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

Mitigating Sourcing Risks at Polaris Polaris set up in 1993 by 7 UK insurance companies Cooperate on major systems for insurance underwriting After several years Polaris acting more like software house No clear objectives Expensive No longer meeting business needs Solution: outsource Polaris

Outsourcing Polaris to Logica Contract signed to 7 year renewable contract $22 million Scope of contract –Applications management –Helpdesk –Training –Software development –Maintenance –Consulting

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