Insourcing versus Outsourcing in Merchant Payment Processing

By: Peter Michaud, TSYS and Laura Richardson, TSYS

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Executive Summary

When evaluating the decision to "bring in-house" or to outsource, the decision depends on the goals and the strategic position of the company. Although payment processing seems like a positive way to add profitability and value, the investment and time, as well as the market position of you and future competitors, must be calculated in your strategic plan. In the end, a company is successful when it focuses on its strengths and invests wisely in its core business.

"All thriving companies occupying topmost positions in their business arenas share one characteristic that keeps their market share positions secure and shareholder value growing. They join forces with outsourcing service providers, but instead of using outsourcing just as a tactical means of driving costs or function, they use outsourcing relationships to strategically enable their capability of doing business better than their competitors."1

When evaluating the decision to outsource, a company needs to consider control and investment versus focus and expense.

"Many argue that with outsourcing you lose control. My belief is that we gained more control with TSYS. More so than getting my own internal IT department to do so." – European financial institution

Choosing whether to insource or to outsource for payment processing will force you to look not only at your own operations but those of your competition to determine how best you can position yourself to win going forward. The payment processing industry is a long-established and highly technical industry, and has only a few major players owning or controlling the "backbone" technology. These companies and platforms have existed for decades because they work. They historically have needed only a modest amount of maintenance (though in an environment of increased regulatory control, maintenance is becoming less routine) and are paid for completely. On top of sheer efficiency, these platforms have allowed for this industry to maintain a characteristic of strong cashflow and high net earnings. If you plan to enter this oligopoly by processing in-house and have the resources to do it, then your company must have the flexibility of time to build out the technology to make this method a viable course of action. However, if both conditions do not exist, the time, energy and capital would be better spent concentrating on your core business.

"These were the options: choose an outsource partner or spend a significant amount of money to build an in-house solution. The [processing] business is complex, and we didn't have the capacity to build in-house. It didn't make sense to build from scratch." – Kevin Murphy, Director, Bank of Ireland

Outsourced Industries

Insourcing and outsourcing are long-established business models. The models are numerous and varied in approach, and many industries have been very successful for their customers who outsource. For others, insourcing is not only the normal practice, but competitively superior.

Insourcing is also referred to as contracting in and is usually defined as the delegation of core operations or jobs from internal production to a subcontractor or other internal entity that specializes in that operation.2

Outsourcing is the practice of having certain job functions done outside a company instead of having an in-house department or employee handle them; functions can be outsourced to either a company or an individual.3

Payroll processing is a highly technical, specially skilled, constantly changing and highly regulated industry, with significant liability. ADP,® Paychex® and others are commonly used to handle this process and alleviate the burdens of most companies. For example, telecommunications is a commonly outsourced function due to the expense of building a network and connecting to the user. Customer service is another industry where outsourcing is commonplace due to the high costs of labor and the manpower needed to offer coverage 24 hours a day, 365 days a year. Application development is also experiencing an outsourcing trend due to the availability of lower labor costs and the need to keep the entrepreneurial spirit thriving without the burden of keeping the ship afloat. Many of the point-of-sale (POS) application developers or value-added resource (VAR) partners are leading payment product development because of this freedom from the "backbone" application. Recent mobile devices are even built on "open" platform software to allow "app." development, which incidentally could be considered a new model of outsourcing.

Outsourcing does not always work, though. Companies have attempted to outsource accounting and finance, human resources and legal functions, but the risks of moving these support groups outside of the company are just too precarious. Although it would provide a marginal financial benefit, the loss of control, lack of responsiveness and missing loyalty are too important to risk.

Changing the Oil

In the 1970s, it was common for automobile owners to change their own oil. Cars were big, the engine block fit spaciously, the oil filter was easy to get to, the space under the car was ample, there were only two types of oil and the old oil could be poured down the sewer. The engine could run for days with little oil and maybe last as much as seven years or 70,000 miles. You may have gotten a little dirty, but you saved time and money.

Then the cars got smaller and the engines got bigger. The oil filter was hidden amidst the other components, oil types were multiplied and government regulation required disposal of oil in a more eco-friendly way. It is not uncommon for cars to last 15 years and 200,000 miles, but if you try to run it when it is low on oil, you need to start shopping for a new car.

Now we take our cars to "quick" oil change businesses like Jiffy Lube.® We pay up to $40, and these companies make a reasonable profit. They increase their value by offering other services like filling up the other fluids, changing the air filter and inspecting the engine. They generate more revenue from additional value-added maintenance like flushing the radiator. We value this service because of its convenience and effectiveness (they have to dispose of the oil, not us) but, more importantly, because these companies take the liability if something is not done correctly. The parallel with payment processing is striking.

Payment Processing

The payments industry has not fundamentally changed in 60 years. The transaction is the same – goods and services are moved from a merchant to a consumer, the bank pays the merchant and the consumer pays the bank – only credit and debit cards have replaced cash and checks as accepted forms of payment.

About 25 years ago, the industry began to evolve with technology. The number of merchants, consumers and banks increased due to the reliance on a quicker and more accurate validation of the transaction. The technological leap was the birth of proprietary, mainframe-based technology from a pure processing perspective. The current payment processing technology is not fundamentally different from the original: green screens still exist, but they are hidden behind a graphic user interface (GUI). Since banks owned most of the technology, the budget for capital improvements has been modest, especially for working platforms.

With this in mind, there have been some minor speed bumps in the industry's development process – for the most part this can be credited to creative hackers breaching the payment networks. In fact, Payment Card Industry (PCI) standards were created in 2006 as a response to one such data breach. Now, every processor has its own PCI expert and has allocated a portion of its technology budget to handle the bi-annual updates. PCI has extended its arm of oversight to include the individual merchant and the procedures they need to follow to ensure the security of the card information. And now, encryption is the latest product to enter the market to more effectively manage the safety of information.

With the growth of the industry and the profitability of the "next" transaction, most payment processors will go to extraordinary means to accommodate every merchant. Command centers are staffed 24 hours a day, every day of the year. Reliability needs to be 100 percent, no exceptions. The plethora of terminals and other POS systems supported by processors are incomprehensible, but limited accessibility would stifle the opportunity for growth. To staff a merchant support center for approximately 9,000 hours a year (24x7x365), with expertise on the different terminals and POS systems as well as any sort of system issues, is an investment that offers little return.

As global competitive pressures intensify, companies have little choice but to consider outsourcing as a strategic tool. The largest non-processing acquirers have account bases and transaction volumes that are much smaller than those of the legacy processors. When compliance, regulatory and other changes are required, processors can still spread the costs of these changes over a greater number of accounts and volumes. This use of resources and capital is more effective with the processors' economies of scale, and it frees the acquirers to invest in ways to grow their business.

If the complexity of technology, compliance and merchant support in the industry does not create a feeling of nausea, the risk that every processor takes on during the normal course of business will make Pepto Bismol a dietary staple. A former executive of one of the leading processors has been known to say "...the only thing that keeps me awake at night is security." Every time a credit card payment is processed, that information is passed through and retained at the processor for an extended period of time. Information from the card, the merchant, the merchant bank, the terminal, the deposit account and everything in between is what the fraudster seeks. And one can only imagine what havoc would ensue if this information got into the wrong hands. Cardholders, merchants and banks trust the processor to keep this information safe and secure so they can sleep at night. John C. Latimer, the enterprise risk management officer at TSYS, says, "No one can tell you that they can protect all data all the time from every threat. But we do assure our clients that we understand the dynamics of risk management, and we are providing the best protection available using state-of-the-art technologies." In short, outsourcing allows you to let someone else worry about the risk.

With all the potential for disaster looming around every corner, the current group of processors relies heavily on one thing – volume. Investment in technology, compliance and merchant support can only cover business risk if enough transactions are going through the payment processing systems, and the current group of processors has a 25- year head start. The executives and senior management of the leading payment processors have grown up within this realm, experiencing both its changes and challenges. This group realizes that it is the backbone, prepared to interface any new program or product that will help them get the "next' transaction, which is even better for most entrepreneurs. With many sunk costs in operating, the processor must create a culture of scalability to succeed.

The scale of processors, as well as the expertise garnered from dealing with a multitude of customers, allows the legacy payment processors to provide issuers with a cost structure and ability level that issuers might have trouble maintaining in-house. Business consultant and writer, Peter Drucker, believed that for true differentiation, an organization must focus on the one thing it does the best. In fact, he famously said you should outsource anything that is not core to your business.

Outsourcing can be transformational – as the best relationships are. Through outsourcing, the dynamics of your business are likely to change, so it makes sense to capitalize on those benefits. Service providers of outsourcing should not be seen merely as sources of low-cost labor but as partners in innovation. Instead, many companies bring a procurement mindset to outsourcing, focusing narrowly on cost reduction and labor arbitrage rather than on leveraging external experience for transformation or for a broader set of strategic objectives. Too often, this mindset leads companies to skip key steps in outsourcing and take shortcuts that undermine the results that could have been achieved.

In order to succeed, companies must select the right vendor for their needs from the start. If you short-cut this process or limit your analysis to costs, you leave significant value unrealized.

In Greek mythology, Sisyphus was a king. As a punishment from the gods for his trickery, Sisyphus was forced to roll a huge boulder up a steep hill, but right as he reached the top of the hill, the rock would always roll back down, forcing him to begin again.4 The maintenance of payment processing systems can be considered a Sisyphean task in that every time a system is brought up to date, the requirements change. For an entity for which processing is not their main line of business, this would be maddening in that it is beyond difficult to catch up or to get ahead. In fact, it could be considered a "Herculean" task.

Market Advantage

Outsourcing results in predictable monthly costs aligned with transaction volumes; reduced costs of operating technology systems; opportunities to eliminate capital investment or lease agreements; and the transfer of staffing and training to a specialist, not to mention the elimination of the ever-increasing burden of keeping up with regulatory requirements.

A survey in 2008 by Deloitte found that a large percentage of companies that implemented an outsourced model reached their financial objectives and averaged a strategically-important return on investment (ROI) of more than 25 percent, and 83 percent of their respondents had met their ROI goals.5 Outsourcing allows companies to gain more financial control by turning large, fixed capital costs for new technology into variable costs in service provider contracts, reducing debt, improving liquidity and lowering risks. Relying on outsourcing specialists also provides a more predictable IT budget than would be possible with the uncertainties of internal application development.

In 2007, the Stanford Global Supply Chain Management Forum published the results of research by GXS, Inc., in which 25 companies had been surveyed on the benefits derived from outsourced technology. There were outlined benefits in technology, business process and people, and the participants reported that the average level of annual benefits from outsourcing their non-core functions were 2.45 times higher than the annual costs:6

  • Higher technical capabilities and reduction of spending on IT infrastructure (up to 83 percent of respondents, depending on the category of outsource)
  • Higher predictability of IT costs (71 percent of respondents)
  • Higher productivity of internal IT resources (57 percent)
  • Reduction of full-time employees (FTE) for internal development (50 – 59 percent of respondents depending on function)
  • Reduction of time to develop new technologies (64 percent)
  • Ability to focus on higher-value business objectives (48 percent)
  • Increase in utilization and extended capabilities of the core systems (45 percent)
  • Reduction of internal training costs (32 percent)

When evaluating the decision to outsource, a company should consider control and investment versus focus and expense. The first question that needs to be answered is clearly "what business are we in?"

Moving into payment processing may initially be a positive short-term outcome, but the long-term prospects dwindle over time. A platform or gateway to process transactions may be an initial driver of sales, but it usually satisfies just a niche and not a market. After this niche is filled, how do you expand – add another niche via technology? One may be able to control the output, but the niche must then make an impact to overall performance. Then the next niche needs to be bigger and better, and soon the entire market. More complicated solutions translate to greater investment in hardware, software, skill sets, experience, people and most importantly time. Then, you must go to extraordinary means to get the "next" transaction, but you also must be prepared to compete against the legacy companies that already have scale.

A company that is built on the strength of its sales force should focus on this strength when evaluating a processing option, whether via technology or other sales channels, in order to propel the company's profitability in the long run. By developing a new technology that has generated strong sales, the company can build on its success and use its powerful sales force to resell another company's technology instead of developing the next technological solution. In this case, a highly developed sales channel will drive more value than developing the next new solution.

At some point in this sales channel, development, either organically or through acquisition, will achieve critical mass. When this is met, it is time to execute an exit strategy. And you should look no further than the legacy processors, because they are the ones interested in protecting their transactions and are willing to pay significant multiples for these companies.

Deciding to Outsource

In the outsourcing study of Senior Executives by Deloitte in 2008, outsourcing decisions are made due to four main business drivers:

  • Cost reduction due to budget restrictions
  • Technology expertise available in the outsourced provider
  • Labor expertise available in the outsourced provider
  • Improved customer value for the same cost7

Further, in 2010, KPMG published a study that enhanced the findings of Deloitte. Eighty percent of 450 CIOs surveyed indicated that responding to market conditions was their top concern. This was followed by cost optimization at 62 percent, portfolio management at 52 percent and risk and compliance at 56 percent. As a result of these concerns, the CIOs expected their number of outsourcing contracts to grow.8

If you view outsourcing in broad, strategic terms, it can even improve your returns while allowing you to gain a competitive edge over those that cling to a traditional procurement mindset. Many companies do not have a clear understanding of their current costs. And this understanding is paramount to realizing the value of outsourcing. While financial assessments are key, they should not be the sole focus of a company's outsourcing business case. Business cases should address less tangible benefits and provide an understanding of the total economic value of outsourcing based on factors that include management focus, quality and reliability. This requires companies to take an honest look at their business model and their costs, as well as their inadequacies. Executives should look at cost reduction as a basic requirement in outsourcing, rather than just as a driver. Companies can reap substantial benefits when they recognize this opportunity and when they explicitly establish transformation as the basis of their outsourcing strategies. Beyond costs, companies should look at other aspects of strategy, such as productivity, the quality of services or products and time to market.

Outsourcing allows you to transform your business. Technically, through outsourcing, you can gain access to world-class technology, with continuous hardware and software upgrades. Industry-specific improvements are made routinely to application software, and there are lower development and regulatory change costs than taking on the project in-house. Financially, you gain economies of scale and make decisions based on real costs rather than on in-house "variable" costs, including "ghost costs" that are never realized, and improve product profitability. Operationally, outsourcing can move functional tasks to the hands of industry-specific experts. You can operate to measurable standards and eliminate internal contention for programming resources or even reduce your staffing levels. Most importantly, you can focus your attention on strategic issues – concentrating your resources on strategic opportunities, rather than on operational challenges.

As governmental regulation, both foreign and domestic, and compliance issues continue to increase, financial institutions and retailers are struggling with the ongoing investment required to keep up. Many of these institutions have invested heavily in technology to meet these changes, but this investment consumes resources needed for innovation and development of new products. A majority of IT expenses are dedicated to basic networking issues, security and regulation/compliance. Outsourcing grants companies the freedom to concentrate on growth while letting others concentrate on mechanical work.

Conclusion

"Outsourcing is about picking the right partner. The usual argument against outsourcing is that you lose control. I believe you gain control of your internal resources because it forces a discipline of planning and strategy." - Dennis Jones, Director, RBSG

Although payment processing looks like a positive avenue to add profitability and value to a company, the investment and time as well as the market position of the other processors needs to be calculated in a company's strategic plan. Many companies have tried this Sisyphean task, but in the end, the ROI did not increase the value to the company. These companies' processing platforms were usually migrated onto the legacy platforms in the end in order to justify the purchase costs through expense synergies. In the end, a company is successful when they focus on their strengths, invest wisely in their core business and execute a timely and effective strategy.

Sources

  1. Everest Group, "The Real Value of Outsourcing to Achieve Process Improvement", July 2002
  2. Investor Dictionary, Investordictionary.com
  3. Entrepreneur Encyclopedia, Entrepreneur.com
  4. Odyssey, xi. 593
  5. Deloitte, "Leaving money on the table: The Changing Market in Cards Processing – In-house versus Outsourcing", 19 June 2008
  6. Stanford Global Supply Chain Management Forum, "Driving Business Value through B2B Outsourcing: Improving Business Performance, Trading Partner Satisfaction, and B2B Capabilities", Research back- ground by GXS, Inc., October 2007
  7. Deloitte, Why Settle for Less? 2008 Outsourcing Report, Paul Robinson, Primary Researcher, 2008
  8. KPMG, "From Cost to Value: 2010 global survey on the CIO Agenda", 2010

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