by Stephanie Overby

The ABCs of Outsourcing

Jun 08, 200719 mins
OutsourcingTechnology Industry

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.

Can I get outside help with this decision?

Many organizations bring in an outside sourcing consultant or adviser to help them figure out what their requirements are and what priority to give them. While third-party expertise can certainly help, 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 or not and then helping you figure out your requirements and priorities. 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.

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 also creates an openness around the process that goes a long way toward allaying fears.

Do you have any tips for 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, 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 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 over more power over the negotiating process to the provider.

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 out 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 (see The Hidden Costs of Offshore Outsourcing) 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, and ongoing staffing and management of the outsourcing relationship. It’s important to consider these hidden costs when making a business case for outsourcing.

What do I need to know about the transition period?

Vantage Partners calls the transition period—during which a new provider’s delivery team is getting up to speed on the buyer’s business, existing capabilities and processes, expectations and organizational culture—the “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 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 mixed-source 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 and set up management plans and governance tools to get the organization over the hump.

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, the positives degraded by the greater need for monitoring and auditing. In that environment, conflicts frequently escalate and projects don’t get done.

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, underbudgeted and undersourced governance models.

Where’s the best place in the world to outsource IT?

You’d probably expect to hear that India is the best place to send work. And indeed, India remains the locus for offshore outsourcing. But again, 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 2005. The index contains some other eye-opening stats. Top financial structures to support outsourcing? Philippines and Ghana. Best IT services business environment? Singapore.

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 (and rising wages in both locations) remain significant 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 there.

The easy answer is that there is no easy answer about what geographical location is best for outsourcing. For a more detailed look at outsourcing around the globe, check out CIO’s Buyers Guide to Offshore Outsourcing. The most important thing to understand is that offshore outsourcing is a big 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.

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

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 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. In a recent study, outsourcing consultancy TPI found an “unprecedented” concentration of contract restructuring in 2005, with a significant number of mega-deals being reworked.

But sometimes backsourcing is the best option, and in those cases it must me 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.