Opinion: does outsourcing add up?

The root cause of why so many organisations are experiencing problems with outsourcing is not badly written contracts, poor relationship management, lack of supplier proactivity and flexibility, disappointing quality of services or hidden costs.

The root cause of why so many organisations are experiencing problems with outsourcing is not badly written contracts, poor relationship management, lack of supplier proactivity and flexibility, disappointing quality of services or hidden costs.

These are only the symptoms of a deeper problem. Quite simply, the economics of many outsourcing transactions are fundamentally flawed and will never yield what the customers are seeking, however hard everyone involved tries.

The classic reasons for outsourcing are to reduce costs, improve quality, save management time and to effect transformations. Simply because a customer wants these, it does not mean they are possible.

Early successes

The early deals were often effective for two reasons: they eliminated waste and exploited economies of scale realisable in mainframe operations. But those days are gone.

Any sensible prospect for outsourcing will get their house in order, so eliminating waste, before approaching the market, and mainframes have given way to server technology which does not lend itself in the same way to economies of scale.

The IT industry has achieved phenomenal economies of scale and reduced the unit cost of hardware and communications dramatically.

Complex software is now available at high street prices, specialist suppliers have reduced the cost of maintenance and support because of their geographical spread, and others are providing services such as disaster recovery more cost effectively than in-house operations could by sharing costs among users.

This left in-house facilities and now outsourcing suppliers with the highly labour-intensive tasks, most of which are not amenable to economies of scale.

Purely increasing scale does not bring economies of scale. They rely on being able to spread costs which do not vary with volume (fixed costs) over a greater volume.

However, economies of scale level off unless investments are repeatedly made in technology to shift more of the variable cost into the fixed base.

This is how the phenomenal economies of scale mentioned above were achieved, through massive investments in chip plants, infrastructure and software developments spread over hundreds of millions of units and squeezing labour costs. In these cases the marginal cost of producing each additional unit is now insignificant.

This does not apply to bespoke application maintenance, helpdesk services, technical support in a mixed server environment, or most other IT services which have been outsourced. The marginal unit cost is still significant (just check the contract).

This makes it impossible for outsourcing suppliers to make savings over what can be achieved by effective in-house management.

Further, the difference between what suppliers' staff are paid and what the user is charged for them makes the greatest contribution to suppliers' profits.

They make little margin on hardware and software because where they try to, smart customers would insist on sourcing these themselves.

So suppliers now have a disincentive to shift their labour costs (which increase with volumes of work) into fixed costs based on technology because their profits would simply evaporate.

This explains why so many users complain about lack of proactivity and flexibility with their outsourcing deals. The suppliers prefer the status quo. Also, all suppliers face the same dilemma, so changing suppliers will not alter the economics.

Insourcing offers an answer

The only way to alter the economics is to insource and cut out any of the suppliers' profit and management costs that arise purely from outsourcing. Insourcing projects cost a lot less than outsourcing and the subsequent reductions in running costs can be very substantial.

As an example, one prominent organisation reduced its IT costs to a third and improved its services by a factor of six by insourcing.

But there are cases where outsourcing can yield benefits, such as offshoring or in organisations that have small budgets but require a wide range expertise from time to time.

Specialist services where suppliers have invested in technology, such as application-specific software to reduce labour costs, can also deliver benefits.

Chris Tiernan is chairman of the Institute for the Management of Information Systems and managing partner at Grosvenor Consultancy Services

 

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