The Practice of Outsourcing
At a very high level, outsourcing is the practice of obtaining goods or services from an outside provider, particularly as a substitute for internal sourcing. In this article, we focus on the outsourcing of information technology and business services. Information Technology Outsourcing (ITO) is the practice of outsourcing IT services such as application development, application support, data centre management, telecommunications and network management, distributed computing (e.g., desktops, laptops, and mobile devices) and cloud computing. Business Process Outsourcing (BPO) is the practice of outsourcing business services, including financial and accounting, human resource management, procurement, research and development and legal services (see sidebar: Legal Process Outsourcing). We have been studying the ITO market since 1990 and the BPO market since 2000. Our research includes thousands of interviews with clients and providers on five continents, in-depth case studies, large-scale sample surveys, and a recent meta analysis of empirical findings from academic ITO and BPO research.Footnote 1 We first describe the maturity, size, and drivers of each market, present the evidence on ITO and BPO success rates, and then describe the proven practices that differentiate positive and negative outsourcing outcomes. We discuss important limitations in contractual governance that still need pioneering work.
Mary Lacity
Leslie Willcocks
Maturity and Size of ITO and BPO markets
ITO is the more mature market compared to BPO. As early as 1963, Electronic Data Systems (EDS) handled data processing services for Frito-Lay and Blue Cross. Over the next twenty-five years, ITO grew to span multiple IT services and transferred a significant amount of assets, leases, licenses, and staff to providers that assumed profit and loss responsibility. Kodak's $500 million, ten-year deal with IBM and Enron's $750 million, ten-year contract with EDS were bellwether deals in 1989, signalling the increased scope of ITO. In the UK, notable deals included contracts between the Inland Revenue and EDS and between BAE Systems and Computer Sciences Corporation (CSC), both ten year deals. BP Exploration's five-year contracts with three providers in 1993 were ground-breaking because it popularised selective sourcing as a new model. Also during the 1990s, ITO contracts went global, with companies like DuPont signing $4 billion worth of contracts with CSC and Andersen Consulting that operated in 22 different countries. ITO continued to grow and Gartner estimates that the global ITO market in 2012 is worth $309 billion.
Compared to ITO, BPO is a less mature market, representing over $160 billion in global revenues 2011Footnote 2, but BPO is growing at a faster rate. Booz Allen and Hamilton estimated that BPO is growing at 25% per year compared to ITO growing at 10% per year. Some early BPO deals piggybacked on ITO deals. For example, Procter & Gamble initially signed a $3 billion, 10-year ITO contract in 2003 with HP and extended the relationship to include global transactional accounts payable operations in 2004. Amore common practice has been to hire different providers for different ITO/BPO activities, for example BAE Systems hired Xchanging for HR outsourcing (HRO) in 2001, BP hired Exult for HRO and Accenture for accounting and finance (from 1993), and each had different ITO providers. However, bundling BPO–that is giving a mix of BPO activities to one provider–has been a growing practice since 2005Footnote 3.
The Economics and Business Drivers of Outsourcing and Offshoring
From a client perspective, research has consistently found that outsourcing decisions are primarily driven by the need to reduce overall client costs, usually by at least 10% to 15%.Footnote 4 Labour is the largest cost component of IT and BP services. Given that the client will spend an additional 6% to 10% of the contract value in transaction costsFootnote 5 and given that the provider has to generate a 10% to 20% profit margin, we begin to understand the economic drivers of offshoring. Labour costs in countries like India and China, though rising, are a fraction of the labour costs in countries like the United States and United Kingdom. For example, a computer programmer in New York City may cost $100 per hour, compared to $25 in India. Compared to the huge advantage of offshore labour arbitrage, providers have less powerful cost reduction levers based on economies of scale (which reduce costs on average by 3% to 5%) or superior management practices (which reduce costs on average by 4% to 10%.)Footnote 6 Given these cost drivers, many providers must locate enough employees in offshore delivery centers to reduce client costs while still earning a profit. By far, India is the dominant destination for offshore delivery centres, exporting at least $75 billion a year in ITO and BPO services. The Philippines, Brazil and China are also popular offshore locations. Nearshore outsourcing is also prominent—particularly with Western European clients outsourcing services to providers with delivery centres based in Eastern European countries. Preferred venues change based on a mix of location attractiveness factors, and a recent development has seen offshore venues such as India also re-outsourcing work to countries like Egypt and ChinaFootnote 7.
Besides cost savings, research has found that clients expect ITO and BPO to deliver a number of additional business benefits, including one or more of the following: ability to redirect in-house staff on more strategic activities, access to scarce skill sets, service quality improvements, business process improvements, innovation, and access to new markets.Footnote 8 (Research has found also that the greater the perceived risks, concern for security, fear of losing control of the service, or fear of losing intellectual property, the less likely a client firm was to choose outsourcing.) The question we address next is this: do clients achieve the expected benefits from outsourcing?
Outsourcing Success Rates
Many academic studies examined the extent to which outsourcing engagements resulted in positive outcomes from the client's perspective. Most of this research is based on large-sample surveys of outsourcing clients or in-depth case studies at client sites. Across these studies, ITO and BPO researchers have used many different types of measures to examine the outcomes of outsourcing. The most frequently used measures include outcomes that capture a client's general perceptions of the success or level of satisfaction with outsourcing in general or with offshore outsourcing in particular, perceptions of the quality of relationships, the effects of outsourcing on a client organisation's business performance, such as improvements in stock price performance, return on assets, expenses, or profits after outsourcing. By aggregating findings from both qualitative and quantitative studies and from both ITO and BPO studies, we have a solid statistic on outsourcing outcomes from the client's perspective: Outsourcing decisions resulted in positive outcomes in 60% of the findings, negative outcomes in 16% of the findings, and no changes in performance as a consequence of outsourcing in 25% of the findings.Footnote 9 (See Table 1). When we uncouple the ITO from the BPO outcome statistics, we find interesting differences. Considering just the ITO outcome data, 63% of the findings were positive, 22% of the findings were negative, and no changes in performance as a consequence of outsourcing were reported in 15% of the findings. In the BPO research, 56% of the findings reported positive outcomes, 11% of the findings reported negative outcomes, and no changes in performance as a consequence of outsourcing were reported in 33% of the findings. These statistics suggest that ITO is riskier than BPO because frequency of failure is greater. BPO is more likely than ITO to result in no changes in performance.
Table 1 Effects of Make-or-Buy Decisions on Outsourcing Outcomes
Another way to slice the data is to extract the findings that only considered the effects of offshore outsourcing decisions on outcomes. In this subset of the data, 58% of the findings were positive, 9% of the findings were negative, and 33% of the findings reported no changes in performance. This statistic must be interpreted with caution because many studies in the general ITO or BPO literature may have included offshore outsourcing data. For example, research that asked clients the extent that outsourcing resulted in cost savings, but did not ask whether providers were domestic or offshore, would not be included in the offshore statistic even though the client may have been outsourcing to offshore providers.
No matter how the data are sliced, many people will consider these statistics quite disappointing—only 56% to 63% of outsourcing engagements have been considered positive by clients. The good news is that scholars have studied the determinants of ITO and BPO outcomes. We thus have a strong understanding of the practices that differentiate positive from negative outcomes.
Practices that Contribute to Success
Based on our review of the empirical ITO and BPO research, we extracted what we call robust practices, practices that have been academically tested and proven to be effectiveFootnote 10. These practices are grouped into four categories: Contractual Governance, Relational Governance, Client Retained Capabilities, and Provider Capabilities (see Figure 1).
Figure 1: Robust Practices That Lead to ITO and BPO Success
Contractual Governance
Contractual Governance is the formal, written rules that govern client-provider relationships. In scholarly works we reviewed, contractual governance was operationalised most frequently as degree of contract detail (e.g., the types of clauses, number of service level agreements), contract duration, contract value, and contract pricing (e.g. fixed price, time and materials). Substantial evidence finds that (a) more detailed contracts, (b) shorter-term contracts and (c) higher-dollar valued contracts were significantly associated with positive outsourcing outcomes.Footnote 11 Detailed contracts that defined the scope of services, prices, service levels, and responsibilities of both parties and prescribed how parties would adapt to changes in character, volume, or market best practices had better outsourcing outcomes than contracts with fewer details. Shorter-term ITO contracts in the three-to-five-year range experienced successful ITO outcomes more frequently than contracts with greater than five years duration. Within the BPO literature, however, contract duration was not a significant determinant of BPO outcomes. Higher-valued contracts perform better than lesser-valued contracts because the transaction costs associated with outsourcing are spread over a greater volume of work. Contract pricing is still an industry-wide challenge, as discussed below in the Contractual Challenges section.
Relational Governance
Relational governance comprises the informal rules that manage client-provider relationships. In scholarly works we reviewed, relational governance was operationalised most frequently as effective knowledge sharing, communication, trust, and viewing the provider as a partner. In 94% of the findings, the research showed that higher levels of relational governance were associated with higher levels of outsourcing success.Footnote 12 In some ways, the findings are trivial. Few people would argue that withholding knowledge, closed communications, or distrusting providers would lead to better outsourcing relationships. A more interesting research finding is that contractual governance and relational governance serve as complements, in that both need to be strong to produce positive outsourcing outcomes. In general, contractual governance and relational governance are not substitutes in that a poorly crafted contract cannot be overcome with friendly, communicative, and trusting account managers. Poor contracts, we have found, can make for poor relationships.Footnote 13
Client Retained Capabilities
Research has found that clients must learn to manage differently after outsourcing in order to achieve expected benefits from outsourcing. Clients must become good at managing providers by shifting their capabilities from managing resources and processes to managing inputs and outputs. This is not an easy transition for many clients. The Supplier Management Capability was often found to be lacking in client organisations and seen as a major reason to explain negative outsourcing outcomes. Technical and Methodological Capability was the second most frequently important client retained capability, particularly in the ITO literature. Technical and Methodological Capability is an operational capability needed by both parties in order to coordinate work effectively. A client also needs to be able to identify, rate, and mitigate potential risks associated with outsourcing (Risk Management Capability). Researchers have studied the effects of a client's ability to manage a business process themselves and found that clients are more likely to successfully outsource a business process that they can efficiently and effectively manage themselves (Business Process Management Capability). This finding resonates with the maximum, “you can't outsource your mess for less.” Clients also need a strong Contract Negotiation Capability, which is frequently supplemented with the aid of advisory firms. Clients must learn to understand, accept, and adapt to cultural differences between themselves and their providers (Cultural Distance Management Capability). Other client capabilities have also been identified as affecting outsourcing decisions and outcomes: Absorptive Capacity, Client Outsourcing Readiness, Change Management Capability, Human Resource Management Capability, and Transition Management Capability. Clearly outsourcing is not about abdicating management responsibility, but about managing differently.Footnote 14
Provider Capabilities
Which provider capabilities contribute to positive outsourcing outcomes? The three most frequently studied and most important provider firm capabilities were Human Resource Management Capability, Technical and Methodological Capability, and Domain Understanding. A provider's ability to identify, acquire, develop, and deploy human resources to achieve both provider's and client's organisational objectives was found to positively and significantly affect client outcomes 95% of the time it was examined. Clients often engage providers because of their superior human resources in terms of both number and quality of staff. The provider's Technical and Methodological Capability was the second most frequently studied capability and it was found to affect outcomes positively (see above). Domain Understanding is the extent to which a provider has prior experience and/or understanding of the client organisation's business and technical contexts, processes, practices, and requirements. Other provider capabilities were also found to be important: Client Management Capability, Managing Client Expectations, Supplier Employee Performance, Risk Management Capability, Security, Privacy & Confidentiality Capability, Supplier's Core Competencies, Absorptive Capacity, Environmental Capability, and Corporate Social Responsibility Capability. Providers are unlikely to excel in all of these areas, but better capabilities lead to better outcomes.Footnote 15
Contractual Challenges
Contract law recognizes that clients and providers behave in their own best interests and that parties may behave opportunistically.Footnote 16 In contract theory, an ideal contract perfectly aligns client and provider incentives. In contract practice, ITO and BPO contracts designed to align incentives have not always operated as intended. Consider the first major attempts to resolve the alignment issue with strategic partnerships and joint ventures during the 1990s. The idea was that the provider investor would sell the client's assets or excess capacity to third parties and share the revenues with the client. Examples of these deals included Swiss Bank and Perot Systems, Commonwealth Bank and EDS, Xerox and EDS, and Delta Airlines and AT&T. These deals did not work as planned. The providers had their hands full just servicing the client investors' operational needs. In addition, clients frequently oversold the value and portability of their assets. The deals we studied all reverted to fee-for-service relationships or were completely terminated.Footnote 17 Years later, two significant challenges remain in aligning incentives in contracts:
Contract Pricing
ITO and BPO contracts use a number of pricing mechanisms including cost plus (e.g. equipment purchase price plus margin), unit pricing (e.g. price per invoice processed), FTE pricing (clients charged based on a rate card), fixed price, incentive-based pricing (the provider is paid extra for over-performance), or gainsharing (if the provider reduces costs, the savings are shared 50%–50% or 75%–25% client/provider split). Most ITO and BPO contracts are still priced based on inputs, such as charging by the number of FTEs the providers use to service an account.Footnote 18 This pricing mechanism does not align incentives as providers have few incentives to improve productivity because fewer FTEs would mean lower provider revenues. Clients have tried to supplement FTE pricing by requiring productivity improvements, but those were frequently incremental. Furthermore, FTE pricing can keep clients in the business of managing resources (such as interviewing each provider employee) rather than managing the outputs. Unit pricing is gaining in popularity, but some providers underestimated the price, which eroded their margins and threatened the viability of their relationships. While the last two mechanisms—incentive-based pricing and gain-sharing—are designed to align client and provider incentives, they are not frequently used, or when used, often represent a small portion of the overall contract. On some accounts we've studied, the parties could not agree on baseline performance or the true value of transformation projects, causing disputes over the incentive bonuses or gain-share value. Julian Millstein, Attorney and dispute resolution professional, said, “Putting a gainsharing clause in the contract doesn't make it happen. Gainsharing only works if the provider has the creativity to identify transformational projects and both parties have to be willing to do things differently.”
Contract Adaptability
Adapting to change is another pervasive contractual challenge. Many respondents in our own research have commented to the effect that their contracts were out of date even before the ink was dry. Change comes from many sources:
• The client's business process and information technology requirements change.
• The client's volume of services fluctuates unpredictably as clients grow rapidly through mergers or acquisitions or shrink quickly through divestitures.
• The political support for outsourcing within client organisations wane with senior executive turnover.
• The market price changes radically as labour costs rise, technology costs decline, or market prices alter with changes in demand, currency value, or political stability.
• The best-in-breed service performance improves.
Partners try to design flexible ITO and BPO contracts to adapt to such changes, particularly during a long term relationship. Standard in contracts are clauses for volume fluctuations for when additional resource charges (ARCs) or reduced resource charges (ROOKs) apply, force majeure clauses, change of character clauses, and external benchmarking to reset prices or service levels. To one extent, these contract clauses are effective. As noted above, greater contract detail was associated with better outsourcing outcomes in the empirical ITO and BPO review.
In our case study research, we continue to hear laments that big changes cause severe consequences to the economic viability of the disadvantaged partner. In practice, significant change harms either the client or provider, which can result in a dispute. Consider the common dispute that emerges after an external benchmark.Footnote 19 When an external benchmark finds that a provider's unit price is well above best-in-breed price, the client wants the price reduced as indicated by the contract. The provider will dispute the benchmark, claiming the comparison is unfair. For example, one provider said the cost per function point (a measure of a unit of software) was high on this client's account because they were maintaining the client's old information systems. Newer technology—the provider argued – would have a lower price per function point. The provider could not meet the best-in-breed price without seriously eroding their margin. From the provider's perspective, the flexibility clause failed. According to Julian Millstein, “Objective benchmarks don't help when one or both parties are hurting. The parties need a mediator to help negotiate what changes might be needed. Sometimes the answer is to re-scope, not to re-price.”
Conclusion
We have consistent evidence as to what motivates ITO and BPO decisions. Clients consider outsourcing to reduce costs, to focus on core capabilities other than the activities chosen for outsourcing, and to inject client firms with provider resources such as skills, expertise, and superior technology to improve client performance. Clients are less likely to outsource activities that have high levels of perceived business risk, such as concern for loss of control or intellectual property. On the determinants of ITO and BPO outcomes, overall we know that both contractual and relational governance are important, that both clients and providers need strong complementary capabilities to make relationships successful, and that certain types of transactions and decisions affect ITO outcomes.
Outsourcing has become an almost routine part of management. The key in that sentence is the word “almost”. In fact, our review of twenty years of research establishes the common denominator that, for management and operational staff, outsourcing is far from easy. There is no quick fix; not in periods of growth nor in periods of economic decline. Outsourcing itself is not a panacea, but represents a different way of managing. Much depends on experiential learning and sheer hard work by clients and providers alike on a daily basis. Our own work on management practice suggests that back office executives must climb a significant learning curve and build key in-house capabilities in order to successfully exploit outsourcing opportunities. They need to accept that outsourcing is not about giving up management but about managing in a different way. We also find providers continually having to re-address their capabilities, their market offerings and competitive forces. In the face of these difficulties, outsourcing will remain a fascinating and growing area for research for many years to come. It also provides a notable area where academic researchers and the distinctive qualities they bring to bear can continue to provide rich insight and guidelines in an emerging, expanding, but still much muddied field of organisational operation.
SIDEBAR: Legal Process Outsourcing
Legal Process Outsourcing (LPO) is the outsourcing of legal services to a third party provider. LPO providers perform legal services such as litigation and business document preparation and review, due diligence, discovery, and contract management. In the US, LPO became controversial when firms like Bickel Brewer LLP and General Electric erected captive centres in India to perform low-level legal work. Opponents to offshore LPO initially claimed that attorney-client privilege was breeched because communication was being sent outside the country, but in 2008, the American Bar Association agreed that offshore LPO was a salutary practice for a globalised economy.Footnote 20 In the UK, the Legal Services Act of 2007 opened the dialogue for alternative business structures.Footnote 21 Since then, the global LPO market has grown to be a $2.4 billion market in 2012.Footnote 22 Indian-based providers are the leaders in the offshore LPO space, with 128 LPO providers exporting legal services worth $640 million in 2010;Footnote 23 Indian's LPO market may grow to $4 billion by 2015.Footnote 24 The LPO market comprises speciality LPO/KPO providers like Pangea3, Quislex, Mind Quest, CPA Global, and Evalueserve as well as the large global providers like Accenture, Wipro, Infosys, and TCS.Footnote 25 Services are priced between $25 and $50 per hour, depending on the skill level, or by the unit of work—per contract, per patent, per page, per project. LPO offers client's value not only by decreasing costs but also by increasing capacity, velocity, throughput, cost predictability, and innovation. According to David Perla, Co-CEO of Pangea3, an LPO with 850 globally located employees, “We help transform how work is done in legal departments or large law firms. We do things for clients that they have never been done before, such as deploying contract management lifecycle systems or combining legal and technical teams by having lawyers and engineers working side-by-side for many years.”
