In the adoption of any new technology, companies always face the classic choice between "make" and "buy"—that is, between developing the technology themselves (insourcing) and buying it from outside (outsourcing). Both have advantages and disadvantages; the key to making a good decision is developing a good understanding of what they are. Having spent a dozen years studying the issue, by examining sourcing decisions with a range of corporations, participating in litigation in international outsourcing contract disputes and examining the economic theory through ongoing research programs at the Wharton School, we have developed a framework for anticipating and managing risks and achieving desired benefits through stable relationships. In this article, I’ll focus on managing the risks of outsourcing; in my next column, I’ll delve more into maximizing the rewards.

The Benefits of Outsourcing

In general, companies outsource when they expect to receive one or more of the following benefits:

* Lower cost, because the outsourcing vendor can produce software or operate systems more cheaply than the company can. Vendors often can offer such scale advantages by reusing code or sharing risk across a large book of contracts, for example.

* Increased flexibility, allowing the company to add capacity or reassign personnel as demand moves up or down.

* Faster speed in development, leading to reduced time to get a product or service to market.

* Some form of accounting advantage—by shifting resources off the balance sheet, the company can sometimes report a better return on assets.

So why don’t companies outsource all their IT? Because outsourcing also poses a number of disadvantages. As in any other area of contracting, software outsourcing increases transaction costs—the costs of arranging to produce or purchase something rather than the direct costs associated with producing it or purchasing it. Some of these are frictional costs: It costs more to administer contract employees than it does to use in-house staffers, for example.

It may also cost more to develop a specification for an outside contract than it would to develop one for internal development. Moreover, legal costs associated with contracting and the expense of monitoring or measuring vendor performance may be higher than the comparable costs associated with internal activities.

There are also risk-based costs. That is, there may be a greater risk of deliberate contractual abuse, for profit, by an outside contractor than there would be from an internal development team. If these risks materialize—if the contractual abuses occur—they will produce real and potentially substantial financial costs.