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Outsourcing IT
Ken Peffers
UNLV
November 2004
“Sell the mailroom.” Peter Drucker, 1989, WSJ
Outsourcing Data
• 14.8% of operations outsourced as of 2001
• Outsourcing growing at 19.6% per year
• IT 10% of global outsourcing
Outsourcing Not New
• Outsourcing and Vertical Integration– Auto manufacturer buys side view mirrors from
independent parts supplier– Firm with low levels of vertical integration does a lot of
outsourcing
• IS outsourcing– 1960’s computer service bureaus– IBM mainframe leasing and service 1960s to 1980’s – ADP payroll services
• Kodak– Technology firm outsourced all of its IT services
Outsourcing in all areas, but mostly in operations. Then IT.
Focus on service industries, but also manufacturing. Service industries have low levels of “specific assets.”
Focus in the US, but growing elsewhere.
OUTSOURCING
CONTRACTING:• COMPUTER CENTER OPERATIONS• TELECOMMUNICATIONS NETWORKS• APPLICATION DEVELOPMENT
TO EXTERNAL VENDORS• The most generic functions in the organization.
*
OUTSOURCING
WHEN TO OUTSOURCE:• IF FIRM WON’T DISTINGUISH ITSELF
BY DEVELOPING APPLICATION• IF PREDICTABILITY OF
UNINTERRUPTED SERVICE NOT IMPORTANT
• IF EXISTING SYSTEM IS LIMITED, INEFFECTIVE, INFERIOR
Sourcing Alternatives
• Development
• Development and Operation
• Operation
• Service
Development
• Obtain resources unavailable within firm
• Obtain additional resources
Development and operation
• Focus on core competencies
• Management attention
Operation
• Obtain operational expertise
• Reduce costs
Service
• Avoid investment in non-strategic activities
• Reduce costs
• Achieve superior service
Outsourcing Types
• Total outsourcing
• Joint venture/strategic alliance sourcing
• Multi-supplier sourcing
• Insourcing
Total Outsourcing
• Outsource 70% or more of IT to single supplier
• Long term contract
• Partnership between vendor and client
Total Outsourcing motivation
• Enable client to concentrate on core business
• Client recoups capital investment from sale of IT assets
• IT perceived as support function
• Eliminate IT function
• For what kind of firm might this make sense?
Multiple-supplier sourcing
• Contracts with a variety of suppliers• Outsourcing as commercial relationship• Medium term contracts• Suppliers compete for the business• Fixed costs become variable costs• Difficulties in managing a variety of
contracts• Organic outsourcing
Joint Venture/Strategic Alliance
• Shared risks and rewards
• Create new company as supplier
• Reduced risks of single supplier or multiple supplier
• Client owns large share in supplier
Insourcing
• Retain large IT staff in-house
• Short term contracts for some staff to manage variance in personnel needs
Risks
• Total outsourcing particularly risky (80% of IT budget outsourced)– Of 116 outsourced contracts
• 38% successful• 35% failures• 27% mixed results
– For selective outsourcing (15-25% of IT budget outsourced)
• 77% successful• 20% failures• 3% mixed results
Why Is Outsourcing So Difficult?
• Technology changing at the rate of 20% per year
• Normal outsourcing arrangement for 10 years
• Needs of the parties change
Cash flow
• For customer– High positive first year– Increasingly negative– Value decreasing
• For vendor– High negative first year from buyout and from
start up costs– Becomes positive just when customer is
asking for new services
In Retrospect
• Outsourcing in the form of service bureaus – Cost effective access to specialized
development skills and services– Avoid building in-house IT– Access to specialized functionality
Current Outsourcing Environment
• Acceptance of alliances– Alliances allow firms to complement
capabilities in their firms
• IT’s changing role– IT as integration tool
• Most software has always been outsourced
Outsourcing Drivers
• Costs and quality
• IT failure
• Growth of the industry
• Cash flow
• Corporate culture
Outsource vendors can improve costs and quality
• Leaner organizations• Geographically distributed sourcing• Higher staff performance standards• Better purchasing• Capacity use• Software license utilization• Management of performance• Access to higher skill levels
IT Failures
• Cumulative neglect of systems development may lead to systems that need to be saved
Growth of the Industry
• Outsource vendors that can handle large scale total outsource arrangements
Cash Flow
• Liquidate firms IT assets
• From fixed costs to variable costs
• Easier to manage real money costs than soft money internal costs
• Prepare parts of the firm for divesture
Corporate Culture
• An outsourcing vendor can act outside the corporate culture– Centralization– HR
• Eliminate an internal irritant
When to Outsource
• Position on the strategic grid– Support, Factory: yes– Turnaround, strategic: Mixed
Support
• Reduce risks of inappropriate technology
• Access current technologies
• Access to professionalism
Factory
• Economies of scale
• Higher quality service and backup
Turnaround
• Internal IT lacks capability
• Internal IT lacks PM skills
Strategic
• Rescue
• Cash flow
• Mgmt of divesture
• Access to technology
Development Portfolio
• Well structured? Outsource
Firm’s IT circumstances
• Laggard? May have no choice but to outsource
How to Manage
• Contract flexibility– Contracts written to allow for evolution
• Selecting areas to outsource– Separability of the function– Requirements for specialized skills– Centrality of the functions to strategy
• Supplier Stability and Quality– Outsourcing hard to reverse– Technology incompatibility– Management fit
Managing the Alliance
• The CIO function– Partnership management
• Performance • Issues
– Long term architecture planning– Emerging technologies– Continual learning for users
• 5% of the outsourced organization?
Customer Vendor Interface
• Oversight can’t be delegated outside the firm– Full time relationship managers for both
customer and vendor
• Coordinating groups to work with narrow issues
Contributing reasons for failure
• Treating IT as undifferentiated commodity• Incomplete contracting• Lack of active management of the supplier• Failure to build and retain in-house skills• Power asymmetries accruing to supplier• Difficulties in adapting deals to changing conditions• Lack of contracting experience• Outsourcing for short term financial restructuring or cash
injection• Multiple objectives with unrealistic expectations• Poor sourcing
Treating IT as an undifferentiated commodity
– Differentiate between what is core to the firm and what is a commodity.
– Keep core processes inside the firm. Retain business knowledge and logic
– Be clear about what IT, if any, provides a strategic advantage
Vendor Selection and Contracting
• Be clear about the vendor requirements for experience, resources, etc.
• Quality of resource critical, more so than cost. Lowest bid selection invites opportunistic behavior
• Understand the systems to be outsourced• Stable systems first, then outsource• All development has a business case and
approved by senior management• At Polaris they invited competitive bids and
compared them with the in-house capability
Incomplete Contracting
• Complete contract
• 3-5 year initial contract
• Regular review
• Notice thereafter
• ‘Smooth termination’ guarantees
• At Polaris, 3.5 year contract, renewable
Active Supplier Management
• Internal staff assigned to monitor supplier performance– Daily performance management– Regular management reviews
Retaining Essential IT Resources
• Core IS capabilities necessary to run any IT sourcing regime effectively– Relationship building– Business systems thinking– Technical architecture– Technology adaptation– IT governance– Informed buying capabilities– IT strategy
• Polaris retains substantial IT staff– In-house technology experts– Business logic and knowledge
Unrealistic Expectations
• Careful delineation of what can be achieved by outsourcing
Power Asymmetries
• Stable software makes switching costs lower
• Retained ownership of software assets and data
• Carefully delineated performance expectations
Lack of Contracting Experience
• Staged 3 to 7 year contract
• Competitive price terms
• Keep key capabilities in-house
Offshore Outsourcing
• Politically charged• Trend toward increasing offshore outsourcing• Driving force—supply chain needs
– 95% of customers live outside of the US– Large proportion of potential personnel resources live
outside the US– Variance in skills and wage rages invites locating
activities where there is a competitive advantage– Low wage rates in LDCs
Offshoring costs
• Vendor selection– Probably requires extensive due diligence– May require one or more trips– Contracting culture differences
• Transition costs– Travel and training.
• Managing an offshore contract– Control– Invoicing
• Site costs, infrastructure, etc.
Intangible offshoring costs
• Coordination– Communication lags
• Not across the hall• Time zone differences
– Travel• Loss of Proximity costs
– Creativity• Culture
– Power distance– Willingness to speak up
• Risk to reputation– Customer facing services