Deloitte Says Outsourcing Doesn't Always Pay

by Timothy Prickett Morgan

One of the dominant services in the IT sector is outsourcing, and the practice has always been one that had its supporters and its detractors. With outsourcing, you pay an expert to do your IT for you, and in theory, you save money and get better IT. That's the theory. The practice, well, that is often a different story. If a new report by Deloitte Consulting is any indication, customers are getting savvy about what outsourcing is really like and they are not necessarily happy.

For three decades, the computer business has been in the process of shifting away from selling products with built in (and often free) services to one that sells products and services side-by-side, often relying on services to make up lost profits due to intense price competition in the hardware and software market. The momentum behind outsourcing began in earnest with the recession in the late 1980s, picked up steam in the recession of the early 1990s, and really got going during the recession of the early 2000s. Outsourcing is often one of the ways that companies try to save money when they are in difficult straits, which is why the trend toward outsourcing is loosely coupled to recessions. But that is only a loose coupling. The advent of the commercialized Internet in the mid-1990s also demonstrated that, for many kinds of applications, a service provider model, which is what many outsourcing deals are structured like, is a preferred one from an accounting and often from a strategic IT perspective.

But the IT outsourcing business, like any services business, is a very tough one. Profit margins are skinny, and problems that affect service-level agreements can be costly to the outsourcing vendor. Moreover, making big promises on the front-end of a 10-year outsourcing agreement is easy for an outsourcing service provider, but living up to those promises is difficult and the outsourcer is often at odds with the outsourcee--just like the normal contentious relationship between the lines of business at any company and the IT department that supports them. You can outsource the IT, but you sure can't get rid of the contention. In fact, outsourcing may exacerbate the inherent contention between business and IT because the company's job is to get good, flexible IT to support changing business conditions and the outsourcer's job is to make money on the deal, and unfortunately, changing as little as possible for as long as possible is probably the best way to ensure this. But, that does not necessarily make for happy customers.

If you have been wondering for the past few weeks why IBM's Global Services unit has seen its backlog of services deals stagnate in recent quarters as its customer base shifts toward short-term contracts and away from megadeals that span many years, then Deloitte Consulting's report on outsourcing, "Calling a Change in the Outsourcing Market", will perhaps explain what might be going on in this part of the services market.

The Deloitte report is an eye opener, but you have to be careful when you read it. Deloitte's survey was for only 25 companies, many of whom are the top players in their markets. The average company in the survey had $50 billion in sales and 60,000 employees, and in aggregate, they spent about $50 billion on their largest outsourcing contracts. To put that into perspective: the outsourcing contracts for the 25 companies represent about 4.5 percent of worldwide IT spending across hardware, software, services, and communications. The study has other information in it--such as collecting and analyzing industry reports of outsourcing deals gone awry and counting negative stories about outsourcing between 1999 and 2004. The report may be about very large organizations, but it is hard to imagine that smaller companies who also outsource have not seen similar problems. Specifically:

• 70 percent of the companies surveyed had "significant negative experiences" with their outsourcing projects, and they are very jumpy when they renew their contracts and are getting more conservative about what they will let outsourcers do and what they really expect them to do. "Outsourcing is an extraordinarily complex process, and the anticipated benefits often fail to materialize," the report said. Cost savings were the most popular reason to outsource, being chosen by 70 percent of the respondents, but 38 percent of the companies that said cost savings were important also said that they had to pay for extra or hidden costs that they thought were covered in their contracts. 44 percent of respondents said that cost savings never materialized. "Vendors give clients better deals until years three or four," Deloitte quoted one respondent as saying. "After that they begin exploiting the clients."
• Outsourcing was supposed to allow companies to focus on their core businesses and to offload non-strategic IT operations, but a quarter of companies that outsourced have since decided they didn't reckon what was strategic very well and have brought key workloads back into their own data centers. 64 percent of companies surveyed have brought workloads back inside after outsourcing.
• Outsourcing was supposed to give IT shops access to top talent, but a fifth of those surveyed said turnover at their outsourcer was a higher than expected and that they were also losing their own strategic employees in the process--about a third of those in the survey were worried about the loss of institutional knowledge in the wake of outsourcing.
• 10 percent of respondents said that the limited transparency that outsourcing vendors provide on their own costs and processes and the lack of control due to subcontracting by their outsourcers was a concern. Because these were public companies that often do business in the United States, weaving in executive accountability and transparency into outsourcing deals is somewhat problematic under the new Sarbanes-Oxley regulations.
• 10 percent of respondents said that they had their intellectual property or industry secrets violated by an outsourcer. One company said that an outsourcer sold its applications to third parties.
• Getting access to best practices and improving the quality of IT was another biggie behind the decision to outsource, cited by 57 percent of respondents, but nearly a third of those who said this was important also said that vendors were complacent once the ink was dry on the contract.

What seems clear from the study is something that is obvious once you think about what outsourcing really is. When you outsource, you are initially in the best bargaining position and the vendor has to accommodate the needs you have now and those needs you can predict in the future. But it is the needs that you cannot predict that are going to cost you, and they are not covered in the contract you just signed. (Given that some of these contracts are--no kidding--10,000 pages long, you'd think every provision would be covered.) In business, about half of what goes on is unpredictable, which is why business is in general so difficult. Putting another force in contention in the middle of the IT organization cannot, by definition, make things easier.

That doesn't mean all outsourcing is bad. There are still good reasons to do it. It would seem wise to not count on expected savings or lower management costs, however. They don't seem to pan out.