Many corporate and business customers still think outsourcing means the payroll division to a third party. The sector has encroached upon almost every business process, with the drive to make up the skills shortfall overtaking the issue of cost. signing their data centre and payroll system over to a superannuated mainframe manufacturer and forgetting all about it for the next seven years.
But organisations can outsource almost anything they want - the more the merrier, say some experts - and not just out of a conviction that a hard-nosed facilities management supplier would squeeze more productivity from its staff and equipment for a lower cost.
According to Hugh Morris, global managing partner at Andersen Consulting business process management, the market is increasingly moving away from the simple concept of cost.
'Cost reduction was a component at one stage, driven by some executive frustration about the amount of money that went into IT compared with the benefit that came out of it,' he says. 'But now there's an increasing desire to obtain access to skills which people can't provide efficiently in-house, or even at all in an increasingly dynamic IT world. To compete, they want the best of breed in everything, including IT.'
Added to this is the so-called core and chore divide - a move to concentrate core business activities by handing over the running of chore functions, such as IT. 'Companies need to focus on their key business activities and not have their management's attention diverted to non-core areas,' says Andy Embling, marketing director of outsourcing at ICL.
Not only do organisations get to focus on their core business, but outsourcing suppliers will focus on their core business, which is design-ing and running IT systems, probably more efficiently than the in-house IT department.
Suppliers are also better able to keep abreast of developments in technology, so customers often leave the detail of the technological implementation to them, concentrating just on specifying the business outputs of the systems.
Outsourcing enables the business to do things such as electronic data interchange (EDI) or internet-based trading, which would otherwise be beyond its capabilities, either because it lacks the expertise or because of the big investment in equipment and staff they would need.
The outsourcing specialists should be able to improve on the performance and service levels of in-house people, not only because they are IT experts, but because there is a contract which says they have to. A leading utility company turned the running of its telecoms department to ICL, despite the fact that it was performing reasonably well. 'Customers may get a better service from us or they may not,' says Embling. 'But if not, they can sue us. You try suing your in-house comms department.'
Although cash remains important, particularly in the cost-conscious public sector, it is not just a question of saving money. Outsourcing should be able to achieve this through increased efficiency and economies of scale, but there are more benefits. There are hidden costs in IT which an outsourcing deal with an obvious bottom line will bring out into the open.
'Organisations have more control, not only because they can measure it, but because they're obliged to measure it,' says Chris Baker, business development director of outsourcing at Logica. Also, as costs and services are renegotiable at least once a year, outsourcing gives the client much more flexibility than if it owned the equipment and paid the staff.
'Ten years ago, the main focus was on data centres and facilities management,' says Duncan Aitchison, executive director of outsourcing at Cap Gemini.
'Now it has moved to a wider range of systems, beyond the IT sector to applications and increasingly the business processes themselves.'
But despite the fact that the outsourcing market is growing by at least 30 per cent a year on average, according to research, analysts believe businesses could outsource even more than they do now. 'Suppliers can achieve more for clients than an in-house IT shop can do - if they are properly managed,' says Bob Aylott, executive director of Outsourcing Management Group and principal consultant at KPMG.
Almost any IT or telecoms function can be successfully outsourced, although some are more amenable to the process than others. Mainframe data centres are probably the easiest and most established area. Other relatively straightforward functions include networks - especially Wans - application support and, increasingly, desktop systems and Lans.
Help desks are sometimes straightforward, although it depends how deeply embedded in the business processes they are. Application development is more tricky because some of the design and planning is highly strategic and therefore better kept in-house, though the actual code-cutting can often be outsourced.
The buzzword for cherry-picking which bits of your operation to outsource is smartsourcing, and observers note a trend towards it. Demand for outsourcing is so high, however, that it has become something of a seller's market and many outsourcing companies are becoming quite choosy.
'It's more likely to be a success if an organisation outsources a series of linked processes,' says Craig Routledge, general manager of support services at Computacenter. 'Just outsourcing bits tends not to work in our experience. We avoid those sort of opportunities. We have to be in control of the process if we're to achieve any benefits.'
Dan Cohen, managing principal of global services at IBM, is more blunt.
'If they don't give me enough dials to control, I can't deliver what they need,' he says. 'If I'm only doing commodity business, I'm not going to be able to add enough value and people aren't going to pay enough for it. The old outsourcing stuff like data centres has now got a part number on it.'
As the outsourcing trend grows, customers are now paying less for traditional outsourcing operations. Margins on data centres used to be 20 per cent; now they are down to about eight per cent. Desktop outsourcing used to command a premium of 35 per cent, but this has dropped to about 20 per cent and will fall further over the next couple of years as the market becomes more commoditised.
Suppliers are therefore trying to open up different areas, where margins can be as high as 40 per cent. The most significant of these is outsourcing entire business processes, often with the IT systems that support them, and are increasingly becoming inextricably linked with them. Some are existing processes, such as accountancy, call centres, personnel, legal departments, and even entire supply chains. Others might be new ventures, such as electronic business, where the customer lacks the experience and skills to manage.
One additional area is business process deals that are run on a risk-reward basis, where payment is linked to the business benefits achieved.
In New York, for example, the city council hired EDS to re-engineer its systems for collecting parking fines. EDS receives a commission on all the additional fines collected.
But observers have warned against using one company to do all the outsourcing.
'I'd strongly advise against outsourcing the whole IT operation to one supplier,' says John Leigh, vice president and research area director of Gartner Group Europe. 'Once it has got hold of you and it has all the services, where are you going to go? It knows you can't walk away. You're better off with specific contracts because your needs are different for different things.'
'The monolithic days are dead and gone,' says Robert Morgan, executive chairman of sourcing consultants Morgan Chambers. 'It's a sign of weak management if you do that. There isn't a single supplier that can do everything well, not even EDS or IBM. If you have to manage the contract, you might as well invest in the best of breed.'
Therefore, the most common strategy is for organisations to negotiate deals with the leading suppliers and then appoint a prime contractor to manage them. Alternatively, some companies subcontract to smaller, expert firms. This practice is on the increase and has the advantage that the subcontractual arrangement, and the risks that go with it, are the responsibility of the service provider, not the client.
This role of prime contractor, also known as a service integrator, is tipped as the next big thing in outsourcing and some large outsourcing companies, such as Andersen Consulting and CSC, are naturally keen to take it on.
A typical scenario is having the service integrator handling application management, and overseeing three separate subcontractors running data centres, networks and desktop support.
While the long-established outsourcing suppliers have developed a wide range of expertise, there is still a perception that they retain particular strengths in their original core business areas, such as legacy systems for IBM and ICL; finance for Andersen; applications for Cap Gemini and CSC, manufacturing for EDS and Debis. More recent entrants tend to stick to what they know, having grown their outsourcing business out of existing core operations: applications management for Logica, for example, or desktop systems for Computacenter.
Naturally, everyone wants a supplier with experience of its own business, yet which does not work for any of its direct competitors. But no such company exists. There is no hard and fast rule about selecting suppliers that work for competing organisations.
Price and technological expertise vary little among the top-rank suppliers - between two and 12 per cent on typical tenders, says Morgan - so a good cultural fit with the firm, and the team involved, is often more important.
'Trust is crucial,' says Embling. 'The closer the client and supplier get, the more likely the project is to succeed.'
Size is important, too. If a contract forms more than between 15 and 20 per cent of a supplier's business, it will be unhealthily reliant on the project for its financial viability. And if it has similar-sized contracts with other clients and one of them pulls out, it could go bust, leaving the organisation with no supplier.
Conversely, if a contract represents less than about two per cent of its business, the customer does not have enough clout to ensure good service levels.
In the early days of outsourcing, contracts ran to hundreds of pages, specifying in minute detail the obligations of the supplier and the penalties for non-delivery. Such mammoth contracts did not do favours to either the supplier or the client because they made it very difficult for the service to adapt to inevitable changes in the business.
These types of outsourcing deals typically ran for between five and seven years (between three and five years for desktop systems) - with some running for more than a decade, making it virtually impossible to predict changes in the focus of the business.
'It's a question of defining the spirit of the agreement and the high-level operation, and setting objectives and targets,' says Routledge.
'The industry changes so quickly these days that putting a lot of effort into a highly detailed, highly prescriptive contract is a waste of time.'
Therefore a modern contract is more likely to consist of a couple of dozen pages setting out the high-level aims and expectations with a series of variable schedules beneath it. These schedules can be re-examined and re-negotiated, annually or even hourly, by mutual agreement.
The areas covered include service level agreements, which incorporate set periods for monitoring - for example, once a quarter; details of what will be monitored and how; and an agreement to set payment levels on, for example, an annual basis, depending on previous performance and general industry trends.
Ironically, the more critical the functions being outsourced, the more flexible the contract needs to be. If a company is merely outsourcing a cost centre, such as a legacy mainframe operation, the contract can be much tighter because the business needs are likely to be more static.
Naturally, the more flexible the service customers want, the more they will have to pay for it.
The key aim of the contract is to identify the expectations of the business, but not necessarily the technology to be used to achieve them - in other words, to define the destination, but not the route required to get there.
This, Morris believes, is the single most important lesson to be learned by outsourcing customers.
Designing a flexible contract is not as easy as it sounds. 'It's very difficult to write an enabling contract for something you haven't defined in advance,' says Aylott. 'Lawyers find it difficult to write contracts that are enabling, not restrictive.' But he thinks modern outsourcing contracts are pretty good, not least because there is plenty of precedent and experience in drawing them up.
Some contracts have an early get-out clause allowing the client to terminate the agreement without penalty, say five years into a seven-year contract.
But deals sometimes go belly-up sooner than that, either because the two parties fall out or because of a change in the circumstances of either the client or the supplier, such as a merger, shut-down, or fundamental change of focus.
Given that true outsourcing means an organisation transferring its hardware, software and most of its IT staff to the supplier, early termination can be difficult or even impossible. So an increasing number of contracts recognise that divorces do happen, and contain the business equivalent of a 'pre-nuptial agreement'.
An idea that is gaining in popularity - although not as quickly as was predicted - is so-called open book accounting. This is when an organisation and supplier agree the margin rather than the fee. The supplier shows the customer the cost of breakdowns for the services it provides - or, in exceptional cases, for its entire business.
In theory, it sounds great. 'Clients love it, although they don't understand it; vendors are petrified of it because they make so much profit in hidden ways,' says Morgan. But he warns that open book accounting can encourage suppliers to obey the letter of the contract and no more, on the principle that if they don't make margin on it, they won't do it.'
Also, if a margin of, say eight per cent is agreed, eight per cent of a big number is more than eight per cent of a small number, so there is no incentive for the supplier to economise on costs. Open book accounting can work very well, especially if there is an element of risk and profit-sharing in the deal. Otherwise it requires maturity on the part of client and supplier.
Morgan recommends that, as a rule of thumb, between five and 7.5 per cent of the value of an outsourcing contract should be allocated to running the contract; this includes client-side staff costs, plus consultancy, legal fees, benchmarking and market tracking. KPMG has a model for making such calculations, which average between five and seven per cent for contracts involving a lot of change and innovation, reducing to two to three per cent for tickover contracts such as legacy systems.
It is not uncommon to see a dip in service levels during the takeover phase of an outsourcing contract, typically in the first three months.
This may be due to the supplier taking time to get its feet under the table, or to the client not committing sufficient staff resources to supporting the transition. After this, there is a trend towards penalty clauses for suppliers that do not come up to scratch. At their most stringent, penalty clauses guarantee the client the service, or its approximate cash value to the business, if the supplier fails to meet its targets.
Outsourcing has been around for so long that many contracts have come up for renewal, some more than once. The majority - 75 per cent according to research firm OTR - are re-let to the same supplier. But about two-thirds of clients, according to research by Morgan Chambers and OTR, would prefer to change, either because they are getting poor value or service, or because they do not much like their suppliers any more.
A report by OTR, Outsourcing Contracts: The Real Options at Contract Expiry, showed it is virtually impossible to change suppliers unless negotiations are started at least a year before the existing contract expires. This is partly because the three stages involved - re-selecting areas to outsource, defining service levels and selecting suppliers - are complicated. But OTR also found that suppliers used delaying tactics and that short timescales discouraged potential suppliers from making bids.
Much of the problem of supplier lock-in can be traced to poor initial contracts. 'The big problem is not having sensible exit provisions, so it's hard to walk away from a supplier,' says Aylott. 'The supplier owns the assets and resources. Can you extract them and transfer them? Often it's not legally or practically possible to do this.'
There is a perception among suppliers, borne out by the high proportion of renewals with existing service providers, that invitations to tender are little more than market-testing exercises, designed to knock something off the existing supplier's price when it gets the contract back. Because it can cost a seven-figure sum just to produce a bid for a large contract, reluctance is understandable.
Cohen says if a renewal from a non-IBM customer was purely about price, he would not bid for it. If there was a problem with the service, he would want to know more. Aitchison agrees: 'I'd want to assume there was an attempt to find a new supplier before I'd bid.'
OUT FOR THE COUNT
The reasons for outsourcing, and the expected benefits, include:
- Freeing up management to focus on core business activities
- Enabling the business to do things it otherwise could not
- Using an IT-specialist supplier to improve the quality and functionality of systems
- Gaining access to a wider skills pool
- Achieving guaranteed levels of service and performance
- Obtaining a variable cost base, with services which can grow or shrink with the fortunes of the business
- Saving money, through increased efficiency, economies of scale, and bringing hidden costs out into the open.
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