Traditionally, organizations have been isolated islands, with fixed sets of business capabilities determined by what they can do on their own, within their own organizational boundaries. Expansion typically meant significant capital outlays for building new factories, entering new businesses or geographies, upgrading and expanding IT.
Such organizations are inherently reactive. Less demand? Factories reduce shifts, workers are furloughed and expensive capital equipment goes underutilized. A spurt in demand is often met by a shortage of products, disruption of services, unhappy customers, frantic hiring and impulsive capacity building.
In fact, one could argue that any successful business today is by definition less than efficient, because its success is predicated on overcapacity to meet peak demand, which also means underutilization of resources—particularly capital—most of the rest of the time.
The invisible hand Slowly but surely, the invisible hand of information technology has been blurring the boundaries between organizations to the point that business capabilities have now started to spill across organizational boundaries. To be sure, the phenomenon itself is not new. In the past, companies have shared business capabilities through various special arrangements such as alliances, trading agreements and industry consortia.
What's new is that IT is now making it possible for business capabilities to cross organizational boundaries at an industrial scale. This has enormous consequences for companies and indeed for the very fundamentals that govern the economics of business.
When organizations can effectively and efficiently share business capabilities, a series of things begin to happen. First, companies need to plan only for average demand and can offload excess demand to a third-party provider on an as-needed basis, with the hope and promise that the provider can gracefully and seamlessly augment the company's capabilities.
Second, much of the unpredictable or variable demand moves from a fixed or capital cost to a variable or operational cost on the balance sheet.
Third, this industrial-strength sharing of capabilities enables companies to enter new businesses and markets with relatively little risk. If the new product or market turns out to be a dog, a company can wind down operations with little or no sunk costs. Alternatively, if the adventure is wildly successful, the company can rapidly scale up to meet demand.
Put another way, when business capabilities can be sourced effectively and efficiently, companies can pass on significant business risks to a provider.
So what's in this for the third-party providers? First, as more clients seek their services, they begin to specialize, and as the process becomes cost effective, they gain price advantage. This, in turn, enables them to provide the same service to multiple clients at lower cost and thereby achieve scale.
Once they have scale—particularly across multiple clients from different industries and different business cycles—providers are in a position to load-balance across all of their clients, taking advantage of the clients' staggered business needs.
When the providers achieve enough scale, they can plan for average (as opposed to peak) demand and achieve high utilization rates by constantly repurposing capacity from one client to another. This enables them to hedge against the risks that are passed on to them by their clients.