The ABCs of Outsourcing

Everything You Need to Know to Avoid the Pitfalls of Outsourcing.

Compliled by Stephanie Overby

What is outsourcing?

There are as many definitions of outsourcing as there are ways to screw it up. But at its most basic, outsourcing is simply the farming out of services to a third party. With regards to information technology, outsourcing can include anything from outsourcing all management of IT to an IBM or EDS to outsourcing a very small and easily defined service, such as disaster recovery or data storage, and everything in between.

The term outsourcing is often used interchangeably—and incorrectly—with offshoring, usually by those in a heated debate. But offshoring (or, more accurately, offshore outsourcing) is, in fact, a small but important subset of outsourcing wherein a company outsources services to a third party in a country other than the one in which the client company is based, primarily to take advantage of lower labor costs. This subject has proven to be a political hot potato (see Offshore Outsourcing: The Politics and Offshore Outsourcing: The People) because unlike domestic outsourcing, in which employees often have the opportunity to keep their jobs and transfer to the outsourcer, offshore outsourcing is more likely to result in layoffs.

Why outsource?

The business case for outsourcing varies by situation, but reasons for outsourcing often include one or more of the following:

  • lower costs (due to economies of scale or lower labor rates)
  • variable capacity
  • the ability to focus on core competencies by ridding yourself of peripheral ones
  • lack of in-house resources
  • getting work done more efficiently or effectively
  • increased flexibility to meet changing business and commercial conditions
  • tighter control of budget through predictable costs
  • lower ongoing investment in internal infrastructure
  • access to innovation and thought leadership
  • possible cash influx resulting from transfer of assets to the new provider

ITO, BPO, KPO—what’s the difference?

Business process outsourcing—or BPO—is the outsourcing of a specific business process task, such as payroll. It’s often divided into two categories: back office outsourcing, which includes internal business functions such as billing or purchasing, and front office outsourcing, which includes customer-related services such as marketing or tech support. Information technology outsourcing (ITO), therefore, is a subset of business process outsourcing.

While most business process outsourcing involves executing standardized processes for a company, knowledge process outsourcing—or KPO—involves processes that demand advanced research and analytical, technical and decision-making skills. Less mature than the BPO industry, sample KPO work includes pharmaceutical R&D, data mining and patent research. The KPO industry is just beginning to gain acceptance in corporate America.

IT outsourcing clearly falls under the domain of the CIO. But often CIOs will be asked to be involved—or even oversee—non-ITO business process and knowledge process outsourcing efforts. CIOs are tapped not only because they often have developed skill in outsourcing, but also because business and knowledge process work being outsourced often goes hand in hand with IT systems and support.

Why is outsourcing so hard?

There’s no debate about it. Outsourcing is difficult. The failure rate of outsourcing relationships remains high. Depending on whom you ask, it can be anywhere from 40 to 70 percent. At the heart of the problem is the inherent conflict of interest in any outsourcing arrangement. The client is seeking to get better service, often at lower costs, than it would get by doing the work themselves. The vendor, however, wants to make a profit. That tension must be managed closely in order to ensure a successful outcome for both client and vendor.

Another cause of outsourcing failure is the rush to outsource in the absence of a good business case. Outsourcing is increasingly pursued by organizations as a "quick fix" cost-cutting maneuver rather than an investment designed to enhance capabilities, expand globally, increase agility and profitability, or bolster competitive advantage.

That said, according to a recent study by CIO magazine and MIT’s Center for Information Systems Research, some outsourcing arrangements are easier to make work than others. Transactional outsourcing deals, in which a company outsources discrete processes that have well-defined business rules, are successful a whopping 90 percent of the time. Co-sourcing alliances, in which client and vendor jointly manage projects (usually application development or maintenance work that goes offshore) are successful only 63 percent of the time. And "strategic partnerships", in which a single outsourcer takes responsibility for a big bundle of IT services, works only half the time.

Generally speaking, risks increase as the boundaries between client and vendor responsibilities blur and the scope of responsibilities expands. Whatever the type of outsourcing, the relationship will succeed only if both the vendor and the client achieve expected benefits. For more on how to target that sweet spot in managing outsourcing, see the CIO/CISR special report.

How is outsourcing priced?

There are various ways to structure pricing within an outsourcing contract, including:

Unit pricing: The vendor determines a set rate for a particular level of service, and the client pays based on its usage of that service. For instance, if you’re outsourcing desktop maintenance, the customer might pay a fixed amount per number of desktop users supported.

Fixed pricing: The customer pays a flat rate for services no matter what. Paying a fixed priced for outsourced services always looks good to customers at first because costs are predictable. And sometimes it works out well. But when market pricing goes down over time (as it often does), a fixed price stays fixed. And suddenly it doesn’t look so good. Fixed pricing is also hard on the vendor, who has to meet service levels at a certain price no matter how many resources those services end up requiring.

Variable pricing: This means that the customer pays a fixed price at the low end of a supplier’s provided service, but allows for some variance in pricing based on providing higher levels of services.

Cost-plus: The contract is written so that the client pays the supplier for its actual costs, plus a predetermined percentage for profit. Such a pricing plan does not allow for flexibility as business objectives or technologies change, and it provides little incentive for a supplier to perform effectively.

Performance-based pricing: At the opposite end of the spectrum from cost-plus pricing, a buyer provides financial incentives that encourage the supplier to perform optimally. Conversely, this type of pricing plan requires suppliers to pay a penalty for unsatisfactory service levels. This can be tricky to pull off successfully, but is becoming more popular among outsourcing customers, dissatisfied with performance in their previous forays into outsourcing.

Risk/reward sharing: With this kind of arrangement, the customer and vendor each have some skin in the game. Here, buyer and supplier each have an amount of money at risk, and each stands to gain a percentage of the profits if the supplier's performance is optimum and meets the buyer's objectives. The buyer will select a supplier using a pricing model that best fits the business objectives the buyer is trying to accomplish by outsourcing.

What about bundling?

Bundling services means paying an IT services provider one price that has more than one IT service or product lumped together. It’s usually not a good idea (see Bundle With Care). If you agree to the bundling of certain service levels into the price of a product, for example, you must buy that service every time you buy the product—whether you need it or not. Bundling also makes it difficult to understand what you’re paying for individual products or services and to benchmark that against market pricing. Itemizing products and services keeps the vendor more accountable and enables the buyer to be able to charge back the usage fees to its various user departments.

What is an SLA?

A service level agreement (SLA) is a contract between an IT services provider and a customer that specifies, usually in measurable terms, what services the vendor will furnish. Service levels are determined at the beginning of any outsourcing relationship and are used to measure and monitor a supplier's performance.

Often, a customer can charge an outsourcer vendor a penalty fee if certain SLAs are not met. Used judiciously, that’s an effective way to keep a vendor on the straight and narrow. But no CIO wants to be in the business of penalty charging and collecting. Bad service from an outsourcing vendor, even at a deep discount, is still bad service, and can lead to greater problems. It’s best to expend that energy on finding out why the SLAs are being missed in the first place and working to remedy the situation.

What is the best length for an outsourcing contract?

What’s the best length for a skirt? While the outsourcing industry is not quite as fickle as fashion, the prevailing wisdom about the best length for an outsourcing contract has changed over the years. When outsourcing first emerged as a viable option for providing IT services and support, long contracts—as many as 10 years in length—were the norm. As some of those initial deals lost their shine, clients and vendors began to look at contracts of shorter duration.

So what is the best length for an outsourcing contract? As with most other questions about outsourcing, the answer really depends on what’s being outsourced and why. A transformational outsourcing deal will require more time to reap benefits for both client and vendor and therefore must be structured as a longer-term contract. But when outsourcing desktop maintenance or data center support, a shorter relationship may work better. Generally speaking, overly long contracts (more than seven years) are frowned upon unless there is a great deal of flexibility built into the contract.

Should I outsource everything to one vendor? Or should I use a best-of-breed approach?

Several years ago, the megadeal—multi-billion-dollar IT services contracts awarded to one vendor—hit an all-time high, and the IBMs and EDSs of the world couldn’t have been happier. But this wholesale outsourcing approach proved difficult to manage for many companies. Today, although the megadeal is not dead, the trend has turned toward the multi-vendor approach, incorporating the services of several best-of-breed vendors to meet IT demands. And the major IT services players say they’re able to accommodate this change. The highest-profile example of this brand of outsourcing is GM. After years of outsourcing much of its IT to EDS, GM is pursuing what it calls the “third wave” of outsourcing, bringing together a cadre of competing outsourcers to work together.

But the multisourcing approach is itself not without great challenges. According to CIO Senior Writer Susannah Patton, to make sure they are getting the most from their various outsourcers, CIOs need to dedicate staff to oversee each vendor relationship and establish regular reviews of vendor performance with measurement applications such as dashboards or vendor scorecards. In contract negotiations, CIOs need to spell out that vendors should cooperate and refrain from blaming each other, or else risk losing the job. CIOs need to find qualified staff with financial as well as technical skills to help run a project management office or some other body that can track all outsourcing agreements. The whole new set of skills is outlined in Multiple Choice Answers.

How do I decide what vendor or vendors to work with?

Selecting a service provider is a difficult decision. But start by realizing that no one outsourcer is going to be an exact fit for your needs. Trade-offs will be necessary.

To make an informed decision, you need to articulate what you want to gain from the outsourcing relationship and extract from that your most important criteria for a service provider. It’s important to figure this out before soliciting any outsourcers who will undoubtedly come in with their own ideas of what’s best for your organization, based largely on their own capabilities and strengths.

Some examples of the questions you’ll need to consider include:

  • What’s more important to you: the total amount of savings an outsourcer can provide you or how quickly they can cut your costs?
  • Do you want broad capabilities or expertise in a specific area?
  • Do you want low, fixed costs or more variable price options?

Once you define and prioritize your needs, you’ll be better able to decide what trade-offs are worth making.

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