IT outsourcing:
Carving the Right Strategy Sara Cullen and Leslie Willcocks
Sara Cullen and Leslie Willcocks

<Learning Curve> > Managing IT Outsourcing >Adopting the right mix of models to reach strategic goals >Deciding on the outsourcing approach

Information technology outsourcing (ITO) has enabled organizations to survive the pace of change in the new economy at a time when business activities need to be focused on the right activities and resources need to be kept lean and aligned with the core business. From late 2000, as economies moved into a more recessionary climate, a renewed emphasis on cost savings followed with increased interest in ITO which is all about handing over IT activities and assets to third party management for monitored outcome.
Significantly, ITO has survived the five-year period typical of a management fad and is now regarded as a standard IT management tool. As such, global market revenues have increased from $US 9 billion in 1990 to $US 154 billion by 2004 and an increase to $US 190+ billion has been projected by 2006. Looking at the IT budget of the average corporation or Government agency, it is reckoned that by the end of 2001 some 72 per cent was still being spent on in-house IT, the rest on IT outsourcing, including three per cent on Business process Outsourcing (BPO) and three per cent on offshore outsourcing. Extrapolating global trends, it is likely by 2005 for IT outsourcing to represent 33 per cent of the average IT budget, with offshore outsourcing taking up another 10 per cent and BPO a further 15 per cent. Other sources reveal that half of the organizations across the globe are outsourcing at least 20 per cent of the IT budgets.
Accordingly, in the face of such developments and the unpredictable challenges ahead, managing ITO arrangements and conducting the ITO lifecycle have become one of the essential competencies for IT managers. On our conservative figures alone, it is very clear that, when majority of an organization’s IT spend is with the market, the average corporation has to be very good at its ability to manage outsourcing Information Technology. (See box: Managing it well) And, as in any other job, carving out the right strategies is crucial to effective outsourcing. It structures the game plan and sets the vision regarding the use of ITO within the organization along with overarching strategic preferences.

Managing it well

After failing to attract any outside customers to its commercialized IT services division, an international manufacturer of technology components decided to outsource the operations and concentrate on core business. It was not going to be a major outsourcing deal, but still worth millions per year to a supplier. Because of the moderate size, the organization had originally intended to invite only the second tier suppliers, ignoring the major international companies. It was management’s understanding that a contract would need to be worth hundreds of millions of dollars to gain the attention and focus that the organization wanted of its supplier. However, the forthcoming opportunity hit the industry grapevine and the majors were able to convince management that this belief was unfounded. After a competitive process, one of the majors won the deal and the relationship has been deemed quite successful, even years after the honeymoon.

High-level sourcing decision models for opting the right strategy
Before delving deep into the process, it is important to acknowledge the different outsourcing models and choose the right mix of models to deliver on the strategic goals the organization seeks through outsourcing. There are many forms of outsourcing and many ways to employ it strategically as a management tool.
There are three high-level decision making frameworks that have been successfully employed by numerous organizations to determine the nature of the services best retained and those that should be investigated for outsourcing. The objective here is to provide a tool-kit for making high-level strategic sourcing decisions. The three are:
1. MCA model - it provides a framework for the organization to consider its competence relative to its peers, the maturity of the market providing the services and the degree to which activities are core/non-core.
2. Decision tree - it provides a process of elimination for options other than outsourcing to consider.
3. Models of outsourcing - it provides a framework to consider twelve different methods of outsourcing

MCA (Market, Competence and Advantage) model
The prevailing view is that an organization can let go of commodity functions, but must not let suppliers get their hands on strategic areas. Others call that nonsense, use third parties where possible, just do it smart. The spiral arguments result from generalizations inappropriate on either side.
Outsourcing any part of an organization fundamentally implies an in-depth understanding of the core-competencies on which the organization intends to build its future competitive advantage. Outsourcing segments of the IT infrastructure implies an in-depth understanding of what IT means to the organization and how it intends to use IT to build its competitive advantage. A ‘helicopter’ model that is useful at high level is one that has been developed, called the MCA Model. (See box: MCA strategic Sourcing Model) In this model, three dimensions are considered:
1. The maturity of the suppliers and the market in the relevant geographies - does the IT activity have a sustainable competitive market? How mature is it?
2. The organization’s relative competence in the service area - how good is the organization at the services relative to competitors, other organization, and the market in general in terms of effectiveness, cost and value? Is the organization world-class or a market leader in this activity?
3. The importance of the service in terms of its contribution to the organization’s competitive advantage - what IT-related activity is critical to build and sustain competitive advantage now and in the future? Is it the outcome of that activity that create the advantage (output) or the process of doing the activity (experience)?
In the MCA strategic Sourcing Model, three things need to be analyzed:

1. Look at the maturity of the market
If the market is mature with many suppliers, can the organization exploit it to achieve significant business leverage? Is the organization vertically integrated for historical rather than strategic reasons? If the market is mature, a conventional arrangement can be the starting point.
If the market is immature (few suppliers or immature capabilities), a greater degree of control is required to ensure ongoing benefits, to accelerate the market’s capabilities, and to have alternative competitive supply; hence a more controlled style of outsourcing is required. Control can be obtained through numerous means - for example, split portfolio outsourcing (use of more than one supplier), joint ventures, outsourcing one part, and packaging further part for competitive bid at a later stage but offering the incumbent supplier the first bid for this subsequent work. Another alternative, if you are more competent in an IT activity in terms of cost and capability than the market, is to keep this in-house for the meantime and look to outsource later when the market has caught up on performance.

2. Look at the organization’s relative competence
Are there activities that can deliver competitive advantage but the organization does not possess the competence? Strategic sourcing can bring that competence to the organization, but it will need to design the arrangement to transfer the requisite knowledge while keeping its options open for in-house sourcing as its relative competence grows. If the competence is the key contributor to competitive advantage we recommend that the market be used on a ‘buy-in’ or ‘in-source’ basis - that is placing those external resources under active in-house management control.
Does the organization have at least a tenable position in competitive advantage activities where the market is not mature? The organization will want to retain these services in-house and not let its competitors have access via suppliers. It may also choose to buy in external competencies to work under in-house management control and facilitate transfer of learning in order to build the competence further. However, some organizations use this superiority to offer value to other organizations through commercializing the in-house activity. This can be seen, for example, with development shops in the UK National Health Service, while Philips Electronics over several years helped to form Origin to sell its development and operational IT capability on the IT services market.

3. Look at activities not critical for competitive advantage
If an activity is not creating competitive advantage, is the organization overly investing in it? It still may be critical to strategic direction. For example, aircraft maintenance systems at British Airways give no advantage, but are a minimum requirement to compete in the airlines sector - a critical commodity but not a critical differentiator. There may be better investments an organization can make with its human/asset capital for greater effect. In fact, retaining marginal, or even critical commodity, activities may result in competitive disadvantage if competitors are leveraging scarce resources better. Being the best at non-advantage activities is easy to be proud of but should the organization’s best be at something else?
If the organization is at least competent at a non-core IT activity, it may have unlocked value that can be realized through a sale of the function, then could use an outsourcing contract to provide ongoing service. The market maturity will then drive the type of outsourcing model needed - whether it is controlled or conventional.

Decision tree
This decision tree starts out with a fresh look at what the organization is doing with high-level re-engineering. It then suggests alternatives such as:
>Discontinuing the services altogether, if no longer required
>Outsourcing if the organization itself does not need to perform the services, but instead can be more effective by purchasing the outputs.
>Internal performance improvement if the organization must perform the services itself or cannot obtain value for money from a competitive market.
The outsourcing decision tree provides a tool for logically thinking through the decision process (See box: Sourcing decision tree). It begins by taking into account the future strategies, plans and budgets for IT within the organization, as does any outsourcing strategy. It then leads the decision-makers through a process to determine the responses to the questions like: Are there activities not required in the future? Can the organization be more effective performing the activity or using the output? Is there potential for a monopolistic supplier market? Can the organization control the monopolistic characteristics of the potential supplier market? Will the market deliver better value for money? Does the organization have the strategies and management skills in place?
(See: When a detailed analysis is short-circuited).

When a detailed analysis is short-circuited

The IT helpdesk of the agency was outsourced to a contract labor organization in an attempt to improve user satisfaction and promote new professional ways of working. However, unbeknownst to management at the same time, the nature of the calls to the helpdesk were very specific to the organization and required detailed knowledge, not only of the systems, but of the process of law enforcement. It took about six months to get the helpdesk fully operational and then the officers were redeployed and the labor firm took over full operations. The agency signed a one-year agreement, as it wanted to be able to competitively render frequently to ensure low cost service delivery. During the next round of tendering, the agency discovered it had created a monopoly due to the very specific nature of the knowledge the incumbent supplier now had. No bid came close to the incumbent supplier that had doubled its price in the tender.

Modes of outsourcing
A plethora of sourcing options are available and it is needful to know which ones have a better track record than the others. There are a number of options (some of which have been detailed hereunder) that can be used selectively or as a part of the outsourcing deal.
>Transitional outsourcing - handing over legacy systems to enable in-house focus on building the new IT world. Generally an effective low risk use of the market.
>Value-added outsourcing - combining client and vendor strengths in order to market IT products or services commercially. Nice, logical idea, but in practice such components of a larger IT outsourcing deal have been too small to attract priority attention. Moreover, implementation looks a lot less attractive when it realized that it requires nine times the initial development costs to commercialize a product or service and there are no guaranteed paybacks in a competitive market.
>Co-sourcing - a term coined by EDS whereby a supplier takes over an activity or works with a client on it and gets paid for improvements in the client’s business results. This is a mixed record because many factors can affect supplier performance that may well be out of its control; also, suppliers’ culture have not always been set up to work in this way.
> Multiple suppliers - the preferred option by most client organizations. It follows a ‘horses for courses’, ‘best-of-breed’ logic and spreads risk. At the same time there are additional transaction and management cost incurred by taking the multiple supplier route. Probably needs each supplier to be managed individually as companies like BP exploration and Dupont have not always found suppliers managing each other the most productive arrangement.
>Spin-offs - creating a separate company out of an effective IT function, and allowing it to sell its services on the open market, as well as back to the original host company. EDS grew out of General Motors in this way. With a Dutch software house, Philips created Origin that proved fairly successful during the 1990s. The general record is not a good one, however. It takes a lot of new marketing, customer focused and financial skills to commercialize an IT department, and the market is very competitive indeed for those with no previous track record.
>Application service provision / ‘netsourcing’ - renting applications, services and infrastructure over networks. Web services are the potential means to an expansion in this market, although its development was put on hold during the recession beginning in late 2000. This model has a compelling logic. Once the technology is sorted out and suppliers can find a winning business model that will attract customers on an upswing in the economy.
>Business Process Outsourcing - in cost-pressured economies, a fast-growing market in 2003/3 because of the latent cost reductions inherent in streamlining indifferently managed back-offices and business processes and applying IT to the result. However, the market is still developing, with some good niche players and start-ups, but no supplier yet looks able to service all a customer’s business process needs. Beware of supply chains here, since many have been all too quick to jump into a potential growth area in an otherwise weak IT climate. Check that the marketing is matched by capabilities.
>Backsourcing - bringing aspects of IT back in-house after originally outsourcing them. Thus Lend Lease Corporation brought back aspects of systems development several years into a long term deal with IBM Global Services. East Midlands Electricity actually cancelled its 1992 12-year deal with Perot Systems in 1999, taking advantage of a clause permitting cancellation in the event of a merger (it merged with Powergen that year). From 1995 it had refined the importance of IT to the business and began rebuilding its in-house skills. More often there is a steady creep back, as a result of changing requirements ad contexts or from a realization that the activity was in fact better positioned in-house all along.
>Shared services - for example in accounting services or e-procurement exchanges. Here, several customers identify a non-competitive area worth outsourcing together to the same supplier. Thus seven oil companies outsourced accounting administration to Accenture, based in Aberdeen, Scotland. The aim here is to achieve significant cost reductions through economies of scale.
>Offshore outsourcing - sometimes billed as ‘cheaper, quicker, better’, suppliers in the market have been moving aggressively, with India cornering over 80 per cent of the revenues by 2002, but with Russia and China, amongst others, beginning to position themselves to take care of the market. Initially focused on programming and low-level technical activity in which off-shore economies had a significant labor cost advantage, the bigger players show an ability to move up the IT value chain quickly, including developing high quality technical skill bases. Management and transaction costs can be higher with this form of outsourcing, however. Some companies have already established ‘near shore’ operations in customer countries, while some IT suppliers and customers have themselves established facilities in developing economies.
>Joint venture - client and supplier establishing a third entity through which to resource and share risks and rewards. For example, FI Group and the Royal Bank of Scotland established the jointly owned First Banking Systems in 1999. It was given a budget of 150 million pounds over five years to develop commercial software and manage IT planning and architecture. It was actually terminated in 2002. In 2001-02 in the Business Process Outsourcing market Xchanging took a modified model and created four enterprises with three clients to commercialize their back offices.
Decide the outsourcing approach

Requirements to be effective

The firm should re-engineer practices and work flows to make it work. >Management should be more strategically involved due to impact. >The firm should be ‘outsourcing ready’ - it must be an expert or get expertise.

There is no single approach to outsourcing. In practice, organizations use different approaches and, typically, in a hybrid fashion. The important issue is that the approach is determined as part of a carefully crafted strategy, rather than one that occurred haphazardly. There are primarily three approaches that are used both effectively and ineffectively at different times over the last decade and they are: Big bang, Piecemeal and Incremental

Big Bang
Significant portions of all activities are outsourced at one time; reported often in the media but less used in practice

Strength:
More interest from suppliers due to potential revenue; centralized program and lower coordination costs; management more strategically involved; enables organization wide learning.

Weakness:

Requirements to be effective

There should be an organization-wide mechanism for sharing best practices and lessons learnt >Service interdependencies should be well understood >Completely unambiguous responsibilities should be defined between all parties >Contracts require innovation options in the event that re-bundling or unbundling can achieve greater efficiency and effectiveness at later stages.

Greater risk and impact; resource intensive; more stakeholders; can attract public attention; complex and requires significant management; supplier may not have all requisite skills.
Piecemeal
Each activity is outsourced independently over time and a variety of suppliers are used; most common approach, but often by default rather than by design.

Strength:
Best supplier and price obtained for each outsourced activity over time; staggers risk of disruption; solve needs as they arise; less complexity, thus manageable at lower levels; can incorporate lessons into future deals, if knowledge is shared.

Requirements to be effective

>Should be managed as a continuous programme >Organization should have clear understanding of what services will be subject to further outsourcing >Requires commitment to further outsourcing or lose commitment from supplier(s). >Each deal should be designed to include the lessons learnt from the previous projects >Requires outsourcing escalation criteria

Weakness:
May not be best value overall, over time; high coordination costs and duplication effort; synergies difficult; adversity between suppliers and blaming at interface points; isolated lessons; less able to attract major suppliers.
Incremental
One or more suppliers are selected for pilot project(s) with planned escalation of outsourcing; escalation occurs if preceding outsourcing is successful.

Strength:
Immediate needs met through pilots; staged approach and evolved prototyping - the organization and supplier improve each addition; supplier has incentive to prove itself to obtain more work; attracts interest from suppliers due to potential revenue stream.

Weakness:
Longer time frame; supplier likely to continuously seek escalation of outsourcing irrespective of organization’s readiness; maintaining momentum
Information Technology outsourcing can deliver benefits to any organization, but these benefits are not inherent in the act of outsourcing. Outsourcing is not a transaction led by a contract. Rather, it is an ongoing commercial relationship supported by a number of governance mechanisms. And to realize the full value of it, it is needful to know well the art of war and to have an impeccable game plan by carving out the right strategy.

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