SECTOR FOCUS IT SERVICEST

SERVICESSE
CTOR FOCUS

Striving for superior profitability

Anoop Vijaykumar

Article at a glance

- Medium and Small Indian IT Service Providers

have traditionally lagged their larger competitors
on most operational parameters including
revenue growth rate, profitability and stock price
performance

- The disparity in profitability across firms spanning

large to small indicates that size by itself is not a
determinant of profitability

- Differences in profitability are more a function of

operating efficiency than of pricing premiums as
might be intuitively inferred from additional
investments in branding and training by the large
firms

- Small/Medium-Sized firms can assess their

improvement potential by performing a category-
wise comparison with peers

- Multiple levers exist to improve performance on

individual categories which can have significant
impact on operating profitability, ranging between
3% and 7%
Dominance of ‘The Goliaths’
The story of the Indian IT Services Sector is of two
distinct parts. The „large‟ players who have grown at
annual growth rates of over 15% while delivering
profit margins in excess of 20% and the smaller
players who have more modest growth and
profitability stories to tell.
This dominance has been borne out in multiple
ways; Revenue growth, Operating Profitability and
by consequence, stock market valuations. This delta
in performance across large and medium/small
firms has established an implicit correlation
between size and operating profitability.
A closer look at the performance of the medium and
small IT Services firms shows enough disparity to
indicate that firms with sub-20 Bn Sales Turnover
are not necessarily relegated to significantly inferior
operating profitability when compared to their
larger peers.
A close look at the existing cost structure with
reference to peers and industry leaders to identify
potential areas for improvement followed by
comprehensive roll out programs targeting the key
cost categories can show significant improvements
in profitability for small and medium IT Service
Providers.

Exhibit 1: The ‘Large’ Firm Advantage

Growth Record Operating Margin Performance

Large Firms Medium Firms Large Firms Medium Firms
18.5% 27.0%
16.8% 26.4% 25.9%
24.4%

17.7% 17.9%
10.0% 15.5% 14.2%
6.2%

4 year Y-o-Y Revenue Growth 4 year Y-o-Y Employee Addition FY2007 FY2008 FY2009 FY2010

Large Firms : FY2010 Revenue > `20 Billion (Sample consists of 5 firms)
Medium Firms: `4 Bn < FY2010 Revenue < `15 Billion (Sample consists of 6 firms)
Source: Annual Reports, ISI Emerging Markets, INVERTO Analysis

The key differentiator for the large firms has been their ability to rapidly scale up
operations enabling them to compete with global majors like Accenture and IBM. In
addition, they have focused on establishing dedicated training facilities, rolling out
comprehensive knowledge-management systems and investing in brand-building.

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 Profitability not (just) the purview of the large

The focus on building a stronger brand, establishing dedicated training facilities and comprehensive
knowledge-management systems intuitively point to a higher cost per employee for the large firms and
therefore indicate that the difference in operating margins between the large and the medium firms would
mainly be a function of pricing.

Exhibit 2: Pricing not a key differentiator However, an analysis of the

realization per FTE (Full-Time
Realization per FTE Hour (RFTEH) Equivalent) Hour suggests that
Large Firms Medium Firms pricing might not be critical enough a
differentiator between the two sets of
firms. Although, the effective
$25.2 realization for „Medium‟ firms is
$23.6
$21.6 $22.2 $22.6 $22.7 pushed up by virtue of their fewer
$20.5 $19.8 non-billable resources (trainees) and
shorter training programs, billing
FY2007 FY2008 FY2009 FY2010 rates fail to explain the difference in
margin of over 7% between large and
RFTEH calculated as Revenue / Average billable hours available
Billable hours available = Number of FTEs X Working Days (minus vacation days) X 8 Hours/day
medium firms.
Currency conversion at constant rate of `45/USD
Source: Annual Reports, INVERTO Analysis

Exhibit 3: Disparity in Profitability across firms

The graph of revenue (transformed by natural Relationship between Revenue and Margin
logarithm) versus operating profitability
35%
shows the lack of a strong relationship
EBITDA Margin

30%
between revenues and profitability. While 25% Overlapping profit band
three of the large firms have managed to 20%
deliver EBITDA margins in excess of 25%, a 15%

number of firms are clustered in the 17% to 10%

6.00 7.00 8.00 9.00 10.00 11.00
22% band. Inference – Size is not as
Natural log (Revenue)
influential a factor in determining operating
Large Firms Medium Firms
profitability as an aggregated view of the data
suggests.
X Axis is Natural Log of FY2010 revenue used to normal difference in revenue
Source: Annual Reports, INVERTO Analysis

A medium-sized service-provider should therefore focus on improving

operating margins independent of revenue growth rates.

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A systematic approach to profit improvement employees, Percentage of Fixed Price projects
among others. While these continue to be
The traditional levers of profitability used by Indian IT relevant to medium-sized firms, they are also a
Service Providers centre around the workforce. Some function of the nature of revenue growth
of these are Utilization, Ratio of Onsite to Offshore experienced by the firm.

We recommend a four-step process for small-medium IT Service providers to bring about real and sustainable
profit improvement

Prioritize and
Compare cost- Calculate
Classify costs Implement
structure practical
into value-chain Profit-
against peer savings to cost-
buckets Improvement
group structure
initiatives

Step 1: Perform a cost breakdown analysis

To form a current-state view of the current cost-
structure, it‟s important to standardize
classification of costs across the peer group. Based
on the nature of costs and the extent of influence a
firm has on those costs, we have identified 8 cost
buckets. The „Initial Profit Improvement Potential‟
is a function of the percentage of total costs that
typically fall into the bucket and the levers available
to reduce costs.

Exhibit 4: Cost Classification for peer comparison

Cost Category Description Potential EBITDA Impact
Direct costs of delivery personnel including gratuity, PF contribution,
Service Delivery wages and staff welfare costs, resource allocation, account/project 4
profitability
Office operating costs including communication, computer consumables,
Office Expenses equipment lease, stationery, printing, office maintenance 4
Capacity Building Hiring and on-boarding costs, training effectiveness 3
Advertising, Publicity, Industry seminars (hosting and participation), Client
Marketing development, TCV/Cost of Sales team 3
Project and non-project costs including allowances, accommodation, air
Travel and ground transport, route planning and efficiency 2
Real Estate Recurring lease costs, lease improvement costs and utilization 2
Contractor Expense Cost of hiring subcontractors 1
Catch all category that includes foreign exchange losses, insurance, bank
Miscellaneous charges, taxes, audit fee, legal and professional charges, provision for
bad debts and advances
1
Potential EBITDA Impact 4 – Very High 3 – High 2 – Medium 1 – Low

Source: Annual Reports, INVERTO Analysis

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Step 2: Compare cost-structure against peer group
After the firm‟s costs and its peers have been
classified into the eight categories, the comparison
provides an initial view on where the firm might be
underperforming its peers. These categories,
Exhibit 5: Median Firm per FTE Cost Structure
FTE – Full-Time Equivalent
Source: Annual Reports, INVERTO Analysis
The above breakdown combines several firms and
is therefore the profile of an average-performing
firm. The data indicates that the average medium-
sized firm earns approximately `1.8 Million
combined with the „Initial Profit Improvement
Potential‟ for each categtory, indicate the most
potential for improvement.
All numbers in ` ’00 per FTE
revenue per FTE per year out of which the sizable
expenses are about 1.1 Million for salary and other
manpower costs, 0.09 Mn for travel (project and
non-project related), 0.08Mn on Office expenses
(consumables, power, communication, office
maintenance etc) and 0.04Mn on rent.
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Step 3: Establish target cost structure

Having established a baseline from which to
compare the firm‟s operating profitability to the
„median‟ firm, the target cost structure can be
established. This involves creating a hypothetical
firm that incorporates the best category performers
across the industry. Figure below shows the best-
in-class cost structure for a medium-sized firm.
Since this cost structure incorporates the best cost
category performance of most firms in the industry,
it is better than any individual firm.

Exhibit 6: Establishing a Best-in-Class Target Cost Structure

Current-State Cost Structure (sample firm) Target Best-in-class Cost Structure

All numbers as % of Revenue/FTE

Source: Annual Reports, INVERTO Analysis

The ‘Best-in-Class’ Cost Structure provides a benchmark for the firm to aim at
and exactly how much it needs to improve on the each of the cost categories.
Our estimate suggests most firms can improve operating profitability by
between 3% and 7%

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Step 4: Prioritize and Implement profit-improvement initiatives

The final step requires a look at the available operational levers in each category and the cost-benefit of making
changes to the current cost baseline. We discuss some of the levers available across categories.

Service Delivery

Measuring Operating Profitability at the Replace over-specified resources

project/account level enables validating resource (experienced or subject-matter-experts)
allocation principles. The firm can then make with lower-cost resources where applicable
adjustments to improve profitability from the
ground up. Management can take three steps to Renegotiate terms for specific projects that
utilize the project-profitability lens: require higher allocation in number and
skills
Correct existing over-allocation of resources
at each level in project teams

Exhibit 7: Profitability at a granular level

Business Groups in Major Account Profitability by Project Group

10% 15% Project Group 4

Project Group 3 29.2% Gross Margin
24% Project Group 2 Operating Margin
24% Project Group 1
16.7%
33% 13.2%
28% 9.8%
4.0% 5.1%
2.1%
34% 32% -7.6%

Project Project Project Project

Group 1 Group 2 Group 3 Group 4
Account Operating Costs Revenue

Source: Illustrative INVERTO Analysis

Capacity Building

Cost of acquisition and training per employee can Service providers make substantial investment in
be reduced by examining recruitment channels and getting recruits “job-ready”. Acquisition cost per
training programs. Firms use multiple channels for employee is a function of time cost and resources
Capacity Building like educational institutions, required for training and the time required by the
placement consultants and the web. Total cost of employee to be productive on live projects
hiring an employee by channel should take into
account the „stickiness‟ or average duration that a
new hire stays with the organization and
performance on the job.

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Possible steps to reduce acquisition and training 3 Assess current training effectiveness by
costs: correlating scores on training tests with
performance appraisal ratings. Consider
1 Plot the effective cost per hire by channel, outsourcing to a training services provider
adjusting for attrition versus average
performance rating on the job or performance 4 Interview team leaders to identify key gaps in
on the training program shows the most cost- current training program to reduce duration
effective channels and tailor to ensure coverage of essential
content (technical and business knowledge
2 Rationalize channels of recruitment based on
cost per hire and quality of hires

Real Estate

Exhibit 8: Benchmark Real Estate Utilization

Real Estate Utilization Efficient utilization of available
Real Estate / FTE Rent/FTE facilities can be used to bring down
100,000 200
rent expense in two ways:
80,000 160
Annual Rent per FTE

1. By reducing overall real

Space per FTE

60,000 120
estate required for the
40,000 80 current resource base
20,000 40 2. Consolidating operations
- -
across under-utilized
Peer 1 Peer 2 Peer 3 Peer 4
facilities

Source: Illustrative INVERTO Analysis

Office Expenses

Expenses on external spend categories can be a. Increasing supplier base to introduce

analyzed and optimized in three broad steps: competition and achieve reduction in
Total Cost of Ownership (TCO)
1. Optimize current Requirements b. Streamlining supplier portfolio where
a. Reducing complexity of what is being scale effects can be introduced to
consumed by simplifying requirements obtain favorable terms
b. Reducing number of variants of an
item/service to enable higher volume 3. Implement and sustain savings
purchases a. Develop category-specific strategy and
c. Analyzing existing consumption process based on category criticality,
patterns to reduce resource usage spend volume and supplier landscape
b. Create detailed process guidelines to
2. Apply relevant Sourcing levers ensure improvement is sustainable

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Marketing & Business Development

Exhibit 8: Bang for the marketing buck

Figure shows the percentage of revenue that

Marketing Effectiveness
Revenue - 4 year CAGR Marketing Expense (% of Sales)
is spent on marketing initiatives while also
35% 32% 1.4% looking at annual revenue growth over the
30% 1.2% last four years. Due to marketing‟s tenuous
25%
20% 16% 1.0% correlation with current and future
15% 0.8% revenues, it is important to assess whether
10% 7%
0.6% any steps taken will hamper revenue
5% -4% 1%
0.4%
0% growth. The effectiveness of marketing
-5% 0.2%
Peer 1 Peer 2 Peer 3 Peer 4 Peer 5 spend should therefore be reviewed on an
-10% 0.0%
on-going basis.
Source: Illustrative INVERTO Analysis

There is a more direct relationship between sales costs incurred and the revenue or Total Contract Value (TCV)
signed. Tracking sales leads through the pipeline differentiated by wins and losses and the associated costs
incurred (travel, conveyance, effort hours) will provide a view of the performance of sales personnel. This data
can be used to reallocate and rationalize sales teams.

By taking an analytical look at their cost structure as a logical grouping of costs and comparing against
peers, medium and small IT Service Providers can identify multiple levers for improving their operating
profitability. A collaborative multi-functional effort can energize the organization and deliver significant and
sustainable improvements to the bottom-line.

Anoop Vijaykumar is an Associate Principal with INVERTO’s Mumbai office. He can be reached at
avijaykumar@inverto.com

INVERTO is a management consulting firm specialized in delivering tangible improvement in operating

performance for its clients. We examine every element of the cost structure to identify opportunities, develop
solutions and support in their implementation to realize real and sustainable profit improvement.

Coyright © 2011 INVERTO

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Andheri (West), Mumbai - 400 053, India
Anoop Vijaykumar
Phone : +91 22 4043 1300 Associate Principal
Fax : +91 22 4043 1350 Email: avijaykumar@inverto.com

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