Outsourcing Survey 2006, Part 1: What, How Much, and How Long
We explore what IT is outsourcing, how much it costs, and the length of outsourcing contracts.
- By Dian Schaffhauser
The concept of outsourcing, while far from passé, is becoming dated. That's not to say that organizations are no longer feeding IT or business process work to third parties. They are -- in ever greater numbers. But many companies now have several years of outsourcing experience and have honed their skills in setting strategy, selecting vendors, implementing governance policies, managing relationships, negotiating contracts, and defining the business value of their efforts. It's no longer just outsourcing. They refer to what they do as "servicing," "multi-sourcing," or simply "sourcing." They're able to isolate processes, functions, or activities as well as resources and determine with laser-beam focus which functions should be retained in-house, which can be managed offshore, which should be assigned to a single vendor (some functions may be handled domestically while others are handled offshore), and which should be divvied up among service providers working together. Such is the new face of sourcing.
Gone are the days when a single vendor -- typically, IBM or EDS -- signed a decade-long, multi-million dollar outsourcing contract, inherited 5,000 staff, took over the hardware and software, and turned around and resold the IT services back to the client organization. Such engagements still take place, of course, but they're rare enough to make the headlines. Just as often, it's the dismantling of these initiatives (IBM and JPMorgan Chase, for example, or Sears and CSC) that we read about instead.
Nowadays, the GMs and ABN Amros of the world are signing up multiple vendors, expecting they'll build an IT organization that competes and strives -- on a daily basis -- to deliver best-of-breed service to its users. The contract terms are smaller and the contract periods are shorter.
The largest corporations aren't alone in taking this approach, which is why this year's survey, co-developed by Enterprise Systems and sourcingmag.com, isn't as broad as the last survey on the topic. The service provider handling your application maintenance work is no longer necessarily the same vendor running your IT infrastructure.
To derive more useful, applicable insights about the outsourcing endeavors among our readers, we invited people specifically involved in data center outsourcing to tell us about their efforts. In the course of drilling down on responses to questions about the functions being outsourced, costs and time considerations, greatest concerns, and other matters, we learned many things.
For example, "cost savings" is no longer the primary driver for outsourcing. It's just as likely that companies are outsourcing to access IT resources they don't have internally. (This may be because they've whacked their IT budgets down so close to the bone that there's little meat left when new projects require IT attention.)
We invited visitors and e-mail newsletter subscribers on sourcingmag.com, Enterprise Systems, Application Development Trends, Federal Computing Week, and iSixSigma.com to take the 35-question survey, which was available online. Respondents from 463 companies or organizations did so.
Furthermore, we discovered that IT is not a dying profession in the U.S. and that all the work is not heading overseas. Yes, India does attract a good amount of IT work; but that has little to do with data center operations. Most outsourcing remains on domestic soil. Likewise, more data center work is typically being handled in-house than out-of-house.
Organizations are getting smarter about pricing outsourcing contracts, too. More report paying actual costs in line with what they expected.
Finally, we learned that data privacy and security concerns rank high among companies doing outsourcing in the data center. The fact that many notable security breaches reported in the last two years have involved simple thefts of notebooks or CDs containing customer data left in insecure places says this isn't just something for service providers to figure out; nor is it relevant only to companies doing outsourcing.
Use the following data from your fellow IT and business managers and line staff to formulate your thinking about the sourcing your company is undertaking. Are you signing contracts that are too long -- at the behest of the vendor? Are you handing over more than you should? Are you involved in the total lifecycle of the outsourcing initiative? If your team is more accustomed to doing the work than managing it, do you have a plan in place for bringing their skill sets up to speed or filling in the staffing gaps? Finally, are you constantly evaluating your approach to the data center work your organization needs? There is no longer any single right answer to that question.
What's Being Outsourced
The most common data center functions currently being outsourced is trouble ticket/help desk operations, as reported by four out of 10 respondents. As Figure 1 shows, the next three most commonly outsourced functions are hardware and network operations, end-user support, and disaster recovery and power backups.
A quarter of respondents said they're presently outsourcing all IT functions. However, that's a trend that's showing some pick-up; a third of respondents expect to see all IT functions being outsourced in the next 12 months.
The next most likely candidate for outsourcing in the near future is in the area of disaster recovery and backup; 28% of respondents report that their organizations have taken it under consideration.
That said, overall, more work is still being handled in-house than by a service provider -- the ratio is 55% to 45%.
How Much, How Long
It's common to read about "mega-deal" contracts that extend for a decade in the future. That's actually less common than it might appear. The average contract length reported by our respondents for the mostly commonly outsourced functions tends to be between four and six years. As Figure 2 shows, contracts encompassing the outsourcing of all IT functions were, on average, five years long, as were trouble ticket- and help desk-related contracts.
Only 17% of the highest-value contracts had a duration longer than five years.
Running a data center -- whether you do it with internal resources or through service providers -- is an expensive proposition. It comes as no surprise that the contracts of highest value were those that covered the outsourcing of all IT functions. The median price tag on those contracts is about $4 million. Another similarly pricey proposition for outsourcing in the data center -- though less typical -- are equipment leases, which register a median of $4.3 million.
Aside from contracts encompassing all IT operations or equipment leases, the two most frequently cited outsourced functions with the highest price tag are 1) hardware and network operations, and 2) operations and end-user support. On average, each costs about one million dollars per year.
Developing a contract with a pricing structure you can count on often seems more like an art than a science. However, the largest percentage (45%) of respondents said their actual costs are about the same as those stipulated in their contract. When organizations were wrong, they were more often in the position of spending more -- not less -- than the contract price. As Figure 4 shows, three out of 10 respondents said the actual costs are higher than the contract costs. Half that number said they were lower.
The largest group of people said their contracts are structured with fixed pricing (45%). The next most common pricing structures were activity-based and time and materials (both specified by 19% of respondents). Cost-plus pricing came in at 11% and gain-sharing and transactional pricing were being used by a mere 2%.
Pricing Schemes in Outsourcing
- Activity-based pricing: Clients agree to pay a flat fee to cover the service provider's fixed and variable costs -- including hardware and software, labor, infrastructure, administration, and maintenance. Activity-based costing is often used when establishing an offshore development center (ODC) or putting together a build-operate-transfer model.
- Cost-plus pricing: Also known as "open-book" pricing. In this model, the client pays the service provider for the actual cost of the service plus a markup or profit margin. Popular with offshore development center (ODC) or build-operate-transfer models. Frequently used as an interim contractual measure. Appropriate for efficiency deals.
- Fixed price: A model of pricing in which a project is undertaken by the service provider for a pre-agreed-upon price. One advantage is that it's easy for the client to budget for the project. Two disadvantages are that the service provider may overestimate costs beforehand for possible unforeseen conditions or cut corners during the project to compensate for expenses that are higher than anticipated. The service provider will charge a premium for a fixed price relative to the risks involved. Also, if the service requirements drop, there's no reduction in price for the client. Appropriate for efficiency deals.
- Gain-sharing: The service provider has some form of incentive for constantly improving the business process. When the client benefits (through reduced expenses, greater revenues, or improved efficiencies), so does the service provider.
- Time and materials pricing: A pricing model in which the client pays set rates and related expenses for each worker provided by the service provider. Paying this way, while allowing more flexibility, may lead to a less disciplined approach to the project.
- Transactional pricing: Also known as "unit pricing." The client pays the service provider a flat fee per unit of work (order taken, application processed, sales call made).
Next week we'll explore why enterprises outsource work, and where that work is going.
James E. Powell contributed to this article.