What is outsourcing? Definitions, benefits, challenges, processes, advice
Outsourcing can bring big benefits, but risks and challenges abound when negotiating and managing outsourcing relationships. Here’s what you need to know to ensure your IT outsourcing initiatives succeed.
By Stephanie Overby
Outsourcing is a business practice in which services or job functions are hired out to a third party on a contract or ongoing basis. In IT, an outsourcing initiative with a technology provider can involve a range of operations, from the entirety of the IT function to discrete, easily defined components, such as disaster recovery, network services, software development, or QA testing.
Companies may choose to outsource services onshore (within their own country), nearshore (to a neighboring country or one in the same time zone), or offshore (to a more distant country). Nearshore and offshore outsourcing have traditionally been pursued to save costs.
Business process outsourcing (BPO) is an overarching term for the outsourcing of a specific business process task, such as payroll. BPO is often divided into two categories: back-office BPO, which includes internal business functions such as billing or purchasing, and front-office BPO, which includes customer-related services such as marketing or tech support.
IT outsourcing is a subset of business process outsourcing, and it falls traditionally into one of two categories: infrastructure outsourcing and application outsourcing. Infrastructure outsourcing can include service desk capabilities, data center outsourcing, network services, managed security operations, or overall infrastructure management. Application outsourcing may include new application development, legacy system maintenance, testing and QA services, and packaged software implementation and management.
Today, however, IT outsourcing can also include relationships with providers of software-, infrastructure-, and platforms-as-a-service. These cloud services are increasingly offered not only by traditional outsourcing providers but by global and niche software vendors or even industrial companies offering technology-enabled services.
The most common ways to structure an outsourcing engagement include:
Time and materials
The client pays the provider based on the time and materials used to complete the work. Historically, this has been used in long-term application development and maintenance contracts. It can be appropriate when scope and specifications are difficult to estimate or needs evolve rapidly.
The vendor determines a set rate for a particular level of service, and the client pays based on its usage of that service. Pay-per-use pricing can deliver productivity gains from day one and makes component cost analysis and adjustments easy. But it requires an accurate estimate of the demand volume and a commitment for minimum transaction volumes.
Here, price is determined at the start. This can work well when there are stable requirements, objectives, and scope. Fixed pricing makes costs predictable, but when market pricing goes down over time, a fixed price stays fixed. It is also hard on the vendor, which must meet service levels at a certain price no matter how many resources those services require.
The customer pays a fixed price at the low end of a supplier’s provided service, but this method allows for variance in pricing based on providing higher levels of services.
The client pays the supplier for its costs, plus a predetermined percentage for profit. Such plans do not allow for flexibility as objectives or technologies change, and it provides little incentive for a supplier to perform effectively.
Here, financial incentives encourage the supplier to perform optimally. This type of pricing plan also requires suppliers to pay a penalty for unsatisfactory service levels. This model is often used in conjunction with a traditional pricing method, such as time-and-materials, and can be beneficial when the customers can identify specific investments the vendor could make in order to deliver a higher level of performance.
Pricing is based on the value delivered by the vendor beyond its typical responsibilities. For example, an automobile manufacturer may pay a service provider based on the number of cars it produces. With this kind of arrangement, the customer and vendor each have skin in the game, and each stands to gain a percentage of profits if the supplier’s performance is optimum and meets the buyer’s objectives.
Provider and customer jointly fund the development of new products, solutions, and services with the provider sharing in rewards for a defined period of time. This model encourages the provider to come up with ideas to improve the business and spreads the financial risk between both parties. But it requires a greater level of governance to do well.
Outsourcing vs. offshoring
The term outsourcing is often used interchangeably — and incorrectly — with offshoring, usually by those in a heated debate. But offshoring is a 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, typically to take advantage of lower labor costs. This subject continues to be charged politically because offshore outsourcing is more likely to result in layoffs.
Outsourcing of jobs
Estimates of jobs displaced or jobs created due to offshoring tend to vary widely due to lack of reliable data. In some cases, global companies set up their own captive offshore IT service centers to reduce costs or access skills. Some roles typically offshored include software development, application support and management, maintenance, testing, help desk/technical support, database development or management, and infrastructure support.
In recent years, IT service providers increased investments in IT delivery centers in the US, according to a report from Everest Group. Offshore outsourcing providers have also increased their hiring of US IT professionals to gird against potential increased restrictions on the H-1B visas they use to bring offshore workers to the US to work on client sites.
The failure rate of outsourcing relationships remains high, ranging from 40% to 70%. At the heart of the problem is the inherent conflict of interest in any outsourcing arrangement. The client seeks better service, often at lower costs, than it would get doing the work itself. The vendor, however, wants to make a profit. That tension must be managed closely to ensure a successful outcome for both client and vendor. A service level agreement (SLA) is one lever for navigating this conflict — when implemented correctly. An 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.
Another cause of outsourcing failure is the rush to outsource 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.
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.
Many years ago, the multi-billion-dollar megadeal for one vendor hit an all-time high, but wholesale outsourcing proved difficult to manage for many companies. These days, CIOs have embraced the multi-vendor approach, incorporating services from several best-of-breed vendors.
Multisourcing, however, is not without challenges. The customer must have mature governance and vendor management practices in place. In contract negotiations, CIOs need to spell out that vendors must cooperate 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 manage the outsourcing portfolio.
The rise of digital transformation has initiated a shift away from siloed IT services. As companies embrace new development methodologies and infrastructure choices, many standalone IT service areas no longer make sense. Some IT service providers seek to become one-stop shops for clients through brokerage services or partnership agreements, offering clients a full spectrum of services from best-in-class providers.
How to select a service provider
Selecting a service provider is a difficult decision, and no one outsourcer will be an exact fit for your needs. Trade-offs will be necessary.
To make an informed decision, articulate what you want from the outsourcing relationship to extract the most important criteria you seek. It’s important to figure this out before soliciting outsourcers, as they will 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.
Many organizations bring in a sourcing consultant to help establish requirements and priorities. Third-party expertise can help, but it’s important to research the adviser well. Some consultants may have a vested interested in getting you to pursue outsourcing rather than helping you figure out if outsourcing is a good option for your business. A good adviser can help an inexperienced buyer through the vendor-selection process, aiding them in steps like 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.
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, prioritizing issues that are important to them, rather than being led around by the outsourcer.
Creating a timeline and completion date for negotiations will help rein in the process. Without one, discussions could go on forever. But if an issue needs time, don’t be a slave to the date.
Finally, don’t take 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 begin moving the work to the outsourcer, you will be handing over more power over the negotiating process to them as well.
Outsourcing’s hidden costs
Depending on what is outsourced and to whom, studies show that an organization will end up spending at least 10% percent above the agreed-upon figure to manage the deal over the long haul. Among the most significant additional expenses associated with outsourcing are:
the cost of benchmarking and analysis to determine whether outsourcing is the right choice
the cost of investigating and selecting a vendor
the cost of transitioning work and knowledge to the outsourcer
costs resulting from possible layoffs and their associated HR issues
costs of ongoing staffing and management of the outsourcing relationship
It’s important to consider these hidden costs when making a business case for outsourcing.
The outsourcing transition
Vantage Partners once called the outsourcing transition period — during which the provider’s delivery team gets up to speed on your business, existing capabilities and processes, expectations and organizational culture — the “valley of despair.” During this period, the new team is trying to integrate transferred employees and assets, begin the process of driving out costs and inefficiencies, while still keeping the lights on. Throughout this period, which can range from several months to a couple of years, productivity very often takes a nosedive.
The problem is, this is also the time when executives on the client side look most avidly for the deal’s promised gains; business unit heads and line managers wonder why IT service levels aren’t improving; and IT workers wonder what their place is in this new mixed-source environment. The best advice is to anticipate that the transition period will be trying, attempt to manage the business side’s expectations, and set up management plans and governance tools to get the organization over the hump.
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, the positives degraded by the greater need for monitoring and auditing. In that environment, conflicts frequently escalate and projects don’t get done.
Successful outsourcing is about relationships as much as it is actual IT services or transactions. As a result, outsourcing governance is the single most important factor in determining the success of an outsourcing deal. Without it, carefully negotiated and documented rights in an outsourcing contract run the risk of not being enforced, and the relationship that develops may look nothing like what you envisioned.
Repatriating or backsourcing IT work (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 always easy to extricate yourself from an outsourcing relationship, and for that reason many clients dissatisfied with outsourcing results renegotiate and reorganize their contracts and relationships rather than attempt to return to the pre-outsourced state. But, in some cases, bringing IT back in house is the best option, and in those cases it must be handled with care.