The Total Cost of IT Outsourcing

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The Total Cost of IT Outsourcing
by Eric Krell

Offshore outsourcing of IT services can save companies 30 percent or more on labor costs, but that's not the whole story.
The word "tantalizing," with its hints of both reward and risk, arises frequently in discussions of IT outsourcing. It seems fitting that the word derives from a Greek legend, since a growing mythology has attached itself to the practice of sending IT work overseas, particularly to the distant shores of India, China or Eastern Europe. Outsourced services generally fall into one of four categories: infrastructure (data centers and servers), network man-agement, application development and maintenance, or help desk.
"Executives often are enticed by the labor cost savings of offshore outsourcing," says Bob Cecil, vice president and finance and accounting practice leader for Houston-based consulting firm EquaTerra. "And then they race off thinking it's the best thing since sliced bread without having thought through all of the challenges, costs and risks associated with it."
When a $100,000 U.S.-based IT professional can be replaced through an outsourcing arrangement for $20,000 a year, that mentality is easy to understand. Richard Sneider, Ph.D., director of IT advisory firm InterUnity Group in Concord, Mass., reports that companies using offshore outsourcing post an average savings of 30 percent. He also notes that companies are realizing only about half of the potential benefits of IT outsourcing.
Michael Van Handel, executive vice president and CFO of staffing giant Manpower Inc. in Milwaukee, has so far resisted the temptation, although IT outsourcing remains an option that he, his CIO and the rest of the executive team regularly evaluate. In studying the option, Van Handel says, he's noticed that most outsourcing problems arise from weak service level agreements and inadequate management or governance. "IT outsourcing is a business decision," he says. "IT outsourcing should support the overarching need for IT-business alignment. IT helps the business accomplish its objectives."
The Conference Board's senior management team recently addressed the same topic with a similar focus on IT-business alignment, but they decided to send some IT operations to a third-party data center based in Annapolis, Md. Salvatore J. Vitale, senior vice president, operations, in New York City, identifies three reasons his organization outsourced its data center to USi in a five-year agreement. First, because The Conference Board has offices in Brussels and Hong Kong and contractors in Europe, South America, Asia and Australia, it increasingly needs global IT support. Second, outsourcing enables the organization to access deeper technology expertise and keep pace with rapidly changing IT needs. And finally, the move will reduce costs.
In the selection process, Vitale and his colleagues spoke to about a dozen finance, IT and businesspeople within four USi customers. Despite their due diligence, their rigorous approach to crafting the agreement and internal enthusiasm about the deal, the team still has concerns about turning IT control over to an outside partner. "We've definitely mitigated that through the contract," Vitale says. "But there is still almost a leap of faith you have to make that you're going to wind up in a better situation even though you no longer have as much control."

Hidden Costs
Some trepidation is understandable in light of the prevalence of cost creep in IT outsourcing. Cecil says companies engaging in offshore outsourcing can expect a typical cost savings for help-desk or other frequently outsourced IT processes, such as call centers, of about $30,000 per person per year: Compare a total annual compensation of $35,000 for a call-center employee in a low-cost Sun Belt city with $5,000 for a call-center worker in India. Savings on application development employees are even higher.
"But it is easy to look at that difference and then fail to consider other hard costs and some soft costs," Cecil explains. When companies outsource IT processes to India or China, he says, they typically spend $8,000 to $12,000 per seat for facilities, telecommunications and the rest of the technology infrastructure. In addition, outsourcing often requires investments associated with upgrading the client's capabilities. For example, moving an IT help desk overseas may require a new customer relationship management (CRM) system. The service provider may pay part of that cost, but some of it will appear in the deal's pricing.
Cecil adds that buyers of IT outsourcing services often fail to figure relationship management costs into their pro-jections. These expenses average 4 percent of the contract's value for domestic outsourcing and about 8 percent of the contract's value for offshore partnerships. Finally, the costs of laying off employees, terminating leases, supporting expatriates, and using legal and consulting services -- often a necessity on larger deals -- also must be figured into the equation.

Lost in Translation
The essentially contentious nature of outsourcing negotiations can aggravate the challenge of flushing out all of a deal's hard and soft costs. "People like to say that it is an adversarial relationship by definition," says Bob Carlson, president and CEO of IT outsourcing and consulting firm SilverTrain Inc. in Brookfield, Wis. "It doesn't have to be. The success of the agreement really comes down to the honesty and openness of the relationship."
At the end of the negotiating game, the chess pieces from both sides go back into the same box. "It's more about relationship management than it is about contract management once we're into the deal itself," says Rudy Puryear, vice president and co-leader, capability sourcing practice, for Bain & Co. in Chicago. The success of an IT outsourcing relationship depends on both parties' ability to sidestep problems in three areas:

1. Complexity. Five- to 10-year IT outsourcing deals worth as much as $100 million or more are usually detailed in contracts 500 pages to 1,500 pages long. Although outsourcing service providers are used to navigating such complexity, most buyers are first-timers.
Dan Mummery, a partner with Latham & Watkins in Menlo Park, Calif., and formerly a partner with Cooley Godward LLP, has negotiated some 70 outsourcing agreements, ranging in value from $5 million to $8 billion. "You're dealing with a transaction that's a hybrid of M&A, financing and technology," he says, comparing the creation of an effective contract to "nailing a jellyfish to the wall." When Mummery negotiates a large deal, he often calls on technology transaction outsourcing specialists, tax specialists, employment and labor specialists, real estate experts, and -- increasingly -- Sarbanes-Oxley compliance experts.
For finance executives, the complex brand of financial engineering that a company and its outsourcing partner engage in prior to signing the agreement warrants particular scrutiny. "CFOs sit down and say that they need to have X percent savings," Mummery notes. "So, often, suppliers will come in and engineer a solution that gets you those savings, particularly in the early years, but a lot of the costs are back-loaded."
Part of the allure of long-term agreements is that the pricing can help finance forecast costs with greater accuracy deeper into the future. Providers commit to consistent pricing over several years -- but that stability comes with a cost. Terms on such agreements are often less flexible, and escape clauses are more restrictive.

2. Governance. Cooley Godward lawyers return to their corporate clients two years into each agreement they helped arrange to find out what has gone right and what has gone wrong. "Invariably people say, 'I should have spent more time on governance than I did,' " says Mummery. Too often, outsourcing purchasers focus much more time and energy on selecting a provider than on monitoring service once the arrangement is in place. In the past, governance of outsourcing translated to putting in place a steering committee with some sort of dispute-resolution protocol. Today, Mummery says, savvy buyers of all types of outsourcing dedicate significant thought and conversation to identifying how the deal should be managed and what, exactly, governance should look like.
Puryear agrees that failure to establish a suitable governance structure poses the largest risk to the success of outsourcing deals, especially when the service provider is offshore. He says buyers of outsourcing services routinely under-estimate the number of IT professionals they need to keep on staff to manage the relationship. He has found that the right level of retained IT staff is generally 7 percent to 12 percent of the outsourced function's original head count. So a company that outsources a 100-person IT shop should expect to keep seven to 12 IT professionals in house to manage the relationship. Part of these employees' responsibilities should be to assist the rest of the organization with the business process changes that are necessary when chunks of IT move outside the organization -- another challenge that, according to Puryear, buyers tend to underestimate.

3. Flexibility. Change may be the most consistent and most challenging characteristic of IT outsourcing agreements, regardless of the deal's scope or size. "Nobody can predict the future," says SilverTrain's Carlson. "That's the case even with shorter-term outsourcing relationships." One example of a change that would require rethinking an agreement: Suppose the client company acquired a business that delivers the same efficient, best-in-class capability the outsourcer is providing. "In that case, why would you continue to pay an outsourcer?" Carlson asks. "You've got to be willing to build into the contract mechanisms to escape if need be." SilverTrain includes in its contract a plan for returning outsourced processes back to the client company.
Many organizations undergo several rounds of major strategic changes over the course of a five- or 10-year agreement. Puryear has a telecommunications customer that signed a large outsourcing deal during a difficult stretch when the company was focused on taking as much cost as possible out of the business. Eighteen months later, the marketplace had drastically improved and a new CEO had taken the helm. The executive, who had a host of ideas about growing the business, asked Bain & Co. a simple question: Can we reposition the existing outsourcing deal to deliver capabilities that will support the company's new growth strategy?
Vitale says exclusivity is one of the most important aspects for finance executives to focus on when poring over a thick contract. Does the agreement allow the customer to test the waters with other outsourcers down the road? "You have to make sure you have the proper protection in your contract," he says. In its contract with The Conference Board, USi is obligated to help the organization either move to another service provider or return the data center to its own site if circumstances warrant a change.
"The ability to take some work and give it to another provider is a true market test," Mummery points out. "That's a very important tool for a customer. So the provision around exclusivity [should] be very heavily negotiated; you have to come up with a way to solve diametrically opposed needs."
Many companies use benchmarking, as well as exclusivity and escape clauses, to build flexibility into their outsourcing contracts. Mummery emphasizes the importance of regularly benchmarking an outsourcing provider's pricing throughout the duration of the agreement. Providers can be wary of this practice because of concerns about accuracy in comparing the quality of their services with that of other providers. "Many outsourcing experts feel that benchmarking is a very important tool that you need in every contract," Mummery explains.

Context Is Crucial
Disciplined management of these three primary risk factors can get lost in the contracting shuffle, particularly when the hype around IT outsourcing reaches a high pitch. In the past six months, the subject has inspired a spate of media coverage. U.S. IT professionals have protested outsourcing conferences. The business press has published claims of infrastructure shortcomings and stories about exasperated workers in India. IT trade publications have predicted that offshore outsourcing will sabotage the United States' ability to innovate. And, in an effort to increase costs for companies transferring IT services to foreign providers, limits have been proposed for visa programs that enable foreign workers to visit the United States to shadow workers here.
Bob Pryor, president, outsourcing services, North America, for Cap Gemini Ernst & Young in Dallas, says most studies estimate the movement of IT jobs overseas at about 3 million over the next 15 years. "If you do the math, that basically says that 1 percent to 1.5 percent of our workforce is moving offshore. It's not a wildly significant number in the scheme of things."
Pryor and other outsourcing experts frequently compare the current trend in IT employment to the movement overseas of low-skilled manufacturing jobs 30 years ago. The differences, of course, are the income levels and skill sets of those affected. "The message to the average IT worker is that you have to continually re-skill and continually move to higher sources of value-added production and services," Pryor notes. "You cannot assume that you'll be doing the same job for 20 years."
Pryor points out that Mexico and Ireland were the largest offshore IT outsourcing destinations 20 years ago. That may help put in context the attention India, China and Russia are receiving right now. Clear thinking and careful analysis are vital for finance executives seduced by the allure of offshore IT outsourcing. To fully realize the potentially Olympian benefits, CFOs need to mitigate the substantial risks and ferret out all of the deal's hidden costs.