PDO - Captive vs. Outsourced

Akshay Upadhye , 8th January 2007

“To be or not be: that is the question”, written by William Shakespeare and is one of the most famous quotations in world literature. However with the changing times, question “Captive or Outsourced facility” has become one of the questions that is troubling most of the Independent Software Vendors (ISVs) planning to offshore their product development.

Leading ISV’s such as Oracle, Microsoft, Adobe, iflex, Veritas (now Symantec), to name a few, started offshore outsourcing to India way back in the 90s. Today this trend of Product Development Outsourcing (PDO) [also known as Outsourced Product Development (OPD)] is growing rapidly and currently there are over a hundred ISVs that offshore primarily to India and Eastern Europe which is an upcoming & a growing offshore destination.

The reality is that ISV market is aggressively adopting an offshore (captive or outsourced) development strategy

  • 94% of ISVs have outsourced some or all software development projects in the last 12 months (source: "2007 US ISV Market Report: Key Factors in Outsourcing“, SDForum & Luxoft)
  • Desire for top-line growth rather than bottom-line savings drives ISV outsourcing - “You wouldn’t think that revenue would be the factor impacted by offshore … but the impact is because of time to market.” (source: David Thomas, executive director of the Software & Information Industry Association)

Offshoring is less a concept, more a reality!

ISVs planning to offshore their product development are struggling with finding what amongst would work best for them; either setting up their own captive facility or utilising the skills of an outsourced service provider.

There have been various studies around this topic, each drawing different observations and conclusions, example:

  • A McKinsey study indicated that a captive centre is 30 percent more expensive than working with a third party outsourcer
  • Everest Research Institute found that third-party outsourcing suppliers typically cost five percent to 15 percent less than captives in terms of total cost of operations

 However, most of these studies are generic and there is no specific data around PDO / OPD. Hence this adds up to confusion for most ISVs. Generally, the next question to cross your mind is what best can you do to arrive at a decision on whether you should set up your captive centre to go a third party service provider.

Is there a formula to arrive at a decision? The answer is yes and no!

All the more confusing, isn’t it? But before this question can be answered, let us take a closer look at comparisons between both these models and understand what each one of them has to offer you. 

Outsourced Centre

Captive Centre

  • Risk of sharing your Intellectual Property (IP) with a third party
  • Low capital expenditure
  • Faster Go Live
    • No need for company formation and other legal approvals in a foreign land
  • Ease of ramp-up / ramp down
    • Vendor can “accommodate” within his large resource pool
  • High process maturity
    • Vendor’s core business; multiple client experience
    • Sharing of “best practices” by vendor
  • Higher maturity and experience on third party product integration
  • Set-up with DRP / BCP already in place
  • Reasonable financial benefits with smaller team sizes
  • Comparatively lower management overheads
  • Risks are shared between the client and the vendor
  •  “Feel” of loss of control
  • Transition at the end of contract “may not” be easy
  • Retain Intellectual Property (IP) within the organisation
  • High capital expenditure; especially if going offshore
    • Company formation, legal approvals, infrastructure, etc
  • Go Live needs considerable lead time and planning
    • Would require someone with feet on the ground
  • Limitations with ramp-up / ramp down
    • Will add to the overheads
  • Cultural alignments needs considerable efforts
  • Building process maturity will take some time
    • Learning curve will be longer
    • Additional overhead
  • DRP / BCP needs to planned in advance
  • Financial benefits are realised with larger team sizes
  • Complete ownership of risks
  • Higher management overhead
    • Have to manage day to day operations at captive centre
  • Under constant pressure to identify cost- reduction opportunities

Now let us go back to answering the important question.

The two reasons for ISVs to consider offshore outsourcing are:

  • to improve their speed to market and
  • reduce costs to be competitive

But out of these 2, creating world class products and launching them ahead of their competitors is most important for an ISV rather than just delivering a product at lower cost. Listed below are sample requirements for a typical software product development:

  • Product development goes through an ongoing evolution process, hence requirements keep changing frequently
  • The product release date is usually decided and the development team has to work backwards to meet the targets
    • This demands for flexibility in terms of team staffing (ease of ram-up and ramp-down is critical)
  • In today’s environment, most of the products need integration with other third party products. Hence there is a demand for experts with varied technical skills and integration expertise
  • Access to R & D Labs, Testing Labs and Centre of Excellence (CoE) to ensure your products are technically futuristic.

Though initially ISVs started the offshore outsource trend by setting up their captive centres, over the last few years, the number of ISVs outsourcing to a third party company specialising in OPD is increasing rapidly. Today there are several hundred ISVs worldwide who are working with specialised third party companies with expertise in OPD.

The captive model may work better for ISVs that value gaining access to new geographic markets, direct access to local management talent, total control and greater integration with the parent company.

The third party outsourcing model may work better for ISVs who intend to start with a relatively smaller team size and minimise their capital expenditure. The third party outsourcing model provides greater flexibility to ISVs that is critical during the early phases of outsourcing.

Lately there has been news around companies selling their captives, to pursue lower-cost outsourcing models. Around 3 to 4 years ago, a few ISVs adapted to a Build Operate Transfer (BOT) model and exercised their Transfer option at the end of 3rd year. Within a short time of acquiring the facility, the ISV went back to the outsourced partner requesting them to manage and run the centre as they could not manage it as effectively as the partner.

Several ISVs initially started with their captive centres. But today, there are several examples of ISVs having a captive centre and who balance work between captive centre and an outsourced centre. P & G has termed this strategy as “Leveraging Our best, with Their best”.

Today ISVs see value in working with a company / partner specialising in Product Development Outsourcing. This approach has helped ISVs to grow stronger and faster by tapping into the strengths of external partners.

Hence the “Comparison of Outsourced and Captive Centre” needs to be done more thoroughly on a case to case basis evaluating total benefits, costs, risks for each model, including operating costs, productivity, transition, sales and marketing, and margins. Value and not just cost, should be the driving factor when you decide whether to work with an outsourced vendor or go by yourself.