Service Providers Basing Margin Expectations on Flawed Math Assumptions

As legacy service providers excelling in the labor arbitrage-factory model look to participate in the digital world of cloud, automation, agile, DevOps and AI technologies, they are basing their prices on flawed mathematics assumptions. They expect that they not only will be able keep the same margin structure they now have but also that those margins will increase. Their thesis is that digital work is more valuable and worth more to clients; therefore, they should make more money for doing the work.

Inconveniently, this assumption is flawed. Margins have very little to do with the value a company creates; they have everything to do with the underlying market structure.

New Digital Work Will not be at a Higher Margin
I think it’s fundamentally unrealistic that the new digital work will be at a higher margin. It may be at a higher price person, but not a higher margin. There are many reasons for this including:

  • The providers’ inability to utilize offshore factory, as digital environments demand close collaboration of business and IT teams that are located onshore close to a client’s business
  • The talent required to deliver these digital services is much more expensive than the talent base in the old factory model
  • The more automation a company introduces, the more the client captures the financial benefit, not the service provider.

New Margins at a Lower Rate
All these and other reasons suggest that the new natural margins for digital services will be at a lower rate than the margins of the offshore factory model that currently dominates the marketplace.

I also want to point out offshore margins are structurally higher for services than we’ve seen in previous generations. So, it shouldn’t be surprising that the new model would be lower because this is an aberrant model to begin with.

So, why should service providers’ clients care about this issue? I believe service providers are likely to exaggerate their DevOps, agile and other digital capabilities yet not make the system changes necessary for delivering these services. They won’t make the changes because they’ll make less money. Delivering digital services requires a fundamentally different business model. If they do not make the necessary structural changes and business model changes, they will under-deliver services in the new digital models.