002 period to less than 750 from 2002-2004. This points to decreasing bargaining power for suppliers; we found this to be true across all three segments of the market.

"Spiky" behavior. The market has shown very "spiky" behavior, with swings ranging from 50-185 percent on an annual basis. After almost tripling in value (TCV terms) from 1999 to 2000, the global outsourcing market took a sharp hit in 2001. Since then, it has recovered steadily, with growth accelerating every year. Similarly, the average annual revenues from government outsourcing deals have been fluctuating from a low of around $2 billion to a high of $20 billion in 2004. Average annual revenues per transaction fluctuated from a high of $50 million in 2000 to as low as $14 million in 2002.

The dot com bust and the larger number of recompete opportunities help to explain this behavior. Moreover, some government departments are operating with 25-year-old legacy IT systems; new tech-savvy bureaucrats see outsourcing as their only opportunity to close in on the technology curve.

Decreasing contract terms. The average term of a deal is around 4.5 years. This number has decreased significantly from six years in the pre-2002 period to around four years post 2002. This is primarily due to more sophisticated and educated buyers with the benefit of experience, who realize that longer term deals do not readily adapt to changing environments and buyer needs. In the earlier deals, government was more accommodating of suppliers' desire for longer-term deals and higher TCV. Today, government uses shorter deal terms as a key strategy for managing risk, both in terms of deal competitiveness and supplier capability.

US share declining. There has been a slight decline in US share of global government outsourcing deals, with the share of TCV declining from an average of 72 percent in the pre-2002 period to 66 percent post-2002. Similarly, the number of transactions has come down from a pre-2002 average of 67 percent to just under 60 percent post-2002.

We expect this trend to continue for the foreseeable future as more governments in Europe and Asia use outsourcing to improve the cost and quality of government services. This is evidenced by the fact that the number of countries that have outsourcing arrangements more than doubled from 2001 to 2004. The US, on the other hand, has fewer opportunities for new outsourcing initiatives because it is a more mature market.

Government buying power. Clearly, buyers today are in a better bargaining position than five years ago: they have greater supplier choice, and they are better informed. These factors lead to increased value from their outsourcing arrangements. On the supplier side, those who are able to craft flexible offerings that deliver value to government should reap the rewards of participating in this growing market.

BPO penetration increasing. This penetration level has fluctuated over the years, but the more recent numbers reflect the overall average. However, there is a comparative reluctance against using BPO services in the defense-related sector, with local government being a more active proponent (at 18 percent penetration in deal number and 25 percent in terms of value).

In the US, the BPO contract length in government is in line with the non-BPO transactions, whereas in the UK there has been a tendency to have BPO deal terms 10 percent longer than the average outsourcing contract term. This discrepancy could be explained by the extent of transformation required, as well as supplier investment, which is a significant factor in establishing the appropriate contract term.

Number of transactions increasing. The number of transactions has shown a steady growth from 1999 to 2004 with a CAGR of over 60 percent. This trend will increase as government departments use outsourcing more widely to help them overcome their access to current technology, capital, and skills limitations. Taxation authorities in a number of countries, who have a heavy reliance on technology, have already taken this step. Other departments with similar needs are following this trend.

Based on Everest's learnings on real-life engagements, one word of caution to both sides: do not rush into contracts without adequately preparing yourself for the challenges.

How the study was done: The Everest Group examined central/federal government, defense, and local government outsourcing transactions between 1999 to 2004. The data came from ComputerWire, which collates information on public announcements only, and so the findings are only indicative. The author wishes to thank Allen Barnard (Everest US) and Richard Zabow (Everest Australia) for their contributions to this article.

¹ The Herfindahl-Hirschman Index (HHI) provides a comprehensive picture of industry concentration. The HHI uses the market shares of all the firms in the industry, and these market shares are squared in the calculation to place more weight on the larger firms. An HHI of less than 1,000 represents a relatively un-concentrated market, an HHI between 1,000 to1,800 represents a moderately concentrated market, and an HHI greater than 1,800 would be a highly concentrated market. An increase in HHI by more than 100-200 points would represent a significant shift in behavior.

Publish Date: May 2005

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Copyright © 2005 - Everest Partners, L.P.

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