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IT outsourcing doesn't provide clear cost savings

While companies often rely on IT outsourcing to reduce costs, there are better reasons to farm out IT management.

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Outsourcing has been a controversial -- if sometimes effective -- way to reduce IT costs. Companies save money by paying for services that are not their core competence, such as IT infrastructure services. By taking over work for many other companies, outsourcers can drive efficiency, negotiate volume discounts, reduce risk, automate and attract top talent, which can reduce unit costs in a way that their customers could not match.

Outsourcing is supposed to be a viable option to companies looking to reduce cost of some noncore functions, such as IT infrastructure services. But curiously, outsourcing doesn't always result in lower costs. As a CIO at my company, I have championed IT infrastructure outsourcing projects twice in the past 10 years, and in both cases costs ended up higher than before the outsourcing. How to reconcile this?

To start, let's consider the corporate finance concept in this: Outsourcers have to cover their overhead and taxes and still remain profitable to exist. The arbitrage enjoyed by the outsourcer from economies of scale is not sufficient to offset this mark-up. Well-managed, tight IT shops don't have the same cost burden, which nullifies the cost savings premise of outsourcing.

Does outsourcing automatically save money?

To identify whether outsourcing can save money, you need to establish a comparable cost baseline, and that is typically miscalculated. Outsourcing shops are structured in a different way from in-house IT shops, and costs are charged for differently. Here are a couple of examples:

  • In-house IT resources usually play many roles, while outsourcer resources are highly specialized. For example, a typical in-house server administrator does both support and project work, takes care of email and sometimes security as well. An outsourcing contract typically includes only service-level agreements (SLAs) surrounding support activities. Project work is charged extra on a time-and-money basis.
  • Outsourcing services include features that in-house IT shops can't afford or justify. Outsourcers, for example, can systematically refresh all hardware every five years, while in-house IT shops might extend the life of equipment and pay for a refresh far less frequently.

These factors can understate in-house IT costs when compared with outsourcing costs. To sign the contract, outsourcers will match current costs however they were calculated, knowing they will profit along the contract through change orders or simply growth. Unlike in-house IT costs, outsourcing fees grow linearly with the growth of servers, storage and helpdesk calls. At my current company, for example, server and storage needs are growing on average at 17% annually. If left unchecked, outsourcing costs would grow at the same rate year after year (17% annually equals 87% increase on a five-year contract).

Twice in the past 10 years, my decision to outsource resulted in higher costs than before the outsourcing.

Finally, alignment is a factor. As with any business, outsourcing companies have an incentive to make money, not necessarily to save clients money. More revenue for the outsourcer means more cost for the customer, which means the outsourcer and the client have completely opposite goals.

While cost savings are not intrinsic to outsourcing, scalability, stability and quality are. In-house IT shops have a hard time justifying refresh or upgrade projects that don't have tangible business benefits, while outsourcers can do that simply to mitigate risk. In-house IT shops stretch resources beyond the limit to cope with ever-changing business priorities and limited funding, while outsourcers follow proven methodologies and best practices. Outsourcers invest in infrastructure with plenty of room to grow, so integrating a large acquisition, for example, becomes a lot easier when IT infrastructure is outsourced.

Cost savings can be achieved as a result of outsourcing, though, through concerted effort by both parties on initiatives to reduce volume, such as self-service password resets, database server consolidation, cloud offerings and data archiving. In fact, cloud computing has changed the IT infrastructure outsourcing scenario significantly by packaging services with a well-understood monthly cost and clear SLAs. But cost reduction is not always a consequence of going to the cloud, but it can be achieved through consolidation, rationalization and control, all driven by the in-house team, very much like traditional IT infrastructure outsourcing.

Outsourcers that can't align with customers' cost reduction agendas because they're concerned about the impact to revenue are likely to see their customers go at the first opportunity. Disappointed with their outsourcers, these customers will repatriate services to save costs, only to revert to prior scalability and quality challenges.

However, outsourcers that are willing to establish true partnerships with their customers and see beyond the short-term revenue impact will remain profitable by taking advantage of the margin provided by economies of scale, multiplied by the growth of their customers' success. That's where the value proposition of outsourcing resides.

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This was last published in June 2015

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Does your company have an IT outsourcing success story? What were the challenges along the way?
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My company uses outsourcing for our software development teams, which are staffed with about 85% contractors. It is a bit of a burden on the full time employees, who are all involved to at least some extent in guiding and contractors, providing knowledge transfer, and checking over their work.

Most of the contract teams are made up of the nicest people you'll ever meet and they try to be very accommodating. I have to say, though, that their work is often mediocre at best. It gets frustrating.

There are also a lot of travel costs involved, and we usually want to see the contractors on site every now and then, and many of them are flying in internationally.
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I have heard and witnessed a lot of declared success stories, but most of them weren't perceived so by the staff. It's just an unrealistic expectation that this model will work very well from the start.
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I can see how this would be the case. There are many subtle costs involved in outsourcing. In my case, my company does not outsource many infrastructure roles. It is done mostly among the software development teams, which are about 85% contractors. 

Software development requires some background knowledge of a company's business and industry, and new people require a training period. Contractors are no different; they don't simply show up and become productive immediately.

The number of contractors that we use has always required us to complete entire projects involving our lower environments, because there were legal issues involved in letting contractors have access to some of the sensitive data that we have in QA and development databases.
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I cannot see how this amounts to big savings. We had contracted out a website design to be done to our specs from a reputable company. It took a little longer than expected, had to be tweaked a bit to finally be finished. The final cost was about the same as hiring a new employee out of college looking for real world  experience. If we use this contractor more than once a year, I'd see no cost savings.
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There are always short-term and long-term effects. In short-term outsourcing appears to be very attractive. In mid-term - less so.
There are also many kinds of outsourcing. If a company simply doesn't have an in-house expertise or can't afford maintaining it - hiring right contractors might be the key. Alas, the first factor considered is the price, not the expertise.
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