Q & A on Strategies for Managing Outsourcing Relationships

The Yankee Group Technology Management Strategies advisory service receives frequent inquiries from clients on managing outsourcing relationships. Our February 2003 audio conference—Business Process Outsourcing: Opportunities and Challenges highlighted the importance of factoring the cost of internally managing outsourcing contracts into end-user ROI assessments. That prompted many questions on this topic.

Below are the most frequently asked questions and our responses.

Question
Much has been made of the hidden costs of outsourcing that eat away at end-user savings. In conducting a ROI assessment for a projected outsourcing project, what hidden costs should be included in end-user assessments?

Answer
Measuring the ROI of a service—including outsourcing—is complex. That’s because a cost/benefit analysis must include both tangible and intangible benefits. Our discussions with end users indicate most have not measured the cost of provisioning the service internally.

Calculating the cost of outsourcing is one of the first steps in measuring ROI, so it is critical to get it right. Costs that should be factored into end user ROI assessments, but that are often overlooked include the cost of:

• Internally managing the outsourcing relationship
• Technology transfer
• Offshore outsourcing

Our discussions with end users engaged in outsourcing indicate that, on average, users spend from 5 to 12 percent of the total contract value on managing the relationship. The cost of managing a $100 million contract contracts that focuses on specified service levels (i.e., data center and desk top outsourcing), leans toward the low end—from $5 million to $8 million. On the other hand, the cost of managing contracts that focus on managing specific business results (i.e., more complex business process outsourcing and applications outsourcing contracts) leans to the high end—ranging from $8 million to $12 million or more depending on the specified business results. Because reducing costs is one of the top drivers of outsourcing, the cost of internally managing a multi-million outsourcing deal is too big to be overlooked.

Another hidden cost of outsourcing focuses on capital assets—the cost of technology transfer (i.e., the cost of transferring assets including servers, databases, and software to the outsourcing provider). It is especially important to include technology transfer cost in an ROI assessment of ITO that focuses on managing hard assets.

Our research indicates the cost of technology transfer for a typical ITO deal involving the transfer of data center assets, such as servers, storage, security, and systems management, ranges from 5 to 15 percent annually.

Offshore outsourcing can reduce costs 20 to 30 percent (the cost of application development labor in India and China is more than 50 percent lower than in the U.S.). However, there are hidden costs that users need to include in their ROI assessments, including travel, infrastructure access (such as connectivity and power and what it will cost if failures occur), culture and language differences, and geopolitical risks.

As the trend toward offshore outsourcing continues and enterprises broaden the scope of functions and processes they send offshore, our research indicates the cost of managing outsourcing will increase from the 5 to 12 percent of total contract value range we indicated earlier to 10 to 18 percent depending on the scope of the project.

Question
What is the most common mistake that end users make in managing an outsourcing relationship? What strategies can be utilized to mitigate it?

Answer
Aligning the management processes with the established outcomes of the outsourcing relationship (clearly outlined in the contract) is the first step in designing an effective management model. Exhibit 1 provides a taxonomy for outsourcing services available to users today and how the management process varies across offerings.

The management process for standardized transaction-based offerings such as infrastructure technology outsourcing (ITO) focuses on monitoring and managing service levels. For more complex and custom goal-based services such as business process outsourcing (BPO) managing established business outcomes is the focus.

Question
Because the risks of BPO are much higher than the risks of less complex ITO, what specific tools help end users to mitigate this risk?

Answer
In comparison to the traditional approach (i.e., take the whole enchilada and make it better), fee-based outsourcing is designed to reduce risks by enabling users to do two important things: narrow the scope of outsourcing and retain their infrastructure and systems.

Although the development of utility computing may one day erase the need for enterprises to own, operate, and maintain their own infrastructure, the fee-based approach is the most widely used and effective tactic for reducing risks associated with traditional outsourcing.

Strategic contracting tactics such as taking an investment stake in your outsourcing provider is another option that some, albeit large, enterprises are using to reduce risks by getting closer to their outsourcing provider. For example, when BP Amoco (Exult’s first client) signed a $600 million human resource-outsourcing contract with Exult in 1999, BP International (a division of BPO Amoco) also made a 10 percent investment in Exult.

The Yankee Group originally published this article on 8 August 2003.