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The make-versus-buy decision at the heart of any outsourcing proposition is not as black-and-white as many IT leaders think.

Keeping IT work insourced versus contracting with a partner organization no longer needs to be a yes or no decision. Over the past two decades, progressive sourcing models have emerged to enable companies to work more strategically with suppliers in a way that creates value and drives innovation. But to do so, IT leaders must move beyond a transactional mindset when it comes to outsourcing partnerships, as far too many fall into a classic catch-22 of wanting a strategic outsourcing solution while implementing a transactional contract.

This catch-22 comes into play because companies using conventional sourcing and contracting methods find their service providers are meeting contractual obligations — but they are not driving innovations and efficiencies at the pace they would like to see. Suppliers argue that investing in their customers’ business is risky because buyers simply take their ideas and competitively bid on the work. Companies want solutions to close the gaps but do not want to invest in people, processes, and technology where they do not have a core competency. The result is that IT organizations are at a crossroads, with both buyers and service providers wanting innovation — but neither wanting to make the investment due to the conventional transaction-based commercial structure of how the companies work together.

But there is another way.

Sourcing as a continuum, not a destination

Academic research offers insight into this dilemma. The University of California’s Dr. Oliver E. Williamson (1932-2020) challenged the traditional make-versus-buy view with his work in Transaction Cost Economics. Recognizing this catch-22, Williamson advocated for a third “hybrid approach” as the preferred method for dealing with complex services where there is a high level of dependency. In such a scenario, the market cannot be used to switch suppliers freely, and an insourced solution may not be a good fit. Williamson suggested companies seek approaches with suppliers to create more strategic and longer-term relationships to balance the weaknesses found in a pure market-based or pure insource-based approach.  Williamson received the Nobel Prize for his work in 2009.

Our work at the University of Tennessee (UT) evolved the concept of using hybrid approaches into what we have coined Sourcing Business Model Theory, which suggests sourcing should be thought of as a business model between two parties with the goal of optimizing the exchange. Figure 1 aligns seven sourcing businesses to Williamson’s economic theory.

Figure 1: Sourcing business model continuum

University of Tennessee Haslam College of Business Administration

Two models (on the left) align with what Williamson refers to as “the market,” while two models (on the right) align with what Williamson coined as “corporate hierarchies.” In the middle, three models align with the hybrid approach for complex contracts for which Williamson advocated. These demand flexibility, continuous improvement, and investment in innovation. The key to optimizing your outsourcing relationship is picking the most appropriate sourcing business model for your situation — and architecting the deal points appropriately.

Selecting the right sourcing model

To pick the right model for your venture, it’s imperative to know the economic basis of each sourcing business model and the kinds of situations for which each fares best. Here is a breakdown of each model along the sourcing continuum.

The Basic Provider Model is transaction-based, offering a set price for individual products and services for which there is a wide range of standard market options. This model should be used only to buy low-cost, standardized goods and services in a market with many suppliers.

The Approved Provider Model is also transaction-based, but here, goods and services are purchased from suppliers that meet a pre-defined set of qualification characteristics — quality standards, proven performance, or other selection criteria. Organizations using this model establish a limited number of pre-approved suppliers from which buyers or business units can choose. If one supplier is not performing, you can easily replace them with another.

As organizations shift up the sourcing continuum, a key differentiator to success is consciously choosing to build stronger and deeper relationships with suppliers. Unfortunately, here is where far too many organizations get it wrong. They begin to say “strategic partner” and “innovation” yet fail to invest in rethinking their transactional approaches, thereby falling into the catch-22. To escape this trap, it is important to architect the commercial aspects of your outsourcing deal to align with the nature of the sourcing business model (see Figure 2 below for a cheat sheet on architecting the commercial structure for each model).

The first stop along a more relational approach is a Preferred Provider Model. IT organizations seeking to do business with a preferred provider often enter into multi-year contracts using a master services agreement that allows them to conduct repeat business efficiently. The model still uses transactional economics, but how the parties work together and achieve efficiencies goes beyond the simple purchase order.

A Performance-Based Model (or Managed Services Model) embeds this strategic mentality in an even longer-term agreement. When structured well, this model shifts to a relational contracting approach with an output-based economic model. Performance-based agreements move away from activities to predefined “outcomes” that are well-defined achievements of an event or deliverable typically finite in nature and easily understood. A good example is a supplier’s ability to achieve pre-defined service level agreements (SLAs) or to meet a savings glide path.

A Vested Sourcing Business Model is highly collaborative, with both buyer and supplier havingan economic interest in each other’s success. Such “win-win” arrangements are designed to create value for both parties beyond the conventional buy-sell economics of transaction-based or performance-based agreements. The model combines an outcome-based economic model with behavioral economics and the principles of shared value. A vested model works best for transformational or innovation objectives that a company cannot achieve itself or by using conventional transactional models.

On the far right of the continuum are the insource options, which require a company to consciously invest in internal operations instead of working with suppliers. With a Shared Services Model, processes are centralized into a “shared service” organization that charges members for services used. It is possible to employ this model and still outsource parts of the work under a market-based or hybrid-based model.

Equity Partnerships include a variety of solutions, such as a joint venture, acquisition, or investing in a subsidiary. Investment-based solutions should be considered only when an organization does not have adequate internal capabilities to acquire mission-critical goods and services but does not want to outsource or invest in a shared services organization. Equity partnerships create a legally binding entity and as such offer the least amount of flexibility to change or exit the relationships that are involved in the equity partnership.

Alignment is key

One of the most common traps in sourcing IT services today is for IT leaders and their procurement departments to be misaligned. If you are saying “strategic partner,” “innovation,” and “outcomes,” and the procurement is using the wrong sourcing model, you will likely get what the sourcing team bought and the legal team contracted for. Simply put, it will be akin to putting a square peg in a round hole.

Equally important — and harder to get right — is to architect the commercial aspects of the relationship properly. For this, we suggest using Figure 2 below. For a deeper dive, read the book Strategic Sourcing in the New Economy: Harnessing the Potential of Sourcing Business Models for Modern Procurement. The University of Tennessee also offers a free online course to help you determine which Sourcing Business Model best fits your situation. (Disclosure: I am a professor at the University of Tennessee and the book’s co-author.)

The bottom line? It’s your bottom line. Organizations that fail to use the appropriate sourcing model are likely to find themselves in either a classic catch-22 outsourcing trap or, at a minimum, adding unnecessary transaction costs from a poorly architected outsourcing agreement.

Figure 2: Business model cheat sheet 

University of Tennessee Haslam College of Business Administration

Outsourcing

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How many IT services vendors do you rely on?

Splitting responsibility for the IT organization into multiple outsourcing vendors, overseen (or overlooked in some unfortunate cases) by a small IT management team, has become a popular practice. Hardly “best practice” — a meaningless but popular justification for doing things a certain way — but popular nonetheless.

If you’re on top of an IT organization that’s structured like this, or if you’re thinking about joining the club as a bold way to turbocharge IT organizational performance, don’t be hasty. It’s an alternative that can work, but it can easily backfire.

Here’s a sampling of what can go wrong and what you can do to prevent it, or at a minimum mitigate the risks.

Service level addiction

Yes, yes, yes, if you can’t measure you can’t manage. That’s doubly so when assessing a vendor’s performance.

And yet …

When you’re leading an internal team there are intangibles you insist on — for example, you might ask for innovative thinking and a willingness to go a few extra miles to turn innovative thinking into innovative reality.

SLA-driven vendors can become complacent, and in the absence of a well-defined and tracked “innovation SLA” neither they nor their management will have any incentive to suggest anything new.

It’s tricky. On the one hand, the vendor you select should, in theory, have more expertise in their area of responsibility than an internal team might have, and so it should be able to offer a steady stream of improvement possibilities.

But on the other hand, many — perhaps most — improvement opportunities would reduce the vendor’s billings. It’s hardly reasonable to ask a vendor to take the initiative in reducing their own revenue, unless you can at least offer them increased margins or some other incentive.

Leadership voids

Leadership is about people and motivation. Management is about getting work out the door. In a very real sense, outsourcing is about shifting the CIO’s attention from leading to managing.

That’s a mistake. An outsourcer’s employees should certainly receive day-to-day leadership from the vendor’s account manager. But that’s in addition to the leadership they should get from their client’s CIO.

They are, after all, people, too.

Inter-vendor politics

Just as there’s no such thing as a perfect org chart — one that clearly and unambiguously defines each manager’s responsibilities in ways that avoid overlap — so there’s no such thing as a division of outsourcer responsibilities that avoids the potential for game playing.

Potential? The game playing is often overt, although concealed from view: Many vendors have regular internal strategy sessions in which they exchange ideas about their “endgame” — how they plan to eliminate a competing vendor from the IT organizational gameboard.

The most common examples of inter-vendor politics occur when one vendor needs data from another vendor in order to move a project forward, and the vendor that receives the request, instead of providing the asked-for data, emits an unending stream of excuses, or complains that providing it isn’t in the contract, and as a custom service it will cost a significant and unbudgeted sum.

Often, the stonewalled vendor will be hesitant to complain, on the grounds that this might look a lot like they’re playing inter-vendor politics themselves.

And there’s another layer of complexity to deal with when trying to prevent, or at least manage, inter-vendor politics: In addition to one vendor trying to torpedo a rival by failing to fulfill data requests, there are times a vendor will request data from a rival in order to uncover something damaging about that vendor’s performance.

The annoying solution to inter-vendor politics is to insert yourself into any and all inter-vendor interactions. Because Vendor A refusing to provide information to Vendor B is one thing. Refusing to provide it to you? It’s your data.

Exit mitigation migraines

Here in the USA our entire system of economics is built on a single empowerment, namely, that a customer can threaten to take their business elsewhere. When it comes to IT services vendors, however, this can be a hollow threat.

To be effective, an IT services vendor’s employees have to engage in the osmotic process of learning their customer — its key staff and their quirks and temperament just as much as the application portfolio and integration architecture.

Once a services vendor is firmly entrenched, transferring that incumbent’s tribal knowledge to a replacement vendor would be, to put it gently, a non-trivial task, and that’s just the quantitative view. The political dimension exacerbates the problem: Why would you expect a vendor you’re kicking to the curb make it any easier than necessary for their replacement to succeed?

Fair’s fair, though. The same was true for the IT staff the CIO kicked to the curb during the outsource.

And beyond the political angle, in many cases the services vendor will have installed its own toolkits to help in fulfilling its responsibilities. It will take that toolkit with it should you decide to make a change.

So on top of all the rest of your exit mitigation planning, make sure your contract includes an obligation to leave these toolkits in place for a long enough transition that the replacement vendor has the time it will need to install its own proprietary toolkit.

In any event, prudent CIOs have two possible exit strategies, and they’re complementary, not dichotomous.

The first: Keep a small cadre of IT professionals on staff to work alongside each vendor. That way, if circumstances dictate, they can smooth the transition to the next vendor.

And the second? Keep a close enough eye on your vendors that you can circumvent the need to replace any of them in the first place.

It’s a quandary. Managing outsourcing vendors is arguably more complicated than in-house management and staff, because CIOs who have outsourced IT services have fewer management tools at their disposal than those who need to lead employees.

After all, when you have to deal with poorly performing employees you can call on HR.

But when you’re dealing with a poorly performing vendor, in contrast, who do you have to call on?

That would be your company’s general counsel, who would be no happier about being called in than you’d be in calling them.

IT Leadership, Outsourcing

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Outsourcing definition

Outsourcing is a business practice in which services or job functions are hired out to a third party on a contract or ongoing basis. In IT, an outsourcing initiative with a technology provider can involve a range of operations, from the entirety of the IT function to discrete, easily defined components, such as disaster recovery, network services, software development, or QA testing.

Companies may choose to outsource services onshore (within their own country), nearshore (to a neighboring country or one in the same time zone), or offshore (to a more distant country). Nearshore and offshore outsourcing have traditionally been pursued to save costs.

Outsourcing services

Business process outsourcing (BPO) is an overarching term for the outsourcing of a specific business process task, such as payroll. BPO is often divided into two categories: back-office BPO, which includes internal business functions such as billing or purchasing, and front-office BPO, which includes customer-related services such as marketing or tech support.

IT outsourcing is a subset of business process outsourcing, and it falls traditionally into one of two categories: infrastructure outsourcing and application outsourcing. Infrastructure outsourcing can include service desk capabilities, data center outsourcing, network services, managed security operations, or overall infrastructure management. Application outsourcing may include new application development, legacy system maintenance, testing and QA services, and packaged software implementation and management.

Today, however, IT outsourcing can also include relationships with providers of software-, infrastructure-, and platforms-as-a-service. These cloud services are increasingly offered not only by traditional outsourcing providers but by global and niche software vendors or even industrial companies offering technology-enabled services.

For more on the latest trends in outsourcing, see “7 hot IT outsourcing trends — and 7 going cold.”

Outsourcing pros and cons

The business case for outsourcing varies by situation, but the benefits and risks of outsourcing often include the following:

Outsourcing BenefitsOutsourcing Risks
lower costs (due to economies of scale or lower labor rates)
increased efficiency
variable capacity
increased focus on strategy/core competencies
access to skills or resources
increased flexibility to meet changing business and commercial conditions
accelerated time to market
lower ongoing investment in internal infrastructure
access to innovation, intellectual property, and thought leadership
possible cash influx resulting from transfer of assets to the new provider

slower turnaround time
lack of business or domain knowledge
language and cultural barriers
time zone differences
lack of control

IT outsourcing models and pricing

The appropriate model for an IT service is determined by the service provided. Most outsourcing contracts have been billed on a time and materials or fixed price basis. But as outsourcing services have matured to include strategic transformation and innovation initiatives, contractual approaches have evolved to include managed services and outcome-based arrangements.

The most common ways to structure an outsourcing engagement include:

Pricing modelEngagement detailsTime and materials
The client pays the provider based on the time and materials used to complete the work. Historically, this has been used in long-term application development and maintenance contracts. It can be appropriate when scope and specifications are difficult to estimate or needs evolve rapidly.
Unit/on-demand pricing
The vendor determines a set rate for a particular level of service, and the client pays based on its usage of that service. Pay-per-use pricing can deliver productivity gains from day one and makes component cost analysis and adjustments easy. But it requires an accurate estimate of the demand volume and a commitment for minimum transaction volumes.
Fixed pricing
Here, price is determined at the start. This can work well when there are stable requirements, objectives, and scope. Fixed pricing makes costs predictable, but when market pricing goes down over time, a fixed price stays fixed. It is also hard on the vendor, which must meet service levels at a certain price no matter how many resources those services require.
Variable pricing
The customer pays a fixed price at the low end of a supplier’s provided service, but this method allows for variance in pricing based on providing higher levels of services.
Cost-plus
The client pays the supplier for its costs, plus a predetermined percentage for profit. Such plans do not allow for flexibility as objectives or technologies change, and it provides little incentive for a supplier to perform effectively.
Performance-based pricing
Here, financial incentives encourage the supplier to perform optimally. This type of pricing plan also requires suppliers to pay a penalty for unsatisfactory service levels. This model is often used in conjunction with a traditional pricing method, such as time-and-materials, and can be beneficial when the customers can identify specific investments the vendor could make in order to deliver a higher level of performance.
Gain-sharing
Pricing is based on the value delivered by the vendor beyond its typical responsibilities. For example, an automobile manufacturer may pay a service provider based on the number of cars it produces. With this kind of arrangement, the customer and vendor each have skin in the game, and each stands to gain a percentage of profits if the supplier’s performance is optimum and meets the buyer’s objectives.
Shared risk/reward
Provider and customer jointly fund the development of new products, solutions, and services with the provider sharing in rewards for a defined period of time. This model encourages the provider to come up with ideas to improve the business and spreads the financial risk between both parties. But it requires a greater level of governance to do well.

Outsourcing vs. offshoring

The term outsourcing is often used interchangeably — and incorrectly — with offshoring, usually by those in a heated debate. But offshoring is a subset of outsourcing wherein a company outsources services to a third party in a country other than the one in which the client company is based, typically to take advantage of lower labor costs. This subject continues to be charged politically because offshore outsourcing is more likely to result in layoffs.

Outsourcing of jobs

Estimates of jobs displaced or jobs created due to offshoring tend to vary widely due to lack of reliable data. In some cases, global companies set up their own captive offshore IT service centers to reduce costs or access skills. Some roles typically offshored include software development, application support and management, maintenance, testing, help desk/technical support, database development or management, and infrastructure support.

In recent years, IT service providers increased investments in IT delivery centers in the US, according to a report from Everest Group. Offshore outsourcing providers have also increased their hiring of US IT professionals to gird against potential increased restrictions on the H-1B visas they use to bring offshore workers to the US to work on client sites.

Some industry experts point out that increased automation and robotic capabilities may actually eliminate more IT jobs than offshore outsourcing.

Outsourcing risks and challenges

The failure rate of outsourcing relationships remains high, ranging from 40% to 70%. At the heart of the problem is the inherent conflict of interest in any outsourcing arrangement. The client seeks better service, often at lower costs, than it would get doing the work itself. The vendor, however, wants to make a profit. That tension must be managed closely to ensure a successful outcome for both client and vendor. A service level agreement (SLA) is one lever for navigating this conflict — when implemented correctly. An SLA is a contract between an IT services provider and a customer that specifies, usually in measurable terms, what services the vendor will furnish. Service levels are determined at the beginning of any outsourcing relationship and are used to measure and monitor a supplier’s performance.

For more on outsourcing contracts, see “11 keys to a successful outsourcing relationship” and “7 tips for managing an IT outsourcing contract.”

Another cause of outsourcing failure is the rush to outsource as a “quick fix” cost-cutting maneuver rather than an investment designed to enhance capabilities, expand globally, increase agility and profitability, or bolster competitive advantage.

Generally speaking, risks increase as the boundaries between client and vendor responsibilities blur and the scope of responsibilities expands. Whatever the type of outsourcing, the relationship will succeed only if both the vendor and the client achieve expected benefits.

See also: “9 IT outsourcing mistakes to avoid” and “10 early warning signs of IT outsourcing disaster.”

Types of outsourcing

Many years ago, the multi-billion-dollar megadeal for one vendor hit an all-time high, but wholesale outsourcing proved difficult to manage for many companies. These days, CIOs have embraced the multi-vendor approach, incorporating services from several best-of-breed vendors.

Multisourcing, however, is not without challenges. The customer must have mature governance and vendor management practices in place. In contract negotiations, CIOs need to spell out that vendors must cooperate or else risk losing the job. CIOs need to find qualified staff with financial as well as technical skills to help run a project management office or some other body that can manage the outsourcing portfolio.

The rise of digital transformation has initiated a shift away from siloed IT services. As companies embrace new development methodologies and infrastructure choices, many standalone IT service areas no longer make sense. Some IT service providers seek to become one-stop shops for clients through brokerage services or partnership agreements, offering clients a full spectrum of services from best-in-class providers.

How to select a service provider

Selecting a service provider is a difficult decision, and no one outsourcer will be an exact fit for your needs. Trade-offs will be necessary.

To make an informed decision, articulate what you want from the outsourcing relationship to extract the most important criteria you seek. It’s important to figure this out before soliciting outsourcers, as they will come in with their own ideas of what’s best for your organization, based largely on their own capabilities and strengths.

Some examples of the questions you’ll need to consider include:

What’s more important to you: the total amount of savings an outsourcer can provide you or how quickly they can cut your costs?Do you want broad capabilities or expertise in a specific area?Do you want low, fixed costs or more variable price options?

Once you define and prioritize your needs, you’ll be better able to decide what trade-offs are worth making.

Outsourcing advisers

Many organizations bring in a sourcing consultant to help establish requirements and priorities. Third-party expertise can help, but it’s important to research the adviser well. Some consultants may have a vested interested in getting you to pursue outsourcing rather than helping you figure out if outsourcing is a good option for your business. A good adviser can help an inexperienced buyer through the vendor-selection process, aiding them in steps like conducting due diligence, choosing providers to participate in the RFP process, creating a model or scoring system for evaluating responses, and making the final decision.

For more advice, see “Outsourcing advisors: 6 tips for selecting the right one.”

Negotiating the best outsourcing deal

Balancing the risks and benefits for both parties is the goal of the negotiation process, which can get emotional and even contentious. But smart buyers will take the lead in negotiations, prioritizing issues that are important to them, rather than being led around by the outsourcer.

Creating a timeline and completion date for negotiations will help rein in the process. Without one, discussions could go on forever. But if an issue needs time, don’t be a slave to the date.

Finally, don’t take any steps toward transitioning the work to the outsourcer while in negotiations. An outsourcing contract is never a done deal until you sign on the dotted line, and if you begin moving the work to the outsourcer, you will be handing over more power over the negotiating process to them as well.

Outsourcing’s hidden costs

Depending on what is outsourced and to whom, studies show that an organization will end up spending at least 10% percent above the agreed-upon figure to manage the deal over the long haul. Among the most significant additional expenses associated with outsourcing are:

the cost of benchmarking and analysis to determine whether outsourcing is the right choicethe cost of investigating and selecting a vendorthe cost of transitioning work and knowledge to the outsourcercosts resulting from possible layoffs and their associated HR issuescosts of ongoing staffing and management of the outsourcing relationship

It’s important to consider these hidden costs when making a business case for outsourcing.

The outsourcing transition

Vantage Partners once called the outsourcing transition period — during which the provider’s delivery team gets up to speed on your business, existing capabilities and processes, expectations and organizational culture — the “valley of despair.” During this period, the new team is trying to integrate transferred employees and assets, begin the process of driving out costs and inefficiencies, while still keeping the lights on. Throughout this period, which can range from several months to a couple of years, productivity very often takes a nosedive.

The problem is, this is also the time when executives on the client side look most avidly for the deal’s promised gains; business unit heads and line managers wonder why IT service levels aren’t improving; and IT workers wonder what their place is in this new mixed-source environment. The best advice is to anticipate that the transition period will be trying, attempt to manage the business side’s expectations, and set up management plans and governance tools to get the organization over the hump.

Outsourcing governance

A highly collaborative relationship based on effective contract management and trust can add value to an outsourcing relationship. An acrimonious relationship, however, can detract significantly from the value of the arrangement, the positives degraded by the greater need for monitoring and auditing. In that environment, conflicts frequently escalate and projects don’t get done.

Successful outsourcing is about relationships as much as it is actual IT services or transactions. As a result, outsourcing governance is the single most important factor in determining the success of an outsourcing deal. Without it, carefully negotiated and documented rights in an outsourcing contract run the risk of not being enforced, and the relationship that develops may look nothing like what you envisioned.

For more on outsourcing governance, see “7 tips for managing an IT outsourcing contract.”

Repatriating IT

Repatriating or backsourcing IT work (bringing an outsourced service back in-house) when an outsourcing arrangement is not working — either because there was no good business case for it in the first place or because the business environment changed — is always an option. However, it is not always easy to extricate yourself from an outsourcing relationship, and for that reason many clients dissatisfied with outsourcing results renegotiate and reorganize their contracts and relationships rather than attempt to return to the pre-outsourced state. But, in some cases, bringing IT back in house is the best option, and in those cases it must be handled with care.

For more on repatriating IT, see “How to bring outsourced services back in-house.”

More on outsourcing:

7 hot IT outsourcing trends — and 7 going cold Top 10 IT outsourcing providers 9 outsourcing myths debunked The hidden costs of outsourcing 11 keys to a successful outsourcing relationship 9 IT outsourcing mistakes to avoid 10 early warning signs of IT outsourcing disaster 12 signs your strategic partnership has gone wrong 7 keys to transformational outsourcing success SLA guide: Best practices for service-level agreements 10 dos and don’ts for crafting more effective SLAs How to contract for outsourcing agile development IT Leadership, IT Strategy, Outsourcing

Posted on Posted in Digital transformation, General topics Tagged with , , , , , , , ,

Outsourcing continues to be an essential function for IT leaders given their growing laundry list of technology requirements.

Historically, IT outsourcing has largely been seen as an opportunity to drive cost savings and efficiency, or for technology teams to specialise in a limited number of core areas. And while those benefits remain, outsourcing’s value has shifted in recent years.

In their efforts to drive transformation and continue to deliver at the unprecedented levels seen through the COVID-19 pandemic, today’s CIOs are increasingly reliant on onshore (within the same country), nearshore (to a nearby country or in the same time zone), offshore (to a distant country) and cloud computing providers to bolster teams, focus in-house staff on core operations, improve service delivery and round out the IT function, and oversee tasks as varied as help desk support, software development and disaster recovery.

So getting IT outsourcing right isn’t always straightforward.

IT outsourcing market continues to expand

IT outsourcing vendors offer everything from a fully managed service to providing additional, ad hoc support, and it’s a market that has continued to blossom.

In Gartner’s IT spending forecast last year, the analyst firm said global IT spending would reach $1.19 trillion in 2021, with worldwide spend on consultancy and implementation services, and IT-centric managed services, infrastructure and application support, expected to come in at $490 billion and $475 billion, respectively.

Separately, the Global Industry Analytics report proclaimed that the value of the IT outsourcing market would grow by 5% year-on-year between 2020 and 2024.

Some industry observers say that this was, in part, brought on by the pandemic pushing IT leaders to accelerate digital transformation initiatives, expedite project delivery and supplement resource shortcomings, not least through the widely-publicised IT skills gap and Great Resignation.

In a survey of 200 companies across industries, the Boston Consulting Group (BCG) found that 79% of organisations had asked service providers for help in some form through COVID-19, such as for longer payment terms (47%), price reductions (45%), or free support for more processes or additional services (41%).

John-David Lovelock, distinguished research VP at Gartner, believes acceleration of technology is facilitated by more influential IT leaders, adeptly supported by trusted third parties.

“2022 is the year that the future returns for the CIO,” he said. “They are now in a position to move beyond the critical, short-term projects over the past two years and focus on the long-term. Simultaneously, staff skills gaps, wage inflation and the war for talent will push CIOs to rely more on consultancies and managed service firms to pursue their digital strategies.”

IT outsourcing benefits move beyond cost control

IT outsourcing is a flourishing $92.6 billion market, says Forrester senior analyst Jeffrey Rajamani, who adds that partners can offer CIOs greater stability in an uncertain market while helping them to be more creative and resilient.

He does, however, believe that cost control is no longer the primary benefit. He cites Delta Air Lines as an example, which outsourced to IBM in 2016 to reduce costs through bankruptcy, only to strike a more recent agreement in 2020 to concentrate on cloud migration and application modernisation.

“From IT maintenance to CRM to BPO, outsourcing is firmly ingrained in company culture and is becoming central to the smooth operation of the world’s big firms,” says Rajamani. “Cost-reduction was the number-one goal of outsourcing, but that’s gradually changing. Organisations are meanwhile outsourcing not just for efficiency but for effectiveness, access to skills, and for focusing on core business, cutting-edge innovation, modernisation and business transformation.”

Kaveh Pourteymour, former Neptune Energy CIO and current head of business partnering and projects at Rio Tinto, says outsourcing consideration needs to be part of the organisation’s overall digital strategy, which describes the capabilities it needs to have internally, and what can be safely sourced externally.

“The principle I’ve pursued is to have in-house capability that understands and manages the end-to-end IT value chain, from business partnering to supplier management, and uses outsourcing partners to deliver components of it.”

He adds that outsourcing can drive efficiency as organisations get instant access to talent to serve a “geographically diverse operation” as well as well-established methodologies and approaches that bring consistency to how IT services are delivered.. It’s also a chance to gain access to IT specialists, so long as you still make them feel like part of the team.

For experienced IT leader Kelly Olsen, now CIO of professional services firm PA Consulting, outsourcing gives organisations the advantage of adding expertise and skills, or keeping up in an advancing field such as cybersecurity or business intelligence (BI). It does, however, need to be more based on partnerships than it has been if both parties are to derive value from the contract.

“I think people are now thinking about it much more strategically, and being able to burst the team, for example,” she says. “It’s more than body shopping…because [the partners] know you; they understand you.”

For Shauna McMahon, CIO at Northern Lincolnshire & Goole NHS Foundation Trust, this reliance on third parties has become critical at a time of talent shortages and budgetary constraints in already over-stretched health and social care.

“If you can’t recruit to roles and you’ve tried a number of options, outsourcing may be the only option,” she says, adding that she’s used outsourcing when having a “hard stop” on production targets, for rapid delivery, and to fill talent shortages on a short-term and longer-term basis.

Outsourcing IT for application development, cloud migration and security

If the value of outsourcing is established, harder questions for today’s CIO revolve around what and when they outsource, and to whom.

Pourteymour, believes that leaders should only look to outsource the service if it’s a commodity and can be bought and delivered faster, more efficiently or more professionally than in-house service, or if it requires certain specialist skills, such as application management, for example.

In addition, he says that CIOs may also come to this decision when the service can be enriched by experience from other customers, like a shared security operations centre or if the SLA required by the business is too difficult to deliver in-house.

There’s a belief, too, that the types of applications and workloads being outsourced are changing.

According to IEEE Computer Society’s 2021/2021 IT Outsourcing Statistics report, the most commonly outsourced function within IT today is application development (56%), although IT leaders also outsource helpdesk and desktop support, networking monitoring and management, system implementation and integration tasks, as well as backup and disaster recovery services.

Pourteymour sees four immediate areas worthy of consideration: server/infrastructure management, data centre management, applications management, and helpdesk and workplace services, such as laptops and software patching. Meanwhile, McMahon has recently outsourced records management, storage, digital transcriptions, components of cybersecurity and device management, as well as data warehouse management.

“I am currently outsourcing data warehouse management so my internal team is able to focus on the business intelligence, insights and data analytics, and drive value forward for our operational and clinical areas,” she says. “In healthcare, I don’t need to build and have skills to manage a data warehouse—that can be done in the cloud by other experts.”

For Forrester’s Rajamani, though, data centre consolidation and cloud migration in particular are pushing CIOs into new relationships, often in the search of outside “perspective, orchestration skills, assets and speed”.

Minding the pitfalls of outcome-based IT outsourcing

Olsen and Rajamani say the outsourcing market is moving to become more outcome-driven with value-focused pricing, with Rajamani adding the former is an “engagementstructure that explicitly targets business-oriented goals, including cost savings, time-to-market, higher revenues, or customer acquisition/retention”.

“The key for outcome-based pricing is that the contract terms focus on business value delivered with shared accountability,” he says, adding that IT outsourcing is moving to become more product and platform-centric, and more co-creative and business focused with partners. This means less of a focus on transactional IT and cost, and a step toward co-creation to move away from long-winded RFP processes.

The Forrester analyst also says there’s greater use of automation, from chatbots to RPA, in order to drive efficiency, costs savings and better customer satisfaction, as well as a switch from SLAs to so-called experience-level agreements, which measure the performance of IT by quantifying the end-user experience and IT service outcomes.

There are, however, still dangers CIOs need to be aware of when it comes to IT outsourcing. Cost savings can be a trap, culture differences across teams can remain, time-to-market benefits aren’t always realised, and contracts can contain loopholes or grey areas.

PA Consulting’s Olsen encourages IT leaders to review the small print of contracts, but also give the third-party space and energy to deliver innovation beyond BAU.

“There’s no point in writing a contract where it’s so punitive that neither company is going to get what they want at the end of the day,” she says. “So make sure the contract is clear.”

She also believes in-house teams should make sure third parties are capable from the start of the project.

“Don’t outsource a problem,” she says. “Make sure that whatever you’re handing over is in good order. Give your partner a fighting chance.”

Rajamani also highlights that although cost was long replaced by value, many firms are still using cost savings to measure the success of outsourcing, with bad estimates sometimes provided by service providers owing a lack of proficiency. “The result of this inaccuracy is failed deadlines on scheduled campaigns,” he says, “which hurts much more than pure money loss.”

IT Leadership, Outsourcing

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Outsourcing’s business value has long centered on labor arbitrage. While outsourcing partnerships have become more strategic, getting costs down remains a significant draw of the sourcing model. But outsourcing costs have been driving higher for months. A chief factor in this is an unprecedented talent shortage.

“It’s hard to get people, and it’s hard to retain them,” says Amy Fong, partner in Everest Groups’s sourcing and vendor management practice.

In many ways, the challenges of outsourcing today mimic the material supply chain issues that companies have been dealing for the past two years — albeit it with a twist: Here, we’re talking human resources, which can be much more complex and nuanced to predict and manage.

According to a recent Everest Group poll, 39% of respondents say their outsourcing prices have risen more than 10% over the past year; and almost half (48%) say they have increased 10% or less. No one said their IT services costs had gone down.

“We have been in a state of increasing costs and talent shortages for at least six months,” Fong says, “and we’re still at a point of uncertainty. Many economists are forecasting a recession.”

All this suggests CIOs may be at an inflection point that will require rethinking their outsourcing strategies. “You need to think about what’s appropriate for the long term and how you build in flexibility in the short term in case things level out,” Fong says.

IT leaders may want to choose a new location for IT services or bring in a new supplier. Or they may want to factor in pricing before locking themselves into a three- to five-year contract. The industry is unlikely to mint an extra million people in the IT workforce in the short term. High-demand skills will continue to be in short supply.

Now is the time to create a playbook for managing outsourcing costs in new ways that build in flexibility. IT leaders should consider various scenarios and understand how their workforce plans might need to change as they encounter various demand and supply imbalances, Fong says.

Following are five tips for wrangling outsourcing costs and making the most of your outsourcing relationships as prices rise.

Consider your commercial model mix

There are a variety of methods available for contracting IT services today, from the tried-and-true approach of paying by time and materials all the way up to outcome-based deals, in which the buyer pays only for the end result, placing more risk and cost management concerns on the supplier.

With IT services costs rising, it’s important to be discerning when selecting which model to apply to your outsourcing IT portfolio. Steady-state processes and services can still be handed over using a managed services model, Fong says. But early stage projects or those where high-end skills are paramount may require taking a cost hit on a time-and-materials basis if it ensures higher quality talent, she says. Because of this, IT leaders may find a mix of models with a variety of providers will be the best approach to controlling costs while maintaining quality.

David Rickard, vice president of business process services at Everest Group, says here, more is more. “When we’re looking at organizations seeking to bring transformation to the organization, they’re starting to think about who are the specialists in the technology stack, who are the functional or methodological sub-providers that we should be thinking about, and — if we’re in in a specific industry or a particular function — are there specific providers we should be working with as well,” he says.

For more generic work, the choice may be different. “Consolidating with providers that you’re already working with can give you an opportunity to start to push for competitive pricing or changing the commercial models because you’ve got an established relationship,” Rickard says. “It’s all about context.”

Location, location, location

The IT talent shortage is a global phenomenon. Worse, in the IT services industry, some large providers are seeing attrition rates double to 30%. “Your providers might be losing one third of their people on a regular basis,” Fong says. “That’s a big cycle through of head count.”

Onshore geographies have been especially vulnerable due to broader demographic trends, including an aging workforce population and immigration issues. 2022 has seen the US and Western Europe facing the greatest hiring and retention challenges in IT, according to the Everest Group, but India and Central and Eastern Europe aren’t far behind.

COVID-accelerated digital transformation efforts are also straining supply. Lead times to hire and acquire across a variety of digital skills, including cloud, data services, and cybersecurity, have extended as much as four to six months.

Attrition and lead times may be leveling out, but IT leaders seeking cost competitiveness need to reassess where they send their IT services work, Fong says.

“Locations that we’ve always relied on may not necessarily be the ones that we can rely on in the future,” agrees Rickard, adding that changing workforce demographics are poised to impact popular outsourcing geographies, with the growth of working-age populations set to stall over the coming decades in counties such as Brazil, Colombia, and Costa Rica and to decline in places such as Czech Republic, Poland, and Lithuania, which are great sources of tech talent today. Now may be a good time to double down on India because that’s where the talent is, Rickard says. “It’s all about managing the impact now, but also thinking about what long-term strategy they need to be deploying,” he says. “We are also getting inquiries right now around Africa, which is a massive source of potential talent as we look forward.”

Cost analysis is an ongoing initiative

There’s been a significant increase in FTE prices offshore since the first half of 2021, according to Everest Group, with the highest increase in next-gen skills in IT infrastructure and applications. The curve has been even steeper for onshore roles, says Fong.

It’s more important than ever to benchmark your costs against the marketplace. “We’ve seen examples where people think they’re paying a good rate, they negotiate, and they’re really proud that they get a 10% reduction or keep it flat,” Rickard explains, “but actually they’re paying way above the market and that’s why a provider can give them an attractive rate.”

IT leaders should also evaluate total cost of ownership versus rates on a card. “Often, the rate card may be attractive, but there are lots of add-on services, operational costs, or relationship and account management costs to add in,” Rickard says. “It’s really about understanding what’s the total cost of that operation.”

Most outsourcing agreements include a cost of living adjustment (COLA) clause, which were largely ignored during COVID. IT leaders should keep in mind the value of any COLA clause with a fixed increment tied to the Consumer Price Index or a cap and collar in which you agree on minimum or maximum increases. “Organizations are realizing these clauses are there to protect both sides so people can plan and forecast around that.”

IT leaders should also understand that wage increases should not lead to equivalent price increases. A 15% increase in wages should have, at most, a 7% to 9% impact on price, Rickard says.

Another sneaky driver of increased costs is role inflation. To retain employees, many service providers have been offering junior resources early promotions leading to rising costs for customers. Typically, outsourcing deals are staffed with around 80% lower-level IT professionals and 20% senior roles. Even a slight shift in those ratios can lead to a 6% increase in overall costs for a customer, according to Everest Group analysis.

IT leaders should review their suppliers staffing ratios to look for any increase in senior roles. “There could be a genuine reason to staff more senior resources, such as service delivery concerns or project complexities,” says Bhanushee Malhotra, practice director in Everest Group’s sourcing and vendor management practice. “But putting junior resources in your senior bracket has been becoming a norm, which shouldn’t be the case.”

Understand your end-to-end workforce strategy

In the past, there was limited visibility of how IT sourcing and contingency staffing fit into the larger workforce strategy — particularly among procurement offices. Now, everyone must understand IT’s workforce needs, both now and in the future, to manage costs. “We’re not talking about buying widgets. In the services world we’re talking about people human capital,” says Fong. “It’s important to think about how all these different parts of the workforce fit together.”

When IT faces hiring or retention challenges, or institutes a hiring freeze, it’s likely that outsourcing and contingency staffing will increase to meet short-term needs. “They have big projects that they can’t add head count to and therefore they may need to bring on another provider” or other contingent workers, says Fong. “These are very interconnected sources of talent that everyone should be thinking about.”

IT leaders should work with HR and other sourcing stakeholders to strategize end-to-end. That will involve assessing future demand based on business needs and external scenarios, understanding the existing supply profile and key gaps, evaluating talent sourcing options, matching supply and demand on an iterative basis, and monitoring the situation on an ongoing basis. “It sounds a lot like the demand planning process for manufacturing; it’s just that we’re talking about people,” says Fong. “And people are much more nuanced and difficult.”

Go beyond cost savings

Regardless, IT leaders are still likely to deal with increased IT services costs, at least in some areas. Because of this, it’s important to shift the outsourcing narrative to business value, as IT outsourcing can deliver business benefits beyond cost savings. “There’s risk management. There’s making sure there’s an adequate supply at all times. There’s maintaining those relationships with suppliers and driving the constant flow of innovative ideas,” Malhotra says.

IT and procurement leaders should integrate more qualitative benefits into their outsourcing scorecards. It’s important “to take credit for all that you’ve done to get through the last couple of years, whether it’s ensuring that your supply was available at all points of time or just creating the right type of impact in the organization,” Malhotra says.

At a time when IT may be struggling to hit cost savings targets, it’s even more important that outsourcing arrangements continue to deliver in other areas. Being transparent about the increase in costs as well as the continued benefits IT service providers are delivering is paramount. “We all know we’re in inflationary times,” says Fong, “so having these hard talks up front is really important.”

Outsourcing