|
|
Business Value and Third-Generation Outsourcing by Daniel J. Ryan
Managing an organization's information technology infrastructure is by-and-large a thankless task. Computers and networks are all too often viewed by senior management as at best necessary evils that are squarely on the cost side of the ledger. Sure, the accounting system is important, and of course e-mail is useful, but the technology that makes it all possible is hard to understand, expensive to buy and maintain, and seems to be fragile since the computers are often "down" for interminable periods while long-haired acolytes in jeans and t-shirts puzzle over how to get them back up and functioning. As with any cost, the executives' instinct is to minimize, and the insatiable appetite for more, bigger, faster and more powerful computers in the operating divisions is met with stubborn resistance in the Board Room and a frustrating demand for evidence of the contribution of all those "gadgets" to the bottom line. The notion that computers and networks are simply commodities, and the inherent tension between the growth of information technology (IT) requirements and the need to contain costs, has led to some serious and expensive mistakes as senior managers try to control and reduce their expenditures on information infrastructures. Some of the most serious of those mistakes were made in the outsourcing of development, operation, management and control of information technology and services. First-Generation Outsourcing: Cost Containment On its face, the logic of outsourcing information technology and services seems compelling. The organization divests itself of its IT department -- hardware, software and those acolytes as well -- and receives a tidy contribution to capital in return. To ensure that the benefits of computers and networks are still available, the organization leases back its divested assets, incorporating into the lease contract provisions for the levels and quality of services that must be delivered by the company acquiring and operating the assets. The lease contracts are for long terms -- typically five to fifteen years -- so the organization can predict its IT costs much better than when it owned and operated (and maintained and upgraded) all that equipment itself. In one survey conducted by the Outsourcing Institute, companies that outsourced reported an average 9% reduction in costs. Guaranteed service levels, predictable costs, and ready cash. Sounds great, doesn't it? Yet experience shows that seventy percent (70%) of the early outsourcing contracts had to be restructured after a year or two, and fifteen percent (15%) failed completely. What went wrong? Part of the problem had to do with the organizations that were attracted to outsourcing. The capital contribution was the key factor for many organizations that were in financial trouble. But because the divesting company was in trouble and desperate, the vendor had considerable leverage in negotiating the deal, and used that leverage to establish long periods of performance at favorable terms. Being burdened with inflexible leases characterized by fixed service levels didn't help organizations that were already in trouble. They found themselves locked into classic win/lose contracts for which any increase in capabilities or levels of service that they might desire required a negotiation with an ensconced vendor who could demand premium prices, at least in the short run. The pricing is usually transaction oriented (per transaction), and the transactions are stated in technical terms that are difficult to relate back to the business. As time passed, the prices of computation dropped as predicted by Moore's Law and learning curves kicked in, but it was solely the vendor that benefited. Growth of requirements for IT services beyond those contemplated in the original contract resulted in charges by the vendor above and beyond the original deal. The customers found that many of the hoped-for advantages of their divestiture and leaseback were never realized. Unfortunately, for many of them significant early termination penalties and prohibitive start-up costs made it infeasible to return to in-house IT operations. For some organizations, outsourcing was not viewed as an opportunity to refinance the company. Not being in trouble, their executives could negotiate at arms length and from a position of strength, so they were less likely to come up with lease contracts unbalanced in favor of the vendor. When the contracts carefully specified the nature and levels of services to be provided, performance measures, and penalties for non-performance, outsourcing companies were better able to protect themselves from the vendor failure to perform. Even so, significant risks were inherent in most of the contracts. For example, outsourcing could contribute to a loss of competitive advantage as the in-house IT expertise disappeared. Since the employees are transferred to the vendor with the hardware and software assets, there is a danger that they will be moved on to other accounts. Vendors tried to reduce their own costs by taking advantage of economies of scale, which often meant merging the customers data center(s) with those of other customers, raising fears of failure to maintain confidentiality. And the biggest risk of all, that technology would not evolve over the long term of the contract as predicted and after a few years the customer would want to have computing and networking capabilities for which the contract had no provisions, opening them up to opportunism by the vendor. Proper attention to contractual details -- including objective service level measures, reporting, penalties for non-performance, credits for drops in volume due to market changes, volume discounts for excess charges due to market growth, and so forth -- might have prevented many of the ensuing horror stories, but few of the outsourcing deals developed on a pure cost-containment basis proved satisfactory to those who tried them. Second-Generation Outsourcing: Access to Evolving Technology Every time a company decides to "buy" as the result of a "Make or Buy" analysis, the company is deciding to outsource at least a part of its development effort. Companies have long realized that there can be great economic advantage to such outsourcing. Consequently, the second generation of outsourcing contracts focused on correcting one of the most critical problems of first-generation outsourcing: access to evolving technologies. Computer technology turns over very rapidly, each generation lasting only about eighteen months or less. Since outsourcing contracts are of necessity of long duration -- five to ten years -- so that the vendor can recover the initial investment needed to acquire the customer's IT assets and still make a reasonable profit, many generations of information technology will elapse during the period of performance. Not only do computers get better and cheaper, whole new technologies can arise, proliferate, and even dominate IT in only a few years time. If the outsourcing contract does not allow for the evolution of technology, sometimes in directions that cannot be predicted when the contract is being defined, the customer is likely to end up unhappy. In just this decade, for example, we have seen significant changes:
If anything, the pace of change seems to be accelerating. In order to take advantage of evolving and emerging technologies, vendors must be incentivized to implement or incorporate new technology into the infrastructure they are managing for their client. Where make-or-buy decisions are needed, the process for making those decisions must not favor a decision to have the vendor develop the new capability if it might be purchased more cheaply elsewhere. Of course, life-cycle accounting has to be used, not just acquisition cost, and that may favor the vendor who will have to operate and maintain the capability, but the outcome must be the result of an unbiased process. When vendors are chosen by an unbiased process, problems can still arise. When cost, schedule or performance of development projects go awry, the client asserts that the vendor's development group has failed to meet the terms of the contract and failed to deliver the system or component software on time, fully operational, or with acceptable quality. The vendor counter-charges that the client has changed the terms of the agreement and expanded the original work requirements. The root cause of these disputes can almost always be traced to misunderstandings and ambiguous terms in the original contract. Careful attention to drafting of contracts based on function and feature point metrics can often avert disagreements and even disasters. Second-generation outsourcing recognized that the contract must make allowances for technological evolution, and so improved markedly on the first generation of contracts. The new contracts were not based on a fixed price over multiple years that did not anticipate learning curves, improvements, and changes in technology. New and unexpected technologies were introduced at appropriate times and for reasonable prices. Savings were accounted for so as to provide lower costs to the customer. However, outsourcing still suffered from its inherently adversarial nature. Simply put, it was not in the vendor's interest to save the customer money. For outsourcing to come of age, the customer vendor relationship with its win/lose structure had to be replaced with a new relationship in which the prosperity of both parties was inextricably joined. A strategic business alliance -- a partnership -- was needed in which the vendor did not and could not prosper at the expense of the customer. Third-Generation Outsourcing: Strategic Business Alliances that Create Value In a strategic business alliance, two companies can each create value by focusing on core capabilities where they have a competitive advantage. Entering into a carefully crafted partnership, a company can achieve cost savings by outsourcing its IT functions, use the relationship to differentiate its own products and services from those of its competitors, and even find new paths to market for its products and services through the alliance. To make this goal a reality, the relationship must abandon the older customer-vendor model and create an alliance that ties the success of the allies individually to their mutual success acting and working together. Each brings to and concentrates in the alliance their own core competencies, and incentives and penalties are incorporated to motivate win/win behavior. The new model incentivizes creativity in applying IT to improve business processes. It incorporates a methodology specifically designed to foster initiatives that enhance productivity and reduce costs. Both members of the alliance are rewarded for proposing and pursuing innovative ideas. As the alliance evolves and solves the problems of the company, new intellectual capital may be created that has value in the marketplace, representing a further source of revenue that can be shared by the allies. The principles that make the model successful include:
The technical performance metrics developed in the first and second generation outsourcing models are still present. Target and minimal acceptable service levels are specified for the near-term, and the model provides for metrics to evolve in step with industry-wide standard objective measures of IT performance. But layered on top of the service level agreement metrics are new business-oriented metrics that are directly related to financial and performance targets for the enterprise as a whole, not merely for the IT department. Technical performance justifies only baseline compensation; above-baseline rewards are a result of shared value creation. Thus, the model recognizes that value can only be created at the business objective level, not at the IT services level. The key to a successful alliance is establishing trust built on open communications and meaningful, objective and fair metrics for both performance and value creation. For more information, contact: Daniel J. Ryan Corporate Vice President Science Applications International Corporation 8301 Greensboro Drive McLean, Virginia 22102 703.748.5340 703.734.5960
|