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The economics of Outsourcing

Here are a few personal observations on IT Outsourcing based on my experience of both selling and working in and around major outsource contracts in the IT industry. My definition of outsourcing is, the transfer of significant IT functions and management to a third party. No matter how extensive, the use of third parties to simply augment internal resources is not, in my view, outsourcing.

The economics of Outsourcing

Firstly a few words on the economics. Although Outsourcers will sell their offerings on the basis of better service, most organisations now simply look at outsourcing to save money. To make things simple, say it currently costs you £100M deliver a service. You are going to expect your Outsourcer to invoice you £80M or less. Anything more than £80M and a decent internal efficiency programme could probably deliver the same saving without the risk of transferring responsibility to a third party. (Note the £80M will include VAT, if the organisation cannot reclaim VAT the numbers that follow are even worse).

The Outsourcer is going to want to make a profit. Outsourcers typically operate at between 20 and 30 per cent profit margins. I’ll use 25% to simplify calculations. This means the Outsourcer has to deliver the service at a cost of £60M to maintain his profit margin. Let’s go back to the £100M figure. Some of this will be on external spend (e.g. hardware and software). This percentage varies from one IT function to another, and is almost impossible to compare between organisations due to variations in accounting practises. 

Let’s assume that IT spend is split on a ratio of 70:30, internal:external. The Outsourcer is going to struggle to do much about the external spend; some of it will be in contracts that are transferred to the third party. Also most organisations procurement functions are pretty good at getting near market prices. There may be some savings due to the Outsourcer’s purchasing power, let’s say they can bring external spend down to £25M rather than £30M. Internal spend is basically ‘people’. This means the Outsourcer has to deliver the same or better service at a people cost of £35M, or more strikingly half the current ‘people cost’.

In the early days of outsourcing there wasn’t an “offshore” option. Contracts were based on fixing major inefficiencies in the client organisation. Huge outsourcing contracts, running into billions of dollars were awarded, predicated on halving people costs. Despite my calculations, some of these were “made to work".

Outsourcing today

I suppose I ought to finish with some observations on today’s environment, as I promised that in the introduction.

  • Nowadays, outsourcing pretty well always means offshoring. Due to the economics outlined above, outsource contracts are very prone to crippling cost pressures on the supplier
  • Due to the size of these contracts and the importance of the services delivered through them, the only workable outsourcing contract is one that is win/win. Both the supplier and the client need to be happy with the contract
  • Paying too little, forces the supplier to cut costs to the point where service suffers; paying too much is never a good alternative

Apart from “win/win” any other alternative is likely to “end in tears”.

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