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The outsourcing equation

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The outsourcing equation | Outsourcing in the IT Industry

An Academic Paper

Abstract:

Nicholas Carr’s May 2003 Harvard Business Review article “IT Doesn’t Matter”, stoked a debate on the idea that IT has become a commodity: That IT has evolved to the point where it can be viewed as a cost center to be controlled instead of an investment center to provide market leadership. If an element of IT proves to be a true cost center, and not a competitive advantage, then a logical approach is to find an outsourcer who specializes in that business and profit from economies of scale. The company can then save money through outsourcing and focus energy and invested capital on areas that are of strategic advantage. Determining which areas of IT to outsource then becomes critical.

However, the decision to outsource may not be that simple. If an outsourcer can provide a company domain experience or resources that they do not readily have available, even strategic advantages may be candidates for outsourcing.

After it is determined which elements of IT can and should be outsourced, then the remaining staff and projects are important to the company for some reason: Security, Market Leadership, Human Capital, etc. Those remaining areas are best left locally managed and are the areas of IT that are strategic assets.

Part I: Why Outsourcing? Why now?

Nicholas Carr’s Article “IT Doesn’t Matter” suggests that Information Technology has become a commodity: Like electricity, gasoline, salt or sugar, it is standardized and everywhere, but not invested in as a “strategic advantage.” Instead, commodities are generally viewed as interchangeable parts to be managed by cost alone, thus the evolving trend of new technologies moving toward standardization and away from differentiation or competitive advantage [1]. Today, retail companies are increasingly focusing on price alone as a differentiating factor. For example, Wal-Mart is the world’s largest company, yet it sells the same thing as everyone else: Only cheaper. The Personal Computer and Network Server are also good examples, now standardized and provided by only a handful of vendors. Carr’s article goes one step further, suggesting that all of Information Technology is a commodity. Instead of building systems, Carr’s logic suggests, companies should buy and integrate systems, managing by cost. Information Technology, however, is more than just hardware. It can also include software development, helpdesk, administration, and even business process engineering.

Since the origination of IT outsourcing in the 1960s and 70s in the professional services and facilities management areas [2], organizations have loosely agreed that outsourcing was a commodity decision, essentially a choice between “make” or “buy”, and that the changeable and less creative technical skills were the best candidates to outsource [3]. Further, Warren McFarlan writes, in response to Carr’s article, that “Outsourcing the commodity infrastructure is a great way to control costs, build confidence, and free up resources, which can be used to combine data bits in creative ways to add value” [4].

This paper, however, contends that Information Technology, from the call center to IT strategic decision making, is not as black and white as Carr suggests. The view of which areas of IT are core to the business will vary wildly – A tier one auto parts manufacturing company, for example, will have a much different view of IT than an average metropolitan used car dealership. The difficulty then becomes if IT is not the same for every organization, how can each area of IT be objectively evaluated into areas which are or are not outsource-able commodities? By eliminating those aspects of IT that you can outsource, whatever remains then is of strategic value and should be focused on as core. The goal of this paper is not to suggest one “best way” to split IT, but instead, to discuss the issues that executives must consider when making such tough choices.

The Commodities Market

The 20th Century brought a number of innovations to the world: The airplane, the moving picture, the automobile, the breakfast cereal, the electric appliance, and the electronic computer. As each of these innovations became commercialized, a large number of companies surfaced to create, market, and sell them. Over time, standard interfaces for these products evolved, similar to the standards for electricity, gasoline and the telegraph that evolved in the previous century. As products approach maturity, established companies surface and grow – often through a series of acquisitions. As competitors fold or are acquired, the market tends to thin, and the companies that survive are the ones that are able to keep costs low and leverage economies of scale. A final stage in maturity occurs when the products become nearly indistinguishable from one another. This paper will describe this stage as the “commodity” stage where, like wood or tin or cattle, once a careful inspection is passed, the sole differentiating factor is price.

While few 20th century innovations are as indistinguishable as electricity or natural gas, many businesses are directly competing on price alone to great success. Most modern appliances, such as the television, the toaster, the washer and dishwasher, are developed and sold by a handful of electronics companies and produced to standard interfaces. These products are evaluated on standard criteria and tend to have similar feature sets. Over the last decade, even the LAN/WAN architecture for the typical company has become standardized: Personal Computers running TCP/IP to connect to servers for authentication, storage, and print services, using a web browser to access the internet. In the past few years, some technology services have been standardized in a way conducive to outsourcing: Helpdesk, Call Centers, System Administration, and certain software development and project management initiatives can be sent to other companies. According to Carr’s logic, Service Level Agreements (SLA) can guarantee that any company is as good as another, so the best option is to outsource everything and aggressively manage cost.

IT as a Commodity: Second-Mover Advantage

Carr’s argument also contends that companies follow instead of leading. He states “Delay IT Investments to significantly cut costs and decrease your risk of buying flawed or soon-to-be-obsolete equipment or applications.” This suggests a second mover advantage; allow the first movers to run in uncharted territories, implement risky projects, and learn some best practices, and then follow up with a product that is better with significantly lower research and development costs. The second-mover advantage idea is not new: PC clones used it to copy IBM’s Personal Computer instead of developing their own, and Microsoft used it to embrace, extend, and eventually, essentially own the windowing operating system. Finally, companies that focused on first-mover advantage often failed to consider the risk that the technology would fail.

In the early 1980’s, IBM developed the Desktop Computer that became standard for business applications: The IBM PC. To bring the product to market faster, IBM built the PC out of off-the-shelf components and then developed a proprietary Basic Input Output System (BIOS). With substantially less research and development effort, Compaq was able to reverse-engineer the IBM BIOS, buy the same components, license the operating system from Microsoft, and release one of the first PC clones. After the BIOS was successfully reverse engineered, companies could buy the BIOS from Phoenix computer corporation, and any company could be in the business of selling PC clones. In the early PC wars, different positions existed – from developing the system entirely (such as the Apple, IBM PC, and Commodore) to simply integrating the work of others, as best demonstrated by Dell Computer.

Xerox is generally credited with the invention of the windowed operating system, and Apple’s Steve Jobs is credited with its first wide-scale, commercial application in the Apple Lisa. However, it is not Apple, but the Microsoft Corporation which owns the most popular, successful implementation of Windows. Microsoft did not invent, patent, or even have first-mover advantage on Windows technology. Instead, it waited and responded. Although Microsoft wrote the source code, it is arguable that Microsoft outsourced (for free) the creative, intellectual capital work of designing the event-driven, mouse-click interface of Windows.

Another suggestion by Carr to manage IT as a commodity is to focus on the risk of new technologies instead of viewing new ideas as a rosy-eyed opportunity. By the late 1980’s, the PC Market was mature enough that standards had developed, and companies that attempted to enter the market and compete on differentiating factor or niche generally failed: Unisys and Wang failed to market a proprietary PC operating system. NeXT computers and the OS/2 Operating System, though hailed as highly innovative and impressive, failed to capture enough market share to attract software developers. Without working applications, these systems could not attract customers, and without customers, they could not attract developers: Something Joel Spolsky has referred to as a “Chicken and the Egg” problem [5]. Companies that view technology as a commodity will outsource and not gain the first-mover advantage. The key question then becomes which of those two advantages are more beneficial to the organization – for which segment of IT.

Outsourcing and Business Strategy

What Carr’s argument doesn’t take into account is the impact an organization’s business strategy may have on outsourcing. The American Heritage Dictionary defines outsourcing as “To send out (work, for example) to an outside provider or manufacturer in order to cut costs.” It is important to note that the dictionary defines cost alone as a reason to outsource. While cost is a viable business strategy, it is not the only strategy. Others, such as seeking a market niche or differentiating products or services, do exist [1]. However, market niches don’t apply when a product is ubiquitous, like electricity, and differentiation cannot exist when products are identical, such as sugar or grain. It follows that outsourcing defined by cost alone only applies when the item in question is a commodity.

In January of 2004, Software Development Magazine listed the following criteria for projects that could be outsourced:

1) Not much innovation required

2) Close collaboration not essential

3) No critical or strategic code involved

4) Limited need for specialized domain knowledge

5) Minimal dependencies on other projects

6) Stable hardware and software platforms

7) Clearly defined requirements, performance goals and acceptance criteria

8) Internal management and domain expertise available to aid the supplier [6]

The first point, “not much innovation required”, ties in logically with a commodity, as commodities are products that are mature and interchangeable. The second point also follows: Collaboration is not required to buy beef, salt, or any other product at a supermarket. The third point speaks to the heart of this article; that core, strategic code is not a commodity and should not be outsourced.

If the product needed domain knowledge, then it would be possible to have a market niche, and product could not be marketed as a commodity. If the product was dependent on other projects, it would be unique. Stable hardware and software platforms guarantee the product can be standardized and interchangeable. If the requirements and goals can not be clearly stated, the product could not be evaluated by price alone. Finally, the customer has to know what they want. This implies a differentiating factor, but it can not be too large (item #4 makes that clear). Some differentiating factor must exist for software projects; otherwise the project could simply run on commercial, off the shelf software that already exists.

While bullet point lists are a good starting point for identifying some of the characteristics that make projects good candidates for outsourcing, what they don’t do is make those characteristics relevant to a specific business by taking into account an organization’s capabilities and what may or may not provide strategic advantage to the organization. Simple lists are also more open to subjective interpretation. That is, they lack a methodology useful in producing consistent results across individuals and business units. In order for an organization to prescriptively and objectively apply outsourcing across the entire business, a methodology is needed to evaluate (IT) activities and their likely contribution to competitive advantage, as well as the organization’s ability to perform those activities. Adoption of a methodology, such as that proposed by Insinga and Werle, in their article “Linking Outsourcing to Business Strategy,” [7] can give companies a tool to use in deciding how to use outsourcing in conjunction with their business strategy [8].

Information Technology is not as mature as the inventions of the early 20th century, and software development must have some differentiating factor to even be started. Carr’s argument supposes that all software development processes are equivalent, and should be managed by cost alone. The idea that projects that are standardized, non-unique, and not key to strategy are candidates for outsourcing is not unique to this paper. The challenge is separating the projects that are core from those that are non-core, and evaluating the cost and benefits of outsourcing vs. doing the work in-house. A thorough understanding of where an activity falls within the spectrum of outsourcing possibilities doesn’t just allow the organization to know whether or not the activity should be outsourced, but also the best type of relationship the organization should have with its external service provider. Guided by the

Insinga and Werle methodology, an organization can begin to answer which of its processes are truly strategic to organization, what should remain in-house, and what kind of outsourcing relationship may best suit the organization for that process [8].

Part II: Dividing IT and selecting a Model

“What areas of IT are commodities?” seems to be the next natural question. Michael Porter’s “Maturity” and “Decline” phases of the industry life cycle illustrate the Commodity position well [1]. According to Porter, in the “Maturity” phases, the product has mass market appeal, has reached market saturation, repeat buying is common, companies choose among brands, there is superior quality, less product differentiation, standardization, and less rapid product changes. The Decline phase is similar, typically including customers who are sophisticated buyers, little product differentiation, and spotty product quality. The opposite end of the spectrum has the introduction and growth phases, with a large number of competitors, radically different product features, few standards, and quality that differs from company to company. This paper applies Porter’s position to the Gartner strategic technology grid, moving from network infrastructure to applications (mature), to new development and finally business processes (growth).

The two questions that move to the forefront of the topic of IT outsourcing are what to outsource and how to do the outsourcing. The areas of IT that can be outsourced generally follow Gartner’s Ascending value chart [9], moving from Network / Data Center / Desktop support to legacy systems maintenance to new development and business process automation (the included example is customized for the healthcare industry). Once a piece of IT is selected for outsourcing, a company must make two decisions: how to do the outsourcing, as well as how closely to tie the business to the outsourcer; from coaching and growing the business, to a staff augmentation model, to partnering, to complete outsourcing. Once the options are addressed, it is possible to look at the risks and advantages inherent in each style.

Michael Porter’s work Competitive Strategy gives specific tools for industry analysis. According to Porter, industries move through four stages: Introduction, Growth, Maturity, and Decline. The maturity and decline stages correspond to the commodities market: Products reach mass market saturation, have little difference, and compete on cost. Instead of viewing IT as a whole, we consider each area of IT separately (according to the Gartner value chart), and find where that area resides on Porter’s Industry life cycle. As a result, it is possible to determine what areas of IT are commodities and good candidates for outsourcing.

What to outsource: Dividing up IT

Asking the question “what” to outsource implies different kinds of IT – some of which may be outsourced, some left in house. This may include the infrastructure (network, PC’s data center), the applications (software maintenance and development) and the actual business processes themselves (paying claims, providing services, etc.) [9].

The item at the very bottom of the Gartner list, network infrastructure, is very nearly a commodity: According to Tanenbaum, Network (LAN) wiring is standardized along on the 10BaseT standard [10]. Any competent cabling company can perform wiring tasks, and, in fact, most existing buildings are already wired in this way [10].

If the network is standard, then the data center is simply a piece of hardware that serves up data. There is some differentiation among data centers: storage space, disaster recovery, and scalability being among the most important. Also, according to the data center journal, availability is a cost point, and some companies are using Linux or Open Source tools to lower total costs for data centers [11, 12].

Finally, the Desktop Computer and its support are worth consideration for outsourcing. The IBM PC, the Intel Processor, the dominance of the Microsoft Operating System and the consolidation of the PC Manufacturer market are all signs of growing maturity in the desktop computer market. Companies that wish to use off-the-shelf desktop machines may find little room for strategic advantage. Still, the rise of Linux and other open source tools may provide some room for strategic advantage [13]. If companies wish to compete on price based on Open Source tools, they may be able to find an outsourcer, but they may have to retain some skills in house. Overall, the network, data center, and PC Maintenance are areas of IT that hold the most maturity and thus the least strategic advantage.

Applications are the second major area of the IT value grid, both support existing applications, bringing new applications on-board, and perhaps, developing new applications. Supporting existing applications and legacy development are listed toward the bottom of the grid. These are essentially operational tasks; it is hard to find strategic value in maintaining the status quo. Still, software maintenance is not an easy simple task. Marlin Bayes is quoted as saying that one risk of outsourcing IT is viewing IT as a “simple service that can be purchased from external suppliers like a cleaning contract” [14]. With software, incompetent maintenance work brings systems down, which could potentially bring down an entire organization. The key question is then: What is the impact of an IT failure in this area? The greater the risk, the more strategic advantage the area holds. This is especially true in software development, where a very real risk emerges that a lack of feedback will result in a piece of software that does not meet needs, and it may be over-budget or contain defects [15]. Extensive software outsourcing can also create an additional risk that short-term savings come at the expense of eroding business distinction. The loss of differentiation may also be a loss of strategic advantage [16]. That line may very well be the difference between an advantageous outsourcing project and a mistake.

The third area of the grid and at the opposite end from the network infrastructure is Business Process Outsourcing (BPO) – which ties into the very heart of the business: Taking a task that is traditionally performed by employees and may involve customer contact, and sending that work to another company. BPO, which we will define as traditional business processes and IT Decision making, has become extremely popular lately and is also the area that many companies consider a strategic advantage or differentiating factor. This means that outsourcing a Business Process makes the company reliant on its partner for the strategic advantage, and is giving up its control of that advantage. As a result, BPO and IT decision making outsourcing are recommended only when the areas are mature [1], not core to the business and/or are manual, routine work that can be outsourced to anyone. For example, many tax advisor/preparation companies are outsourcing the actual tax paperwork, and instead focusing on client relationships, branding, and marketing [17].

A final rung on the model that is not listed above is outsourcing senior technology management. In 1987, Dearden predicted that the activities of the information technology function would be decentralized or outsourced to the extent that there need not be a senior executive in charge. His arguments were compelling: technologies getting easier to use and outsourcers were skilled and saved precious operational dollars [18].

How to outsource: Selecting appropriate models

If outsourcing is sending work to an external vendor, a question arises of how much of the work should be sent to that vendor, and how closely that vendor interact with the sponsoring organization. This paper discusses five different models for outsourcing: Coaching, Staff Augmentation, Operational Outsourcing, Project Partnering, and Complete Outsourcing [19, 20]. Understanding the strengths and weaknesses of each outsourcing model can allow organizations to make an informed decision about how to outsource, instead of making assumptions or being led by a vendor.

The Coaching decision is unique in the spectrum. While Outsourcing is typically done to cut costs or allow a company to focus on other competencies, coaching has neither of these goals [21, 19]. Instead, coaching is the decision to build technical skills by hiring an outside person. Coaching allows a company to focus on the very thing it is outsourced, and, in the short term, will increase cost. Coaching views quality as an investment, believing that costs can be lowered by eliminating re-work [22].

With a Staff Augmentation model, the outsourcing staff is “absorbed” into the organization instead of reporting through a separate organization. According to outsourcing companies, Staff Augmentation allows companies to expand to have qualified staff when needed, and contract when not needed – thus cutting costs, eliminating waste, and reducing cycle time [23]. This raises obvious questions: For example, why would the outsourcers have fully-qualified staff sitting on a bench, waiting for a phone call? How thick must the bench be to have all specialties available, all the time? What is the “ramp up” cost of a typical staff-aug employee? If the consulting company is collecting an additional fee on the employee, the hourly rate for the staff-augmentation employee will probably be much higher than a traditional full-time employee. If the augmented staff person stays too long, the organization will actually be increasing cost. All of these factors must be considered when examining a staff augmentation outsourcing model.

A third approach to outsourcing is Operational, Delineated Tasks, such as Call Center, Helpdesk, or PC Maintenance. These can typically be identified because they: (1) Are clearly defined, with absolute responsibility limits, and (2) Service Level Agreements are clear-cut and simplistic [24].

We separate Operation Outsourcing from Project Partnering due to the risks involved. Project Partnering may involve something harder, like software development [9, 20]. The company may have a vested interesting in understand the technology, product or service that is outsourced, or may have some financial stake in the product. In any event, Project Partnering involves working with an outsourcer to jointly develop a product, or deliver a service.

A final choice for outsourcing is complete outsourcing, by which a specification is sent to the vendor, who develops the entire system and delivers it. A number of challenges exist for complete outsourcing, such as: Getting complete requirements up-front, communications costs, and integration costs. As Steve McConnell points out, relying on an outsourcer to manage a product without any oversight can create additional risk [20]. Projects lacking oversight only amplify the pressure on the organization to get requirements correct in the first place, thus increasing one aspect of the cost [18]. An additional consideration for complete outsourcing is control: Outsourcing the project means that the vendor is in control of the amount of resources applied to the project and their focus [4]. This puts the organization at the mercy of the vendor – which may be acceptable on non-mission critical projects. A final consideration is distance. Hourly rates generally drop as an organization searches for outsourcing vendors farther away, but communication costs increase, as does the delay of the feedback loop on projects.

After looking at several models, it is clear that how the outsourcing is to occur is a differentiating factor.

Different projects and areas of IT may call for different outsourcing models. If the organization wishes to grow it’s capabilities in a specific direction to add focus, a coaching model is called for. If extra temporary staff is required, a staff augmentation model may make more sense. Operational task outsourcing is more appropriate for clearly divided, discrete elements of IT. Project partnering may make sense if the company can find common advantage in working together. Complete outsourcing is only appropriate if the project is very low risk or non-strategic, preferably both. Understanding which model of outsourcing to use on a particular project can be crucial to the project’s success.

The Four Types of Outsourcing Relationships

The standardization and maturity of the elements of IT at the bottom of the Gartner value chart may allow the organization to more readily “farm” out the work without much thought to their relationship to the external vendor. Conversely, at the other end of the Gartner value chart, software development and IT decision making, there is much more potential for strategic (and financial) advantage. However, special care must be taken when selecting an outsourcing partner for software development or IT decision making, because it often can, and should, involve tighter integration with the external vendor. Once the organization has determined what outsourcing model it would like to follow, the how of outsourcing is still only half answered. In addition to what model to follow, an organization must expand its systematic approach for analyzing each area of IT (the Insinga and Werle methodology as discussed earlier) to include the type of outsourcing relationship to pursue.

In their investigation into Information Systems Outsourcing, Nam, Rao, Rajagopalan, and Chaudhury [25] propose a two-dimensional table for defining the vendor-to-client outsourcing relationship, based on the well known Figure 2.2 [25]

McFarlan-McKenny strategic grid [26]. These four types of outsourcing relationships; Support, Alignment, Reliance and Alliance convene not only the importance of business goals on the decision to outsource, but also that there are two types of competitive advantage that can be gained through outsourcing, the more traditional cost reduction as well as product differentiation [25].

A support relationship is the most limited type of partnership, usually taking the form of outsourcing non-core activities of a limited size that can be easily stipulated, such as hardware maintenance. Reliance relationships are similar in that they involve non-core functionality, but are typically longer in duration and may take the form of data center operations. An alignment type of relationship is one where, unlike the two previous types, substitution of vendors is more difficult, while the impact on strategic direction is high. BPO consultants are one possible example of an alignment relationship. Finally, alliance relationships are most partnership like of the four types. Similar to alignment, there is a significant tie-in to the strategic advantage of the organization, as well as an even higher degree of difficulty in substituting vendors, as the degree of specialization and commitments is very high [25].

Another facet of IT outsourcing that should be factored into what type of outsourcing relationship is right for an organization is whether or not using the “commodity” criteria alone to distinguish which IT activities should be outsourced makes sense. The act of defining an activity strictly as commodity or non-commodity suffers from its overly simplistic definition of IT in three ways. First, interpretations of which aspects of IT are “commodities” or “strategic” are often misleading. Second, areas assumed to be commodities can actually be strategic advantages and areas that were alleged to be strategic may, in fact, not be [27]. Finally, aspects of an organization’s business thought of as “strategic” may have more competitive advantage for an organization when provided by a better qualified external provider.

For example, take the Coca-Cola Company of the late 1890s. They had already established themselves as a leader in the soft drink industry and were looking to grow into new markets. At the time, bottling was considered a source of strategic advantage; however, Coca-Cola did not have the time, capital or expertise to bottle its own product. Instead, it outsourced the bottling of its soft drink to those independent bottlers who could satisfy Coca-Cola’s stringent quality requirements. In this way, Coca-Cola used outsourcing in a strategic manner to gain a competitive advantage [8].

It is to the organization’s advantage to incorporate into their decision of whether or not to outsource, the strategic impact outsourcing is likely to have on business goals. In the past, companies have typically looked for “operational vendors”, or those to take over day to day operations of a particular area to achieve a cost reduction. However, one of the dangers of such an arrangement is that, if allowed, a vendor will likely “pick the low lying fruit” themselves. That is, they will make the deep cost cuts that the client organization could possibly have otherwise done themselves. Except that if it is the vendor making the cuts, it will also likely be the one to reap most of the financial savings [28]. Because of this, companies today are looking for “strategic partners”, or vendors that are capable of handling not just commodities, but areas of strategic importance [29].

Part III: Considerations

Outsource or Offshore?

With regards to IT, the terms “outsource” and “offshore” can be hard to distinguish. This paper chiefly focuses on the decision to outsource: To take an IT process and send the work and cost to another company in the attempt to cut cost or focus on core strategy. “Offshore” is one specific implementation of outsourcing, that is, to send the work to a different continent (“off the shore” of North America) in order to cut costs. In general, the father away the project work is from the company, the easier it is to drive down hourly labor costs. Distance also creates communication delays, penalties, set up costs, conversion costs, and various other costs. The decision to offshore, near-shore (Canada or Mexico), in-shore (MidWest US), develop within the area, or simply augment local staff is beyond the scope of this paper, but this paper will discuss factors to determine if any of these types of outsourcing is viable, and which one holds the most promise.

Laying the Foundation

Once the decision of what areas of your organization are candidates for and the type of outsourcing that best suits your business goals, the first step of building that client-vendor relationship is the contract. As the basis of any outsourcing arrangement, the contract is going to play a central role in relationship to come between client and service provider. While the contract will always remain just a piece of paper that in and of itself will not get the work done, insure against failure or guarantee success, it will define how the client is going to work with the external service provider. The contract will provide the guidelines, stepping stones and structure that people will use to make the relationship work [30].

However, the contract is only the beginning. The importance and spirit of the outsourcing arrangement must filter down to the employees in the trenches performing the day-to-day work. As often happens at the beginning of an outsourcing arrangement, a great deal of tension may loom over the organization. Employees might feel that their jobs are at risk because of an outsourced project, and rightly so. Associates may have been laid off or their jobs transferred to the vendor as part of an outsourcing arrangement. Employees’ who formerly worked side-by-side under the same management and rules, might now still work together, but report to entirely separate management hierarchies. Associates may also be charged with working with others across geographic regions or languages. Because of this, jealously, competition and bitterness are only some of the emotional barriers that may provide obstacles to the harmony sought between client and vendor.

Williamson [31] believes that individuals also have only a limited capacity to process and store information, and as such, can, and do, choose what information to share with others in what he terms as “opportunistic”, or self-interest-seeking behavior. Further, Emerson [32] suggests that “in economic theory, decisions are made by actors not in response to, or in anticipation of, the decision of another party but in response to environmental parameters.” Given that a new outsourcing relationship may be cause for concern among staff, be seen as unwanted, or even traumatic, organizations should keep in mind that the contract alone cannot guarantee a successful relationship between its employees and the vendors.

Because of the inherent tension in a new outsourcing relationship, one of the challenges that every organization seeking to incorporate outsourcing into its business strategy is to do so in such a way that fosters an atmosphere where individuals are encouraged to get beyond simply following the letter of the contract and exchanging information on a limited or required basis and move to acting in the spirit of the contract and to a place of voluntary exchange of information [33].

Finally, one of the most dangerous aspects of an outsourcing contract and what often leads to the most conflict between outsourcer and vendor is what happens when things don’t go as planned. Since we all lack the ability to see into the future, how uncertainty is dealt with in the contract, or the inevitable incompleteness of the contract, can have a significant impact on an outsourcing arrangement. It was also identified by Nam, et al, as an issue as important to deciding whether or not to outsource as the IT organizational context and processes that are to be outsourced themselves [25].

What Do I Have to Lose?

The work of Nam et al and Insinga and Werle has shown that tighter alliances with vendors provide significant advantages over simply throwing it over the wall and hoping all goes well. A tighter integration between organization and vendor, by nature of the closeness of the relationship eases the above mentioned concerns. First, the close link between both parties reduces the loss of control along providing a larger degree of certainty that the vendor’s motivations remain in line with that of the outsourcer. Second, a tightly woven relationship helps to build a win-win relationship which fosters an environment where the vendor and internal staff are less likely to be at odds with one another view the other as a threat to their job security.

However, the price for tighter integration with the vendor can be just as steep as what there is to be gained. If part of your outsourcing strategy includes trying to gain a competitive advantage through a unique product, service or feature, outsourcing may be able to provide short-term benefits for an individual business. But over the long-term, strategic dependence on widely used standardized applications or practices can lead to the erosion of business distinctiveness [16].

Achieving a tighter integration with the vendor is also an expensive endeavor. The larger number of associates that will need to be involved, amplified by the amount of knowledge transfer that must occur equates to a soft cost that is often left unaccounted for when tallying the actual cost of outsourcing. The second half of that equation that is equally likely to be left off the balance sheet, as well as somewhat difficult to specifically ascertain is the inevitable cost of detaching an organization from a tightly coupled vendor. Functionality, knowledge and processes will need to be brought back in-house, staff will need to be retrained or new staff hired and familiarized with the processes.

An alliance relationship with a vendor, while optimally providing much needed strength and resources for both companies to become more profitable together, is also burdened with the increased rigidity of such a relationship. There are times when a single management hierarchy is a slow moving stream, difficult to change course. However, an alliance with a vendor has now doubled the bureaucracy to be waded through; and in the fast paced internet economy, sometimes speed to market is as important as the quality of the product that is eventually sold.

Part IV: Balancing the Budget

As with any strategic moves within an organization, outsourcing must be given serious consideration before it is implemented. Not doing the necessary homework could result in serious repercussions for the organization. However, before a decision is made to send a particular job or an entire IT process to an outside organization, there are some factors that should be measured to assess the impact of outsourcing. One key issue is an objective evaluation of the metrics that are used to calculate these factors, in particularly the more tangible metrics. Tangible benefits that can be measured include increase in productivity, quality, timeliness, cycle time, output and financial [34]. Intangible metrics can include measuring the affect of the corporate image within the public eye, employee morale and turnover. For example, an organization must clearly estimate the possible impact of bad publicity in today’s environment for off shoring (a type of outsourcing) IT jobs. Strategic decisions, while often made based primarily on the impact to the organization’s financial bottom line, should also include in the assessment the intangible impacts on the organization as well, especially over the long-term. This section concentrates on how to evaluate both the tangible and intangible impact outsourcing can have on an organization.

Predicting the Cost

Unlike a few years ago, competitive organizations are not throwing money at the latest technological revolution or the next “cutting edge” technology. Today organizations put a heavy importance in evaluating the financial impact of technology. By analyzing the following factors it is possible to derive this conclusion. 1) Today CFO’s and corporate finances are playing a larger role in determining the need of a technological acquisition within their organization [35]. 2) Technology vendors like SUN and Cisco are emphasize TCO and ROI in marketing their products [36]. For example, SUN strrives to develop technologies to reduce the total cost of ownership for users of its servers [37]. 3) Boards are demanding hard numbers when trying to make a decision on whether to make an IT investment on not. According to Jeff Stewart, CFO at Clarkston, “These days our board won’t even entertain an offer for a large project unless the return on investment [ROI] looks absolutely solid” [35].

Outsourcing is a serious investment that requires large expenditures. According to Gartner, Inc., “As enterprises look to move from internal to outsourced IT service delivery, the cost associated with conducting a formal evaluation and making the transition to an external service provider (ESP) can be high [38].” As cost savings is seen “as the number one reason as to why global companies outsource work” [39], it is important for organizations to make sure that the cost of outsourcing justifies the benefits gained from it. This section will evaluate some of the metrics in detail that can be used in determining the cost of outsourcing.

ROI

ROI “…remains one of the most commonly used metrics” in the industry today to measure the value of an IT project [40]. ROI measures the profit or cost savings realized for a given use of money in an enterprise. This is calculated by measuring for a given time period, the investment made and the resulting profit created through that investment [41]. It answers the question, “If we pay for this, what do we get for our money [42]?” Return on Investment (ROI) is significantly important when large cost is associated with the investment. According to Mitch Betts, director of Computerworld’s Knowledge Centers, “Doing … [ROI] is especially important for projects that have million-dollar price tags. On the other hand, it may be overkill for projects so small that the ROI exercise would be more expensive than the project itself [43].”

Calculating ROI forces an organization to look at the impact outsourcing could have in each area of the organization and come up with hard numbers. According to

Carmen Barrett, director of planning and analysis for Tech Republic, “The reason that it’s so popular to look at IT projects [by ROI] is because it boils everything down into similar metrics, so everybody gets a percentage ROI, and it’s really easy to compare different projects [42].”

The decision whether to outsource is being made, an organization cannot solely depend on ROI as a cost metric. Some of its drawbacks are that it doesn’t take into consideration risks and it cannot calculate intangibles [36]. Also according to Barrett, ROI favors cost-saving projects compared to revenue-generating projects [42]. Some of the alternatives available to ROI are TCO and Payback period.

TCO

Total Cost of Ownership (TCO) is a type of calculation designed to help consumers and enterprise managers assess both direct and indirect costs and benefits related to the purchase of any IT component. The intention is to arrive at a final figure that will reflect the effective cost of purchase, all things considered [41]. By calculating TCO, organizations are forced to evaluate the ongoing expenses related to a product or service purchase, such as outsourcing. As shown in figure 3.1, TCO calculates the costs that are acquired beyond the fees of outsourcing. An organization has to evaluate specific criteria’s that could add expense to the outsourcing project as well as calculate the ongoing expenses that will be there throughout the lifetime of the contract.

Payback Period

Payback period calculates the length of time required to recover the cost of an investment [44]. It gives the decision makers a general idea when they will be able to break even. This is valuable as shorter payback period would allow the organization to make decisions to change their path of investment if it turns out to the wrong the direction. With outsourcing, if the company is not pleased with the direction that the outsourcing is taking, they can change their direction with less economic impact. The smaller the payback period the better it is for the organization in this case.

Calculating the Intangibles

Specialized knowledge

In today’s ever changing technological environment staying on top of the cutting edge technology and having knowledge of the latest tools are a must to successfully take

advantage of them to use it strategically. Having specialized knowledge in house could be very expensive and futile, since new technologies come about very often. In these situations outsourcing makes a lot of sense. For example, GM determines what technology they would like to take advantage of based on their business needs and then allows three or four organizations to bid on that project. This allows focusing on their business needs and not worrying whether they have technological specialization in house [45].

Organizational reputation

These days it is a very sensitive topic especially when it comes to off-shoring. With extensive media coverage on the topic, the organization has to ensure that the benefit of outsourcing outweighs potential negative reputation effects of being resented by customers or bad publicity. Lou Dobbs, host of CNN’s Lou Dobbs tonight, an ardent critic of the current state of off shoring, maintains an ‘Exporting America’ list on his web-site. According to his web-site, the list contains the names of companies that are off-shoring or employing “cheap overseas labor, instead of American workers” [46].

Management of Human Resources

An organization has real incentives to keep their own human resources happy and appreciated. Low morale has an adverse effect on productivity and the overall success of an organization. If employees start to suspect that their jobs are in real danger of being replaced that could lead to productivity losses, resentment and rebellion. Employees who worry about their job stability would not be able to direct all their attention to their work load [47]. Also, it is in the best interest of an organization not to lose those people who are some of the organization’s greatest assets because they feel their jobs are insecure. Also, there could be real problems if there is company wide resentment and rebellion as a result of outsourcing. To avoid these problems an organization must communicate effectively with their employees.

In the process of making the decision to outsource, an organization has to carefully analyze costs. Both tangible and intangible costs associated with this process. Tangible costs have to be measured and evaluated using standard cost analysis metrics. Intangible costs are just as important and overlooking them can often lead to losses in the long run. Certain intangible costs were discussed and the dangers of ignoring them were evaluated. Companies must give serious consideration and carefully evaluate both types of costs when a decision is being made to outsource.

Conclusion

The issue of IT outsourcing is currently controversial. Emotions and fear run on both sides of the issue, from “Outsourcing is costing American jobs” to “We have to outsource to even remain in this industry.” The real question is not one of emotional fervor but one of business: Does outsourcing IT make sense?

If IT truly is a commodity, like gasoline, electricity, or the railroad, then companies will only compete on price, with very small margin. In that event, the decision to turn over IT to an outsourcer is as simple as it was to turn to a natural gas provider instead of burning coal ninety years ago. However, while personal computers and the networks they run on may be standardized, the services provided by IT shops vary much more than that: Data Analysis, Application Development, and IT Decision making may allow companies to be competitive in way their competitors are not. In that case, those elements of IT are far from commodities.

It is also wise to consider the level of involvement and integration between the organization and the vendor. The more tightly coupled and aligned the business partners are, the more the relationship can benefit both parties. However, the larger the entity, the slower it moves. If part of an organization’s strategic advantage is responding quickly to changes in the market, the lack of flexibility inherent in large outsourcing contracts may do more harm than good.

Soft costs should also not be forgotten: Ramp up time, knowledge transfer, human capital and the vendor selection process are all very real costs in the outsourcing equation that should not be taken lightly. As organizations are in the process of making a strategic decision on outsourcing, it is important to calculate the costs that are associated with the process. These costs can be calculated both as tangibles and intangibles. Decision makers in these organizations have to come up with tangible numbers to justify the investment associated with outsourcing by using cost analysis metrics. Some of these metrics are ROI,

TCO and Payback period. It is just as important to evaluate the intangible costs as the hourly rate stipulated in the contract. Ignoring the intangibles can often lead to failure of the process and huge tangible loss for the organization. Before a decision on outsourcing is made, these factors must be taken into serious consideration to evaluate if the cost justifies the investment of resources.

Once a company has decided how to fit outsourcing into the picture and what it can outsource, it must consider the tough question of “what makes sense to outsource?” These elements can then be sent to a sourcing provider. The elements of IT that remain then either can not be outsourced or do not make sense to outsource – in other words, they are not mature, standardized products, and a company can still gain competitive advantage from them. CIO magazine once stated that 43% of companies outsource IT to cut costs, which is an appropriate way to manage commodities [19]. Another 35% of companies surveyed outsource IT to “focus on core competencies.” To paraphrase Sir Arthur Conan Doyle: Once you eliminate the areas of IT that are standard and can not add to competitive edge, whatever remains is the strategic advantage IT can offer the organization.

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