The Hindu Business Line : Breaking out of the middle

SIZE matters. What has been true of manufacturing for all these years is increasingly evident in IT services too - although in a slightly different context.

A look at the performance figures of companies across the sector shows that large-sized IT companies are significantly more profitable than the mid-sized firms.

While some of the leading companies have operating profit ratios in excess of 30 per cent, the smaller ones struggle to get past half that number. What's more, the absolute profitability seems to be clearly correlated with size. A classic case of the rich getting richer!

Why does this happen? In many industries, small companies are more profitable and large companies struggle to maintain margins in the quest for growth.

In the case of Indian IT companies, there is a slightly different dynamic at work. First, the larger companies have significantly higher pricing power. Leading companies have revenues per employee of more than Rs 20 lakh per annum, while the smaller ones realise Rs 12-15 lakh per employee. Given that the cost of employees is relatively similar, this pricing difference turns into a huge advantage.

Second, the cost of sales and overheads shows a clear scale effect. This means that the cost of generating an additional Rupee of sales decreases as one gets bigger. Higher pricing, lower cost of sales and similar employee costs - the result is a huge profitability difference.

Such a drastic difference in profitability confers a large competitive advantage on the leaders. They are able to increase their investments in infrastructure and systems, strengthen the brand and sales force, build domain competencies, acquire companies and explore a larger number of growth opportunities. The gulf is, therefore, set to widen.

What is the way out for middle-sized companies? Business as usual is clearly not enough. To break out of the middle, companies need to tackle four critical issues.

Domain focus

The first question that companies need to address is about their business and segment focus. Despite this issue being on the CEO agenda for several years, precious little has actually been done. It is not enough to be a broad-based IT services player - that race has already been won. A hard look at one's client portfolio and domain competencies is critical to answer this question. Management should be willing to turn down work if it does not fit with the overall focus. This will allow a company to build scale in a domain, sharpen the sales efforts and increase the price point. Unfortunately, too many companies talk about domain focus but are willing to do just about any work that they can sell. This confuses the entire effort.

Client mix

The second area to address is that of the client mix. One needs to scrutinise the client portfolio with sharp lenses of profitability and strategy. Those accounts that do not provide a strategic fit and do not meet profit criteria should be fixed or minimised. This is a very difficult process.

Managers are reluctant to remove clients even if they are unprofitable for the company. Such accounts are justified by reasons of topline growth, long-term potential and employee utilisation. This is self-defeating. Unprofitable accounts are difficult to service and diminish morale. Yet, the clean-up exercise is rarely done with any seriousness. If this is to work, it must be driven from the top.

Focussed investment

The third requirement is for companies to invest aggressively in their chosen strategy. These investments need to be made ahead of sales growth, since this is the only way to leapfrog the competition. This is also where domain focus becomes so critical. Clearly, a smaller company cannot match the investments of a larger company across the board. However, one can match and exceed one's competition if one is focussed on one or two areas. This is one reason why focussed product companies have been more successful in their area compared to service and product companies.

M&A as a tool

Finally, companies need to be more serious about M&A as a tool. Selective acquisition and strong integration management can add a lot of value to a company. TCS has strung together a string of acquisitions over the last year to fill the holes in its strategy. However, few other companies have built their integration skills and are proactively seeking targets. An inability to identify and integrate companies represents a huge hole in the sector's capabilities.

It is time for the middle companies to seriously consider their growth strategy. Building `real' segment focus, improving the portfolio mix, futuristic investments and active M&A are critical to break out of the middle. Failure to do so can shatter a company's profitability and reduce it to an also-ran. The choice is one of mediocrity versus leadership. Where are you headed?

The author is a Bangalore-based strategy and operations consultant who can be reached at amtgrg@rediffmail.com

Picture by K.K. Mustafah

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