Outsourcing Definition and FAQs

We've got answers to your frequently asked outsourcing questions, from how outsourcing is priced to whether to take a multi-vendor approach, and how to select an outsourcing provider.

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Editor's note: This article was originally published in March, 2007. It was last updated in June 2014.

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 HP, 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. Offshoring (or, more accurately, offshore outsourcing) is, in fact, a small but important subset of outsourcing: It's where 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. Offshoring has proven to be a political hot potato 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. (For more on the politics of offshoring, see Prepare Now for Anti-Offshoring Legislation, The Politics Behind Offshore Outsourcing and The Growing Backlash Against Offshore Outsourcing.)

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
  • increased efficiency
  • access to specific IT skills
  • 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.

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 research and development, 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-IT-related 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.

Is cloud computing outsourcing?

Unlike traditional outsourcing, which one tends to associate with multi-year contracts based on developing and maintaining custom code and running on the backs of legions of programmers and on-site systems integration work, cloud-based offerings serve ups IT services (server, networks, applications) via the Internet. Instead of handing, say, customer application development or internal infrastructure support to an outsourcer, customers access "the cloud" for infrastructure services or multi-tenant software-as-a-service on a pay-per-use basis.

Since cloud computing customers are technically relying on a third party to provide IT services, it is a form of outsourcing. Surveys indicate that IT buyers are entering the cloud with caution and are more likely to take a chance on low-risk offerings like email or storage services than mission-critical applications and infrastructure. (For tips on experimenting with cloud services while mitigating risk, read Five Ways IT Outsourcing Customers Can Test Cloud Computing and How to Negotiate a Better Cloud Computing Contract.) And traditional outsourcers—onshore and offshore—are also dipping their toes into the cloud universe.

How quickly adoption rates will increase is anyone's guess, although some say cloud computing has the potential to turn the IT outsourcing industry upside down in relatively short order.

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, anywhere from 40 to 70 percent of IT services deals fail to meet expectations. 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.

According to a study by CIO magazine and MIT's Center for Information Systems Research, some outsourcing arrangements are easier to make work than others. Transaction 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, work 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.

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 who have been 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 Vendor Management: 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 outsourcing 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. (See The Good, The Bad, and The Ugly: 10 Tips for Outsourcing Incentives and Penalties that Work.) 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. It's best to expend that energy finding out why the SLAs are being missed and working to remedy the situation.

As the use of outsourcing has moved further up the IT value chain, some customers find that traditional SLAs are inadequate particularly when looking for innovation from outsourcers or integrating multiple vendors. Some IT leaders are moving away from technical or task-oriented SLAs—uptime, man-hours—to business-oriented SLAs. (See What Matters Most in Outsourcing: Outcomes vs. Tasks .)

How long should an outsourcing contract last?

The prevailing wisdom about how long an outsourcing contract should last 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 and ended in break-up, clients and vendors began to look at contracts of shorter duration.

So what is the ideal contract term? The answer 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?

Ten years ago, the megadeal—multi-billion-dollar IT services contracts awarded to one vendor—hit an all-time high, and the IBMs 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—some customers crave the economic advantages and lower management overhead of a single-sourced environment.

The trend has shifted 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. But the multi-sourcing approach is itself not without great challenges. CIOs need to dedicate staff to oversee each vendor relationship, create more robust project or program management processes, and contractually obligate their consortium of vendors to cooperate even as they compete for new pieces of the business. Indeed, some analysts say successful multi-sourcing can be prohibitively expensive.

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

Selecting an outsourcing 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. For example, what's more important to you: the total amount of savings an outsourcer can provide you or how quickly they can cut your costs?

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, strengths and profit margins.

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

  • Do you want broad capabilities or expertise in a specific area?
  • Do you want low, fixed costs or more variable price options?
  • Do you need onsite help?
  • Do you want a provider that will tailor their work to your existing processes or one that will transform your environment based on their best practices?

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

The outsourcer selection process typically follows a standard structure—gather requirements, issue an RPF, evaluate bids, select a provider and begin negotiations. Recently, however, some IT services customers have explored alternatives to the traditional selection process. Those seeking to ramp up more quickly—and theoretically cut costs sooner—are foregoing some elements of the RFP process via "speed sourcing". IT leaders seeking innovation from their outsourcing partners are also ditching old vendor selection processes . (For more advice on getting your vendor to think outside the box, see IT Outsourcing: Three Reasons Your Vendor Won't Innovate.)

Should I get outside help with this decision?

Many organizations bring in an external sourcing consultant or adviser to help them figure out what their requirements are and manage the vendor selection process. While third-party expertise can certainly help , it's important to research the adviser well. Some consultants may have a vested interest in getting you to pursue outsourcing rather than helping you figure out whether or not outsourcing is a good option. A good adviser can help an inexperienced buyer through the vendor-selection process, aiding them in conducting due diligence, choosing providers to participate in the RFP process, creating a model or scoring system for evaluating responses, and making the final decision. (See Outsourcing Advisors: Six Tips for Selecting the Right One .)

Help can also be found within your own organization, from within IT and from the business. These people can help you figure out what your requirements should be. There is often a reluctance to do this because any hint of an impending outsourcing decision can send shivers throughout IT and the larger organization. But anecdotal evidence suggests that bringing people into the decision-making process earlier rather than later makes for better choices and creates openness around the process that goes a long way toward allaying fears about outsourcing. Indeed, an increasing number of IT leaders are eschewing pricey consultants, not just to save money, but to start the outsourcing transaction off on the right foot. (See DIY Outsourcing Saves Money, Adds Control .)

What's the best location to outsource IT?

You'd probably expect to hear that India is the best place to send IT work. And indeed, India remains the locus for offshore outsourcing. But, as with many questions related to IT services, it depends on what you're outsourcing, why, and your in-house capabilities for managing the relationship.

In fact, the best place in the globe in terms of people skills and availability for IT services remains the United States, according to A.T. Kearney Global Services Location Index 2009. (India was number two.) Today, the combination of rising U.S. unemployment and political pressure to create jobs is increasing interest in onshoring possibilities for American IT buyers and, in an interesting twist, for offshore providers, too (see Offshore Outsourcing Patni Braces for H-1B Visa Restrictions As It Expands in North America.)

The A.T. Kearney index contains some other eye-opening stats. The countries with the top financial structures to support outsourcing are Indonesia and Ghana. The countries with the best IT services business environment are Singapore and Germany.

India and China (to a lesser degree) still dominate for IT services in the Asian region, although turnover in India and intellectual property issues in China (not to mention rising wages in both locations) remain concerns. Central and Eastern Europe are attractive destinations, but costs are rising there, too. Offshoring is actually increasing in Africa and the Middle East, but political instability poses ongoing challenges in those regions. Outsourcing options in Mexico and other Latin American markets are maturing. The Philippines remains a leader in voice and other BPO services.

The easy answer is that there is no easy answer about what geographical location is best for outsourcing.

The most important thing to understand is that offshore outsourcing is a significant decision that can have lasting ramifications for an organization—negative or positive. The decision about where to outsource should be one of the last in the outsourcing decision-making tree. Figure out what your outsourcing requirements are first. (See 14 Emerging Offshore Outsourcing Markets You Can't Afford to Miss and Six Offshore Outsourcing Hot Sports for 2010.

Do you have any tips for outsourcing negotiations?

The advice given above for selecting a provider holds true for negotiating terms with the outsourcer you ultimately select. A third-party services provider has one thing in mind when entering negotiations: making the most money while assuming the least amount of risk. Clearly understanding what you want to get out of the relationship and keeping that the focus of negotiations is the job of the buyer. Balancing the risks and benefits for both parties is the goal of the negotiation process, which can get emotional and even contentious. But smart buyers will take the lead in negotiations and will prioritize issues that are important to them, rather than being led by the outsourcer.

Creating a timeline and completion date for negotiations will help to rein in the negotiation process. Without one, such discussions could go on forever. But if a particular issue needs more time, don't be a slave to the date. Take a little extra time to work it out.

Finally, don't make any steps toward transitioning the work to the outsourcer while in negotiations. An outsourcing contract is never a done deal until you sign on the dotted line, and if you make steps toward moving the work to the outsourcer, you will be handing more power over the negotiating process to the provider.

For more tips, see IT Contract Negotiation: Five Steps To Success, IT Outsourcing: Nine Legal Mistakes That Can Cost You Big , Negotiating Outsourcing Contracts: Beware of Minimum Commitments , Vendor Management: How To Negotiate Contracts , and Experience Base: Vendor Negotiation.

What is benchmarking, and when should I do it?

The benchmarking clause dates back to the mid-'90s, when the number of mega-outsourcing deals began to explode, along with the lengths of the agreements. Signing a 10-year deal with a multi-billion-dollar price tag was a big risk—one that customers wanted to mitigate. The danger with any outsourcing contract is that you end up paying through the nose for services that should be getting cheaper, particularly in the infrastructure area, where prices for hardware are dropping constantly. Outsourcing customers began to include benchmarking clauses in their IT services contracts, which gave them the right to bring in a third party to assess the competitiveness of the outsourcer's prices.

Unfortunately, over the years, some customers used this new tool as a cudgel to beat every last cent out of their providers rather than a fine tuning instrument to ensure competitive pricing over the term of a contract. As a result, some vendors began to push back against the inclusion of benchmarking clauses.

Savvy IT outsourcing customers still insist on benchmarking rights. Many wait until the end of the contract term to invoke them , but some advisors advocate benchmarking much earlier in the contract term. After the second year, prices can become drastically out of sync with the market. (Indeed, IT outsourcing prices have been dropping an average of 15 percent a year, according to outsourcing consultancy Alsbridge's ProBenchmark unit.)

Traditional benchmarking can be expensive and time-consuming. Some consultants have begun to advocate proxy bids as a kind of "benchmarking light" reality check on price. A proxy bid represents what the benchmarker would bid to provide the services if the benchmarker were in the outsourcing business, using existing data on current pricing trends.

A benchmarking clause isn't the only contract term you can use to ensure the competitiveness of an outsourcing deal over time. For more customer-friendly clauses and tips on how to negotiate them, see Outsourcing Contracts: Clause Control .

What are the "hidden costs" of outsourcing?

The total amount of an outsourcing contract does not accurately represent the amount of money and other resources a company will spend when it sends IT services to a third party. Depending on what is outsourced and to whom, studies show that an organization will end up spending 10 percent above that figure to set up the deal and manage it over the long haul. That figure goes up exponentially—anywhere from 15 to 65 percent—when the work is sent offshore and the costs of travel and difficulties of aligning different cultures are added to the mix.

Among the most significant additional expenses associated with outsourcing are:

  • the cost of benchmarking and analysis to determine if outsourcing is the right choice
  • the cost of investigating and selecting a vendor
  • the cost of transitioning work and knowledge to the outsourcer
  • the costs devolving from possible layoffs and their associated HR issues
  • the cost of ongoing staffing and management of the outsourcing relationship.

It's important to consider these hidden costs when making a business case for outsourcing. (For more information on the total cost of outsourcing, see The Price Of Outsourcing and Offshore Outsourcing: Quantifying ROI.)

What do I need to know about outourcing's transition period?

During the outsourcing transition period, the outsourcing provider's delivery team gets up to speed on the customer's business, existing capabilities and processes, expectations, and organizational culture. The new team also tries to integrate transferred employees and assets and begin the process of driving out costs and inefficiencies while keeping the lights on. Knowledge transfer and assimilation is always hard, but it's even trickier when some part of the outsourcing takes place offshore. Throughout the transition phase, which can range from several months to a year or more, productivity very often takes a nosedive.

Complicating the transition phase, this is also the time when executives on the client side are looking most avidly for the deal's promised gains; business unit heads and line managers are wondering why IT service levels aren't improving; and IT workers are wondering what their place is in this new environment.

IT leaders looking to the outsourcing contract for help on how to deal with the awkward transition period will be disappointed. The best advice is to anticipate that the transition period will be trying and attempt to manage the business side's expectations. Also set up management plans and governance tools to get the organization over the hump. (For more advice, see Increase the Success of Your Knowledge Transfer Effort.)

I have an existing contract with an outsourcer. When new outsourcing work arises, should I give it to my existing provider?

There's no easier way for an IT service provider to generate revenue, particularly in slow growth periods, than to sell new work to an existing customer. Traditional IT service providers have relied on the upsell for years, and offshore outsourcers have taken to the practice as well.

But buyer beware. Not only could your current IT provider not be the best choice for the new work, they may not even be qualified at all. And being too quick to award extra work to your current provider—offshore or otherwise—can send the wrong message.

There's nothing inherently wrong with expanding the scope of an existing outsourcing contract, but due diligence is critical. Approach the awarding of new IT work the same way you would if you were starting from scratch—collecting requirements, soliciting bids and evaluating vendors.

How important is ongoing relationship management to outsourcing success?

The success or failure of an outsourcing deal is unknown on the day the contract is inked. Getting the contract right is necessary, but not sufficient for a good outcome. One study found that customers said at least 15 percent of their total outsourcing contract value is at stake when it comes to getting vendor management right. A highly collaborative relationship based on effective contract management and trust can add value to an outsourcing relationship. An acrimonious relationship, however, can detract significantly from the value of the arrangement because the positives are degraded by the greater need for monitoring and auditing. In that environment, conflicts frequently escalate and projects don't get done. Troubled economic times can also take their toll on outsourcing partnerships .

Failing to invest in robust relationship management is one of the biggest mistakes an outsourcing customer can make. In their book, "Multisourcing," Gartner analysts Linda Cohen and Abbie Young point out that successful outsourcing is built on "a network of relationships not transactions," and outsourcing governance is the single most important factor in determining the success of an outsourcing deal. But many companies still haven't internalized that truth. Gartner found that fewer than 30 percent of enterprises will have formal sourcing strategies and appropriate governance in place. In a 2004 survey of 130 CIOs, 42 percent said they were dissatisfied with their outsourcing relationships, according to outsourcing advisory company EquaTerra, primarily due to poorly developed, under-budgeted and inadequately sourced governance models.

What if outsourcing doesn’t work out? Can I just bring the work back in-house?

Backsourcing (bringing an outsourced service back in-house) when an outsourcing arrangement is not working—either because there was no good business case for it in the first place or because the business environment changed—is always an option. However, it is not easy to extricate yourself from an outsourcing relationship, and you may no longer have the necessary skills to repatriate the work. (See Nine Questions to Consider Before Insourcing Outsourced IT for more information.) For that reason many clients dissatisfied with their outsourcing arrangements renegotiate and reorganize their contracts and relationships, rather than attempt to return to the pre-outsourced state.

That said, sometimes backsourcing is the best option, and in those cases it must be handled with care. For more on the good, the bad and the ugly of bringing IT back in-house after an outsourcing deal, see Backsourcing Pain and Bringing IT Back Home.

Can I sue my outsourcer?

An outsourcing relationship is a contract. If you feel your provider is in breach of that contract, you can take them to court. The question is, should you?

Historically, outsourcing lawsuits were rare. Vendors want to avoid the bad publicity of a trial, and customers just want the problem to go away. Consequently, disputes are often resolved between parties or—at worst—arbitrated outside of the courts, which results in confidential settlements.

That may be starting to change. Increasingly, IT services customersparticularly in the public sector are taking their grievances public by suing their outsourcers. (And in many cases, then being countersued by the vendor.) Recent rulings in favor of outsourcing customers could encourage more IT buyers to seek damages for business impact caused by poor IT delivery performance.

As more service providers end up with a least one public court judgment on their records, remaining litigation-free is no longer a competitive advantage, which makes them more' willing to take their chances before a judge or jury.

But while a court judgment can take the sting out of a bad IT services deal, you can't litigate yourself to a better outsourcing relationship.

Should I fire my outsourcing vendor?

Sometimes you have to fire an underperforming IT outsourcing provider. But terminate with care. Ending an outsourcing relationship prematurely is complicated, costly and painful. It results in additional fees, plus the cost of transitioning to a new provider or bringing the work in house.

In many cases, both provider and customer are to blame when an IT services deal fails to deliver, so it's important to examine the root cause of problems before making a decision about the fate of an existing relationship.

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