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Resource-based theory of the firm, including the knowledge-based perspective of the firm, isanother example of important scholarly value, when applied to IT outsourcing models.Bringing w

Hans Solli-Sæther Norwegian School of Management, Norway

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iii

Managing Successful IT Outsourcing Relationships

Table of Contents

Foreword vii

Preface ix

Chapter I Introduction 1

Three International-Based Research Case Studies 4

Chapter II IT Outsourcing 6

Transformational Outsourcing 7

Outsourcing Decisions 10

IT Outsourcing Markets 10

Business Application Outsourcing 12

Business Process Outsourcing 14

Maturity 15

Innovation Diffusion 18

Outsourcing Definitions 19

Business Example: Offshore Insurance Business Process Outsourcing 24

Business Example: Ministry of Children and Family Affairs 25

Case Study: Total Outsourcing Keeping a Strong In-house Group 26

Chapter III Some Fundamental Perspectives 28

Value Configurations 28

E-Business Infrastructure 38

Vendor Value Proposition 52

IT Function Organization 57

Outsourcing Performance 58

Successful Relationships 60

Outsourcing Opportunities 60

Outsourcing Threats 62

Business Example: NetCom 68

Business Example: DuPont 69

Case Study: The Largest Buy-Out in Europe 70

Chapter IV IT Outsourcing Theories 71

Transaction Cost Theory 71

Neoclassical Economic Theory 77

Contractual Theory 78

Theory of Core Competencies 85

Agency Theory 89

Resource-Based Theory 91

Partnership and Alliance Theory 105

Relational Exchange Theory 108

Stakeholder Theory 112

Theory of Firm Boundaries 114

Social Exchange Theory 117

Comparison of Theories 120

Business Example: British Aerospace 120

Business Example: North Cape Minerals 124

Case Study: A Global Deal 125

Chapter V Enter Strategy 127

Distinctive IT Nature 127

Sourcing Alternatives 129

Global Outsourcing 136

Strategic IT Planning 140

Project Management 147

Conclusions 152

Case Studies: Enter Strategies 152

Chapter VI Phases and Activities 155

Phase 1: Vision 155

Phase 2: Evaluation 156

Phase 3: Negotiation 157

Phase 4: Transition 158

Phase 5: Improvement 159

v

Phase 6: Mature 162

Winner’s Curse 163

Conclusions 164

Case Studies: Relationship Phases 164

Chapter VII Contract Development 168

Contract Structure 168

Asset Transfer 170

Risk Sharing 171

Technology Upgrading 172

Contract Duration 173

Due Diligence 174

Outsourcing Relationships 175

Relationship Management 176

Fee Arrangements 177

Dispute Resolution 178

Public Sector 180

Conclusions 180

Case Studies: Contract Development and Management 181

Chapter VIII Personnel Issues 184

Reduction in IT Staff 184

Employment Protection 185

Pension Considerations 186

Predictors of Persistent Stakeholder Expectations 187

Persistence in Managerial Expectations 195

Transplant Perception of Role 201

Conclusions 202

Case Studies: Transfer of IT Employees 203

Chapter IX Governance Structures 205

Perspectives on Governance 205

Interaction Approach 212

Management Control Systems 215

Performance Measurement 218

Partnering Relationships 222

Partnership Quality 223

Stakeholders 227

Hard and Soft Sides 228

The IT Outsourcing Governance Model 230

Conclusions 235

Case Studies: Governance Structures 236

Chapter X Costs, Benefits, and Risks 239

Production and Transaction Economies 239

Hidden Costs 244

Contract Termination Costs 246

Benefits 247

Strategic Risk Behavior 249

Conclusions 251

Case Studies: Outsourcing Costs 252

Chapter XI Knowledge Management 254

Intellectual Capital Management 254

Vendor Value Proposition 258

Business Process Management 259

Knowledge Management Technology 260

Stages of Technology Growth 263

Conclusions 269

Case Studies: Retained Skills 269

Chapter XII Exit Strategy 271

Think Exit 271

Strategic Outsourcing Termination 273

Contract Termination 274

Exit Management 276

Project Management 278

Conclusions 281

Case Studies: Exit Strategy 282

Conclusions 283

References 286

About the Authors 298

Index 299

vii

Foreword

In this well-timed book Petter Gottschalk and Hans Solli-Sæther methodically tackle thesubject of IT outsourcing and how to successfully manage outsourcing relationships,something that is crucial for the success of any organization In doing so, they bringtogether their expertise as academics and researchers, along with Professor Gottschalk’senormous wealth of experience as one-time chief information officer and chief executiveofficer of several organizations

From the humble beginnings of a quarter century ago, IT outsourcing has today come a vast, half-trillion-dollar global industry Gone are the days of ongoing debate onwhether to outsource IT Today it is an acceptable fact that one just cannot buck thetide of outsourcing

be-Outsourcing of IT covers a range from communications network management, ware/software maintenance, application management, IS management, business pro-cess outsourcing, and so forth It represents a substantial segment of overall IT spend-ing Yet not many executives are quite clear about the various aspects of IT outsourcingand therefore run the risk of missing out on certain business opportunities

hard-Recent research by Gartner has revealed that satisfaction among chief informationofficers over their outsourcing contracts has dropped over the past few years It isprimarily because they fail to understand that what, where, when, and how to outsource,and how to manage outsourcing contracts is one of the most demanding, vital, andessential business skills needed for a company’s success Customers and suppliers arestill failing to grasp what makes for a good outsourcing relationship

This book answers the entire range of above questions in a lucid yet exhaustive way Itcovers all aspects of outsourcing and its opportunities and threats For practitioners, itdescribes the phases of outsourcing, details of contract development, governancestructures, costs and personnel issues, and outsourcing challenges Further, it addsacademic rigor to its arguments by dealing with theoretical aspects of outsourcingsuch as resource-based theory and value configurations to outline how a firm can useoutsourcing to bring about fundamental strategic changes rather than just cuttingcosts and improving organizational focus

Inclusion of chapters on entry and exit strategies is notable, and will help the readersdevelop trust and good governance in their outsourcing relationships A number ofcase studies are included to provide additional help to the reader better understand thesubject matter, and relate it to real-world scenarios

All in all, this book is a most comprehensive guide on all aspects of IT outsourcing, and

is highly recommended for practitioners, researchers, policy makers, and consultantsalike

Vijay Khandelwal

Sydney, Australia

ix

Preface

The market for information technology (IT) outsourcing services is growing rapidly,and costs associated with external IT services are rising in most business and publicorganizations The reliance on outsourcing as a means of providing IT services hasbeen growing steadily over the past decade IT outsourcing decisions are importantbecause their resolution involves significant organizational and institutional implica-tions An urgent need for strategy and management of outsourcing has emerged

IT outsourcing is the practice of turning over all or part of an organization’s IT to anoutside vendor Though IT may never have been more critical to business success, IToutsourcing is developing at an unprecedented rate

Even though the IT outsourcing market has grown tremendously over the past years,many organizations do not have a reflective understanding of the complex process of

IT outsourcing The process does affect both technological and business goals andactivities, and companies must establish both strategies and structures adjusted totheir degree of outsourcing Several critical success factors arise, and they touch uponthe relationship with internal and external stakeholders

The overall objective of this book is focus on the important issues of strategy, ture, and management of IT outsourcing relationships Using well-known theoreticalperspectives and experiences earned from several business cases, our mission is todevelop models and guidelines for the complex IT outsourcing process and emergingrelationships

struc-The intended audience of this book includes undergraduate and graduate students, aswell as practitioners, both on the customer and vendor sides Undergraduate students

in management IS will learn how future IT organizations will be restructured from aresource-based perspective Graduate students will learn how strategy will shape fu-ture sourcing, and how management roles change as sourcing strategies evolve Ven-dors will appreciate insights into value propositions, formal agreements, and relation-ships from this book Customers will appreciate insights into strategic choices andrelationship management from this book

Even though IT outsourcing is a practical issue, it also has significant impact on ness organization theories IT outsourcing as a discipline is based on several otherconcepts and disciplines, as well as the relations between them—international busi-ness, marketing, psychology, technology management, strategic management, projectmanagement, knowledge management, finance, economy, organizations, traditional

busi-management, political science, and behavioral sciences For example, transaction costtheory is an important element in the outsourcing decision-making process Resource-based theory of the firm, including the knowledge-based perspective of the firm, isanother example of important scholarly value, when applied to IT outsourcing models.Bringing well-known theoretical contributions together with our own business experi-ence, prior research from related fields, and new case studies of IT outsourcing, themodels and guidelines presented in this book will be a synthesis for effective learning.

Petter Gottschalk and Hans Solli-Sæther

Oslo, Norway, October 2004

How should firms organize their enterprise-wide activities related to the acquisition,deployment, and management of information technology? During the 1980s, IT profes-sionals devoted considerable attention to this issue, primarily debating the virtues ofcentralized, decentralized, and federal modes of governance Throughout the 1980s and1990s, IT researchers anticipated and followed these debates, eventually reachingconsiderable consensus regarding the influence of different contingency factors on anenterprise’s choice of a particular governance mode (Sambamurthy & Zmud, 2000).Today, however, there are increasing signs that this accumulated wisdom might beinadequate in shaping appropriate insights for contemporary practice The traditionalgovernance logic has been turned upside down by utilizing other mechanisms, such assourcing arrangements, strategic alliances, roles, teams, processes, and informal rela-tionships, as the primary vehicles through which business executives orchestrate their

outsourcing Increasingly, the providers of IT products and services are being viewed

as both arms-length suppliers of cost-effective technology and as vibrant businesspartners with an unlimited potential to enhance a firm’s IT and business capabilities ITprocurement has moved from being operational to tactical to strategic, amidst networks

of alliances with IT vendors, consultants, and third-party service providers being builtand managed in order to leverage their associated assets, competencies, and knowledge

As the outsourcing market evolves, a number of important aspects of IT outsourcingdecisions have been explored These studies can be categorized as descriptive casestudies and surveys of the current outsourcing practices, surveys of practitioners’perceptions of risks and benefits of outsourcing, and identification of best practices thatdistinguish success from failure (Hirschheim & Lacity, 2000) We will present many ofthese studies in this book

In general, the current research indicates that selective sourcing is still the norm but thatoutsourcing options are becoming more complex There are many perceived benefits andrisks of outsourcing, but these studies are based on respondents’ perceptions ratherthan actual outcomes The determinants of outsourcing research generally show thatcompanies most likely to outsource on a large scale are in poor financial situations, havepoor IT functions, or have IT functions with little status within their organizations There

is still considerable debate on best practices that distinguish successes from failures.Outsourcing has become popular because some organizations perceive it as providingmore value than an in-house computer center or information systems (IS) staff Theprovider of outsourcing services benefits from economies of scale and complementarycore competencies that would be difficult for a firm that does not specialize in informationtechnology services to replicate The vendor’s specialized knowledge and skills can beshared with many different customers, and the experience of working with so many ISprojects further enhances the vendor’s expertise Outsourcing allows a company withfluctuating needs for computer processing to pay for only what it uses rather than to buildits own computer center, which would be underutilized when there is no peak load Somefirms outsource because their internal IS staff cannot keep pace with technologicalchange or innovative business practices or because they want to free up scarce andcostly talent for activities with higher paybacks (Laudon & Laudon, 2005)

Not all organizations benefit from outsourcing, and the disadvantages of outsourcingcan create serious problems for organizations if they are not well understood andmanaged Many firms underestimate costs for identifying and evaluating vendors of ITservices, for transitioning to a new vendor, and for monitoring vendors to ensure thatthey are fulfilling their contractual obligations These hidden costs can easily undercutanticipated benefits of outsourcing When a firm allocates the responsibility for devel-oping and operating its IS to another organization, it can lose control over its IS function

If the organization lacks the expertise to negotiate a sound contract, the firm’s dency on the vendor could result in high costs or loss of control over technologicaldirection Firms should be especially cautious when using an outsourcer to develop or

depen-to operate applications that give it some type of competitive advantage A firm is mostlikely to benefit from outsourcing if it understands exactly how the outsourcing vendorwill provide value and can manage the vendor relationship

This book consists of two parts The first part, chapters I–IV, provides backgroundmaterial to understand and analyze the phenomenon of IT outsourcing This part covers

Introduction 3

topics such as outsourcing definitions (Chapter II), opportunities and threats, valueconfigurations, e-business infrastructure (Chapter III), and IT outsourcing theories(Chapter IV) The second part presents key topics in managing successful IT outsourcingrelationships, as illustrated in the Figure 1.1 Managing successful IT outsourcingrelationships starts with an enter strategy and ends with an exit strategy Foundationsfor success are phases and activities (vision, evaluation, negotiation, transition, im-provement, and performance) as well as contract development (contract structure, assettransfer, risk sharing, technology upgrading, contract duration, relationship manage-ment, fee arrangements, and dispute resolution) Chapters VI and VII serve as input tothe management of outsourcing relationships, which consist of the four elements:personnel issues, governance structures, costs, and knowledge management

In an outsourcing relationship, the vendor and the client need to transfer, exchange, anddevelop knowledge on a continuous basis All services delivered, received, and evalu-ated are based on an exchange of knowledge between vendor personnel and clientpersonnel If this knowledge exchange is poorly structured or completely unstructured,then misunderstandings leading to poor service quality will occur On the other hand,

if vendor and client both have installed modern knowledge management, then servicedelivery and improvement will be both efficient and effective The importance ofknowledge exchange in managing successful IT outsourcing relationships has led us toinclude a whole chapter on knowledge management at the end of this book Theimportance of this chapter on knowledge management will also be evident as we discussthe vendor value proposition The vendor value proposition may consist of complemen-tary competencies such as personnel development, methodology development, andclient relationship management Knowledge management is a key enabler of growingcomplementarities and expanding competencies

Figure 1.1 Key topics of managing successful IT outsourcing relationships

Chapter VII PERSONNEL ISSUES

Chapter IX COSTS

Chapter VIII GOVERNANCE STRUCTURES

Chapter X KNOWLEDGE MANAGEMENT

Chapter V

Chapter IV ENTER STRATEGY

Chapter XI EXIT STRATEGY

Using well-known theoretical perspectives and experience gained from several businesscases, our mission is to develop models and guidelines for the complex IT outsourcingprocess and emerging relationships This is done throughout the book To highlight ourrecommendations, we end Chapters V to XII with a conclusions section, where we expressour own opinions for managing successful IT outsourcing relationships.

Three International-Based Research Case Studies

In order to understand the inherent complexities and the underlying constructs ofmanaging successful IT outsourcing relationships, empirical research was need Theexploratory case studies, conducted in July–September 2004, had the following guidingresearch question: “How do client and vendor organizations manage their IT outsourcingrelationships?”

The selection of cases was based on an instrumental approach, which means that the casestudy was carried out to provide insight into issue or refinement of theory “The case

is of secondary interest; it plays a supportive role, facilitating our understanding ofsomething else The choice of case is made because it is expected to advance ourunderstanding of that other interest” (Stake, 1994, p 237) All three cases were selectedfor their paradigmatic characteristics in terms of their outsourcing undertaking In otherwords, the cases were selected because the ABB–IBM is a global one, the SAS–CSCcontract belong to the largest buy-outs in Europe, and the Rolls-Royce–EDS contract

is mature one All cases are unique with global client companies from different industries,and all vendor companies are global service providers In all three international-basedcases more than a thousand employees were transferred from client to vendor organiza-tions They provide a broad base of relationship practice, suggesting that a case in eachcompany would be of interest and value to this research study Figure 1.2 shows somecharacteristics of the IT outsourcing relationships studied

Figure 1.2 Three international-based case studies (source: press releases)

Client

company and

interviewee

Industry Origin Outsourced Start of

deal Length of deal Size of deal Number of people

transferred

Customer of vendor company

Rolls-Royce Power for civil

2000 (1996) 144 months $2.1 b 1,220 EDS

automation

technologies

Switzerland Data center,

infrastructure, desktop

July 28,

2003 120 months $1.1 b 1,200 IBM Scandinavian

December

18, 2003 60 months $1.47 b 1,150 CSC

Introduction 5

Data collection was conducted through a total of 16 interviews, with questions ing enter and exit strategies, phases and activities, contract development, personnelissues, governance structures and relationship management, and knowledge manage-ment, with a strong emphasis on what characteristics influenced successful IT outsourcingrelationship For each client–vendor outsourcing relationship, two to three intervieweeswere selected from each organization Interviews were either personal meetings or byphone

address-The individual cases serve only as the evidentiary base for the study and are used solely

in a cross-case analysis The book’s purpose is not to portray any single one of therelationships Rather, the book synthesizes the lessons from all of them and is organizedaround the topics of Chapters V to XII In addition, a brief context and overview aboutthe individual cases is presented as abbreviated vignettes at the end of Chapters II to

IV

Chapter II

IT Outsourcing

Given the potential headaches of managing IT, it is tempting to hand the job over tosomeone else Indeed, outsourcing once appeared to be a simple solution to managementfrustrations, and senior management teams at many companies negotiated contracts withlarge service providers to run their entire IT functions At a minimum, these providerswere often able to provide IT capabilities for a lower cost and with fewer hassles thanthe companies had been able to themselves But many of these outsourcing arrangementsresulted in dissatisfaction, particularly as a company’s business needs changed Serviceproviders, with their standard offerings and detailed contracts, provided IT capabilitiesthat were not flexible enough to meet changing requirements, and they often seemed slow

to respond to problems Furthermore, a relationship with a supplier often requiredsubstantial investments of money and time, which entrenched that supplier in thecompany’s strategic planning and business processes The company then becameparticularly vulnerable if the supplier failed to meet its contractual obligations (Ross &Weill, 2002)

Problems arose because senior managers, in choosing to outsource the IT function, werealso outsourcing responsibility for one or more of the crucial decisions they should havebeen making themselves Companies often hired outside providers because they weredissatisfied with the performance of their own IT departments—but that dissatisfactionwas primarily the result of their own lack of involvement In light of this track record, mostlarger companies, at least, are deciding to keep their main IT capabilities in-house Butmany engage in selective outsourcing Good candidates for this are commodity services,such as telecommunications, in which there are several competing suppliers andspecifications are easy to set, and services involving technologies with which thecompany lacks expertise Unlike decisions to outsource the entire IT function, selectiveoutsourcing decisions are usually best left to the IT unit, assuming that senior manage-ment has taken responsibility for overall strategy

IT Outsourcing 7

Beaumont and Costa (2002) studied IT outsourcing in Australia They found that almost40% of Australian organizations outsource one or more IT applications Large organi-zations tended to outsource more than small ones The three most important reasons foroutsourcing were access to skills, improved quality and focus on core business Fourfactors contributed to successful outsourcing: a tight contract, a partnership, a changeprocess, and the IT manager’s role changing from managing projects and operations toacquiring and managing the internal and external resources required to do the organization’s

IT work

Successful IT outsourcing relationships enable participants to achieve organizationalobjectives and to build a competitive advantage that each organization could not easilyattain by itself Outsourcing success can be viewed as the level of fitness between thecustomer’s requirements and the outsourcing outcomes Outsourcing success can bemeasured in terms of both business and user perspectives From a business perspective,outsourcing is motivated by the promise of strategic, economic, and technologicalbenefits The success of outsourcing, then, should be assessed in terms of attainment

of these benefits From a user perspective, outsourcing success is the quality level ofservices offered A decision to outsource on the basis of saving costs without analysis

of the quality of services frequently leads to higher costs and lower user satisfaction.Therefore, it is imperative to conduct a proper analysis of the service quality beforebuilding a relationship with a service provider for a successful outsourcing arrangement(Lee & Kim, 1999)

Transformational Outsourcing

The traditional way of thinking in IT outsourcing is to move the current IT function out

of the organization and let another organization handle it There is no strategic thinkingbehind it, except the idea of solving a problem, saving some money or improving afunction by means of some undefined solutions The new way of thinking is to make IToutsourcing part of a strategic transformation of the IT function, where new tasks androles are implemented to replace old tasks and roles A classic example of this new way

of thinking is the transformation of the IT function at British Petroleum (BP) in the 1990s.The IT function went through a fundamental transformation consisting of the followingchanges (Cross, Earl, & Sampler, 1997):

shifted from developing systems to overseeing technical integrity and pursuingvalue creation and cost-reduction opportunities through information sharing

telecommunications, systems development, and IT maintenance began, as BPrecognized that it was not essential that these were carried out in-house Some localsites already had experience in facilities management, and as contracts came up forrenewal, lessons were recorded and a worldwide outsourcing program was imple-mented

• From business standards to industry standards IT managers have long been

concerned about coordinating various types of computing and communicationequipment However, throughout most of the research on IT infrastructure, thefocus has been directed at creating and managing the internal infrastructure.Therefore, BP spearheaded a unique initiative to help create an external softwaremarket by being one of the early advocates and founding members of thePetrotechnical Open Software Corporation, which was joined by a number of oilcompanies such as Elf, Mobil, Statoil, and Texaco

realized that the major benefit of centralized management of IT is not budgetauthority, but is in setting standards for infrastructure While some IT resourcesstill remain in the local businesses, it is the job of the top IT management team toprovide the global perspective for infrastructure planning and cost control, which

is here called top sight

personnel The new skill set has an equal balance between business, technical, andpeople skills Such a radical change in the skill set of IT staff has been supported

by a number of human resource initiatives such as skills testing, self-assessment,and personal development planning

craftsmen, viewing each job as a unique, customized process Their task hasswitched to that of project managers, integrating and coordinating stakeholdersinvolved in providing IT applications and operations

ways For example, staff was moved around the world to create global not localloyalties A team-building and team-working program was introduced stressing theuse of multifunctional teams and diluting the functional focus

The IT budget was reduced from $360 million in 1989 to $132 million in 1995 after thistransformation IT personnel were reduced from 1,400 persons to 150 persons in thesesix years Hence, a large portion of the reduced IT budget went to external outsourcingvendors As this pioneering case of IT outsourcing illustrates, outsourcing can be morethan a tool for cutting costs and improving organizational focus Increasingly, it is ameans of acquiring new capabilities and bringing about fundamental strategic andstructural change

According to Linder (2004), the concept of transformational outsourcing is an emergingpractice, where companies are looking outside for help for more fundamental reasons—

to facilitate rapid organizational change, to launch new strategies, and to reshapecompany boundaries In doing so, they are engaging in transformational outsourcing:partnering with another company to achieve a rapid, substantial, and sustainableimprovement in enterprise-level performance

Transformational outsourcing places the power to bring new capabilities to the zation squarely in the hands of executives who have and value those capabilities In otherwords, the outsourcing partner provides a management team that is experienced in the

organi-IT Outsourcing 9

capability that the organization seeking change needs And those executives areempowered by the outsourcing process to implement the practices they bring with them.Not all transformational outsourcing initiatives are alike Linder (2004) identified fourbroad categories from her research on 20 companies that have attempted the practice Thefour categories are start-ups (outsource to rapidly scale up a new business), pathway togrowth (outsource to fix a key process that stands in the way of growth), change catalyst(outsource to signal broad change and focus on adding value), and radical renewal(outsource to improve core operating capabilities radically)

As executives obtain more experience with outsourcing, they are learning the tool’spotential and beginning to wield it for more strategic purposes Some will use it to shapeand reshape their business models Instead of massive, sweeping changes, manyorganizations will master the ability to use outsourcing to make continuous incrementalimprovements But while the potential benefits are incontrovertible, the art of joiningorganizations with unique capabilities is extremely challenging and requires visionaryleaders with strong hearts and a large capacity for hard work By combining the tool’sexecution effectiveness with their own growing skills in partnering, leaders who displaythose characteristics will have a practical and realistic road map at their disposal forbuilding strategic flexibility

Transformational outsourcing is an emerging practice, but the track record of companiesthat have engaged in it is impressive In a study of 20 companies, 17 of them have been

in place long enough to show results Of that group, 13 have achieved dramatic,organization-level impact To the extent that other companies can replicate such success,transformational outsourcing may become a more effective way of improving perfor-mance than major internal change initiatives, mergers and acquisitions, or joint ventures(Linder, 2004)

The key issue is new capabilities In undertaking an internal initiative, a company hasconcluded that it lacks an important set of skills, otherwise it would not be seekingtransformation But it often proves too time consuming to develop the skills internally

In a mergers-and-acquisition scenario, the company acquires the capabilities it lacks, butcultural clashes often interfere with its ability to use them effectively An acquiringcompany seldom, for example, puts executives from the acquired company in charge ofits own organization in order to learn from them Similar cultural impediments make itunlikely that a company will transform itself with the expertise it gains in a joint venture.But transformational outsourcing places the power to bring new capabilities to theorganization squarely in the hands of executives who have and value those capabilities.The outsourcing partner provides a management team that is experienced in thecapability that the organization seeking change needs And those executives areempowered by the outsourcing process to implement the practices they bring with them.Transformational outsourcing is concerned with bringing new capabilities to the orga-nization through important sets of skills These skills can be found in knowledge work,and knowledge management emerges as an important discipline in transformationaloutsourcing Executives have to lead a transformational outsourcing initiative muchdifferently from the way they would manage conventional outsourcing

Outsourcing Decisions

The decision to outsource or insource enterprise-wide activities related to the tion, deployment, and management of IT represents one of the more complex choicesfacing a firm’s managers On the one hand, insourcing requires management to commitsignificant resources to a course of action, the effects of which may be costly to reverse,while forgoing numerous advantages associated with the marketplace On the otherhand, insourcing may be required for a firm to accumulate resources necessary togenerate or maintain a competitive advantage

acquisi-The complexity of this decision is demonstrated in research conducted by Leiblein,Reuer, and Dalsace (2002) They examined the relationship between governance choiceand technological performance In contrast to popular arguments suggesting thatinsourcing or outsourcing will lead to superior technological performance, they foundthat governance decisions per se do not significantly influence technological perfor-mance directly Rather, observed differences in the performance of transactions gov-erned by different organizational forms are driven by factors underlying governancechoice While the increasing rapidity of technological change and the increasingdispersion of knowledge suggest an increased role for outsourcing in the economy, therelationship between governance choice and performance is dependent on the distribu-tion of relevant capabilities and the degree to which performance is driven by autono-mous or systemic innovation

Empirical evidence suggests that carefully crafted outsourcing strategies increase theoverall performance of the firm Outsourcing is generally considered as a very powerfultool to cut costs and improve performance Through outsourcing, firms can takeadvantage of the best outside vendors and restructure entrenched departments that arereluctant to change Outsourcing can also help focus on the core business Sincebuilding core competencies and serving customer needs are critical to a firm’s success,anything that detracts from this focus may be considered for outsourcing (Barthélemy,2003b)

The decision to outsource is influenced by a number of factors In this book, we willdiscuss factors such as production economies, transaction economies, technologicaluncertainty, functional complexity, transaction-specific investments, supplier presence,slack resources, and criticality of IT Many more factors will be presented

IT Outsourcing Markets

Research on global computing services shows that there has been a massive growth inthe number of large outsourcing deals signed in continental Europe The GlobalComputing Services’ contracts database tracks all outsourcing, integration, and consult-ing deals with a value greater than $1 million, and in the major part of 2003, it tracked $21.32billion of deals in the region —a huge 173% increase on the $7.81 billion deals tracked

in 2002 This made continental Europe the fastest growing territory for major IT services

IT Outsourcing 11

deals in 2002, ahead of the U.K., which showed a 110% increase The value of the 10 largestoutsourcing deals in continental Europe is listed in Table 2.1 (as of December 11, 2003).Another good indicator of the health of the outsourcing market across various geogra-phies is to look at the number of IT services deals signed with a value greater than $100m—almost all of which are long-term outsourcing deals There has been a huge surge inthe number of these mega-deals in continental Europe during 2003 Global ComputingServices has tracked 46 contracts with a value of $100 million or more in 2003, compared

to just 13 in 2002 The number of mega-deals increased by 27% in the rest of the world,

by 14.5% in the United States, and by 6.4% in the U.K The growth in the market for ITservice deals is shown in Table 2.2

The outsourcing market can also be studied in terms of industries For example, thehealthcare industry in the United States was studied by Lorence and Spink (2004) Theyfound that IT functions in healthcare organizations most likely to be outsourced toexternal vendors or consultants were transcriptions (patient data) and microfilming.Overall, nonmanagement IT functions were more likely to be outsourced, especiallywhere more use of computerized patient data results in increased demand for IToutsourcing The impact of organizational factors in outsourcing preferences alsosuggested that outsourcing decisions, rather than being function specific, might be theresult of a more general level of comfort for outsourcing across the organization as awhole

There seems to be some key forces shaping the outsourcing market According toconsulting organization Gartner (2004a), real-time delivery offerings require major shifts

Table 2.1 The 10 largest outsourcing deals in continental Europe in 2003 (ComputerWire, 2003)

1 IBM Global Services Nordea Bank Infrastructure management,

Server management, top management

Desk-Sweden $2.66 b 120 months October 1,

2003

2 T-Systems Daimler-Chrysler Network management,

Infrastructure management, Desktop management

Germany $1.40 b 36 months August 11,

2003

3 IBM Global Services ABB Data center outsourcing,

Infrastructure management, Desktop management

Switzerland $1.10 b 120 months July 28,

2003

4 IBM Global Services AXA Sun Life Infrastructure management,

maintenance/support, server management

France $1.00 b 72 months February 27,

2003

5 IBM Global Services M-Real Application development

and support, Infrastructure management

Finland $645.8 m 120 months June 11,

2003

6 Hewlett-Packard Bank of Ireland Desktop management,

Server management, structure management

Infra-Ireland $600 m 84 months November

28, 2003

7 EDS Corp Ministry of Flemish

Community Network management, application development

Denmark $450 m 120 months May 27,

2003

9 IBM Global Services Lego Company Infrastructure management,

Computer engineering, Maintenance/support

Denmark $400 m 60 months August 11,

2003

10 IBM Global Services Banco Comercial

Portugues Infrastructure management, Business continuity/disaster

recovery

Portugal $391 m 120 months July 4, 2003

in outsourcing contracting models, including financing, pricing, service levels, assetmanagement, risk management, and standards A long-term development road map forreal-time infrastructure and real-time delivery can be essential for competitive differen-tiation in outsourcing For example, outsourcing vendors must optimize the managementand financing of IT assets to deliver the on-demand, pay-per-use promises of real-timedelivery IT infrastructure consolidation and standardization characterized the largestmultibillion dollar IT outsourcing contracts during 2003 and are expected to continue forseveral years These outsourcing contracts are not just exercises in cost reductionnecessitated by economic problems, but they are also intended to advance the clientstoward becoming real-time enterprises through the benefits of emerging real-timeinfrastructure and real-time delivery services Gartner defines a real-time enterprise as anenterprise that competes by using up-to-date information to progressively removedelays to the management and execution of its critical business processes.

Business Application Outsourcing

Dramatically reduced network cost due to the Internet and virtual private networks, theever-increasing supply of bandwidth, and advances in the security of Internet-basedtransactions have led to the emergence of application service providers (ASPs), a newcategory of IT service firms An ASP can be defined as an organization that manages anddelivers application capabilities to multiple entities from a data center across a wide areanetwork User organizations can access software applications from one or more ASPsover the Internet for a subscription fee (Susarla, Barua, & Whinston, 2003)

In a typical business, we find several IS applications For example, Weill and Vitale (1999)identified an applications portfolio of 18 systems in a manufacturing business: budget-ing, capital projects, customer complaints, debtors, general ledger, freight cost manage-ment, fixed assets, human resource management, inventory, market data, multiplantaccounting, office support, payroll management, pricing and sales, purchasing, salesforecasting, product safety system, and trading accounts management These systems

Table 2.2 Growth in IT service deals by region between 2002 and 2003 (ComputerWire, 2003)

Continental

Europe Kingdom United United States Rest of the World

Value of contracts in 2003 (to

IT Outsourcing 13

support tasks in peoples’ jobs For example, all systems help planning, investigating,coordinating, evaluating, supervising, staffing, negotiating, and representing to avarying extent

User organizations can access software applications from one or more ASPs over theInternet for a subscription fee A key selling point for ASP services involves a shortertime period required to implement new software applications For businesses plagued byhigh turnover of IT staff, inadequate organizational resources to maintain and upgradeexisting IT applications, and large capital requirements for major IT implementationprojects, the ASP business model could be an attractive alternative with its off-the-shelf

IT applications subscription approach Sophisticated ASPs have gone as far as offeringenterprise resource planning, e-commerce, and supply-chain applications, which mayinvolve integration with existing IS in a user organization (Susarla et al., 2003).While the ASP model has the potential to fundamentally change the manner in which ITservices are provided to user firms, to date ASPs have had a limited success in signing

up customers Moreover, several customers of ASPs are unsatisfied with their service,which questions the viability of the ASP business model and selection of ASP as an enterstrategy for IT outsourcing Evidence also points to the fact that ASPs themselves have

to rework their service strategies in response to market demand It has long beenrecognized that market success depends on designing services to match customer needsand that customer satisfaction has a positive impact on market share and profitability.Satisfied customers are more likely to engage in positive word of mouth, thus loweringthe cost of attracting new customers Satisfaction based on successful exploration andexploitation of the vendor value proposition plays an important role in building otherimportant assets for the firm A focus on satisfaction is important for ASPs if they have

to retain existing customers as well as attract new customers (Susarla et al., 2003).This calls for an assessment of the determinants of client satisfaction with ASPs andevaluation of the effectiveness of the ASP mode of service delivery over the Internet.Susarla et al (2003) analyzed the determinants of satisfaction in ASP service provision.Their analysis shows that the satisfaction with an ASP is negatively affected by thedisconfirmation effect, but positively influenced by the perceived provider performanceand prior systems integration, which is a measure of integration of organizationalsystems prior to using ASP services Disconfirmation is the negative discrepancybetween expectation and performance

Further, perceived provider performance is positively influenced by the functionalcapability of the ASP and the quality assurance by the ASP, but negatively influenced

by the prior systems integration These findings suggest that, to be successful, ASPsmust strive to reduce the disconfirmation effect faced by adopting organizations and toenhance the perceived quality of their solution, possibly through partnerships withleading IT vendors Further, ASPs must improve the integration of their offerings withexisting applications in user organizations, which may require alliances with IT firms thatspecialize in integration services From a client perspective, an enter strategy of ASPselection may thus focus on integration with existing IT, performance delivery, andstandards of software capability From a vendor perspective, the findings of Susarla et

al (2003) indicate a need for ASPs to facilitate integration with existing IT in clientorganizations, ensure superior performance delivery, emphasize rigorous enforcement

of service agreements, and ensure that their application meets standards of softwarecapability Their finding that ASPs are not evaluated on some of the prior experiences

of the organizations is favorable to vendors, since it suggests that firms that are Internetsavvy or that have a strong IT department are not going to have unreasonably highexpectations from the ASPs

A related area of exploration is an analysis of how organizational users form expectationsabout an ASP’s services The literature on outsourcing posits that the trade press,discussion with peers, consultants’ forecasts, and the business strategy pursued by thecompany can contribute to the formation of expectations in the outsourcing context Asthe IT outsourcing literature has documented, management defines the scope of theoutsourcing and the sourcing criteria, while the IT department can provide insights intothe technological reasons for outsourcing and judge the success of the outsourcingproject in terms of performance outcomes that are met Expectations that need to berealized in the outsourcing context may reflect the consensus among the differentstakeholders in the organization (Susarla et al., 2003)

Business Process Outsourcing

Enterprise restructuring is expected to provide fertile ground for outsourcing in thebusiness process outsourcing market segment Some companies turn to outsourcing tofoster change management during consolidation and integration Consolidation, merg-ers and acquisitions result in integration needs for back-office processes, which are oftenmet by outsourcing Divested companies need to grow entire back-office functions fromscratch and look to external services providers to provide this process-managementcapability Business process outsourcing includes enterprise services (human re-sources, finance and accounting, payment services, and administration), supply man-agement (buying processes, storing processes, and moving processes), demand man-agement processes (customer selection, customer acquisition, customer retention, andcustomer extension), and operations A typical business process outsourcing contractincludes discrete project-based IT services, ongoing IT management services, andgeneral process management (Gartner, 2004b)

Business process outsourcing often fills human resources (HR) practitioners with fear,but handled properly, it can help the HR function become more efficient and strategic

Of all the business-related acronyms that are filtering through to the corporate sciousness, BPO (business process outsourcing) is certainly one that appears to beraising interest BPO, although often seen as the next evolutionary step in IT outsourcing,

con-is also very different from it BPO con-is about delegating the ownership, admincon-istration, andoperation of a process to a specialist third party in order to solve a business problem.And because BPO is about delivering outcomes—higher-performing business pro-cesses—it aims to raise a client company’s shareholder value (Strategic HR Review,2004)

Business processes within a company can be broken down into three categories: core;business critical noncore; and finally noncore, noncritical Core processes are seldom

IT Outsourcing 15

outsourced, because they are the very essence of the business and the area that requiresthe most investment Critical and noncritical noncore processes may be suited foroutsourcing to a third-party supplier who will invest in them on the company’s behalf.Process management has the highest expected growth rate in outsourcing Businessprocessing outsourcing is typically the outsourcing of a company’s noncore or back-office business processes Usually those processes are (or should be) IT enabled andhence can be transformed by the use of a new or improved technology platform Theappeal of BPO is that it attempts to involve a new support services model involving cost-effective, scalable, efficient services The growth in demand for process outsourcing hasalso seen an expansion in the range of services being provided by suppliers Processestypically outsourced include finance and accounting, procurement, human resources,and real estate (Honess, 2003)

Maturity

For most firms, becoming a real-time enterprise is an evolutionary development Earl(2000) has described the typical six-stage journey that corporations are likely toexperience The six stages are not necessarily definitive periods of evolution, ascompanies may have activities at several neighboring stages at the same time The sixstages are illustrated in Figure 2.1

wanted a home page on the Internet for the first time The realization that theInternet was a potential communications channel to external stakeholders, such asinvestors, analysts, customers, potential recruits, and suppliers, was matched bythe recognition that the Web provided an interesting and not-too-difficult means

of designing and publishing corporate public relations material The vision behind

Figure 2.1 Stages of e-business maturity

E-MATURITY

creating such Web sites rarely extends beyond external corporate tions Perhaps the only interactive aspect is a provision for e-mailed questions tocorporate departments from external stakeholders.

introduced at this stage to raise the information and communication capacity of theorganization An integrated, familiar front end to frequently used internal applica-tions does appeal to end users Knowledge management applications have evolvedfrom this stage And sometimes having internal access to the same information that

is provided externally is well received

Information technology is applied to design consistent and user-friendly frontends to e-mail, groupware, administrative support systems, and other systemsused by most people in the organization

channels and services are promoted to complement traditional forms of tion In the case of start-ups, customers are identified and attracted by using theWeb and other advertising channels At this stage, organizations struggle withquestions such as “What and how do we tell customers and suppliers that they cantrade with us online?” “What pricing policies do we adopt and how do they relate

distribu-to pricing in our traditional channels?” “Which products and services are suited

to electronic market trading?” “What IS/IT applications and functions are needed

to support e-commerce?”

Building an online channel on top of inadequate or inefficient business processesachieves only one thing: it broadcasts and magnifies the fact that the company’sback-office systems or operational processes are really bad So this fourth stage

is about reengineering and redesigning business processes to match customers’expectations

Customers already recognize the signs of business processes that are not nized with the demands and expectations of e-commerce: goods that do not arrive

synchro-on time; e-mailed requests that do not receive respsynchro-onse; clumsy handling ofreturns; inability to track order status; network access that breaks down; andtelephone requests where persons answering the phone have no idea what you aretalking about

Most firms learn the hard way and treat stage 3 as inevitable, evolutionary,experiential learning Then they accept the costs of stage 4, where reengineering

of business processes and redesign of architecture and infrastructure of theirtechnology base have to be implemented The lesson at stage 4 is that high-performance processes are needed to stay in e-business

processes Decision making occurs increasingly on the network, rather than inmeeting rooms Transactions can be monitored and analyzed in real time Informa-tion can be collected online New ways of representing and analyzing these dataare being developed We are witnessing new ways of communicating across theenterprise using wireless and mobile technologies

IT Outsourcing 17

Wireless and mobile technologies are about to change Internet business This isbeing driven by customer demand for wireless devices and the desire to beconnected to information and services available through the Internet from any-where and at any time Similarly, company employees see no reason anymore forshowing up in the office at 8 a.m and leaving at 5 p.m As a result, telecommuni-cations, the Internet, and mobile computing are merging their technologies to formthe basis for mobile work and management

In stage 5, decision-making is becoming entrepreneurial and about communicatingdecisions across the enterprise This stage is where traditional top managers findthe time to leave the company The critical success factor is to recruit, develop, andempower people who have the skills to use information and act on it

The challenges of the previous stages have been met, and the new business andmanagement solutions required for the e-enterprise are embedded In many ways,this is the goal However, we know that market forces and emerging technologiesdrive continuous change

As firms develop into real-time enterprises, real-time infrastructure becomes critical.Real-time infrastructure is a distributed computing model where infrastructure is sharedacross customers and dynamically optimized to achieve end-to-end service levels at thelowest price Where resources are constrained, business policies determine allocation

of resources to meet business goals Real-time infrastructure services from an outsourcingvendor has the potential of significantly reducing the costs associated with IT servicesassurance while simultaneously improving quality of service and agility and adaptabil-ity Therefore, its adoption is inevitable Enterprises and external service providers arebuilding real-time infrastructure Real-time delivery is the packaging, pricing, andrelationship engagement model for services based on the real-time infrastructure Real-time delivery offerings do not require the full development of a real-time infrastructure.Claims processing, travel reservation systems, mainframe computer time sharing, andother service offerings making use of standardized, optimized architectures and pay-per-use or unit of service are well within the genealogy of real-time infrastructure and real-time delivery Examples of current offerings include application services, hosting, andstorage utilities and communications services The emergence of real-time infrastructureand real-time delivery signals the maturation of IT outsourcing, moving from a custom-ized to a mass-customized delivery that shifts the emphasis for customized services from

IT infrastructure to business processes The focus of cost reduction because of the weakeconomy and the growing disenchantment with the return on investment from ITinvestments are contributing factors to this shift

Based on this analysis, Gartner (2004a) considers the IT infrastructure marketcommoditized and mature to the extent that the IT infrastructure is consolidated andstandardized to obtain real-time infrastructure characteristics Real-time infrastructurehas the potential for offering lower costs, higher quality of service, and agility to changethe allocation of the infrastructure to meet changing business priorities The goal is tomake the infrastructure utility like, so that it can support any application or businessprocess A conservative estimate for the extent of commoditization of adoption of real-

time delivery offerings is about 5% of the total IT infrastructure outsourcing market This

is conservatively forecast to grow to about 20% within the next five years Liberalestimates would be 10 to 30%

BPO is the factor likely to have the greatest influence on commoditization and maturity

of IT infrastructure outsourcing BPO may largely eliminate the IT element in decisionmaking for business unit managers and corporate-level executives looking for costreduction Enterprises are more likely to have separated IT and business processcontracts than a business process contract that subsumes IT, but this is expected to shiftover time with BPO maturity Anticipating this shift in focus to business process level,outsourcing vendors such as EDS, HP, and IBM have already developed strategies based

on emerging real-time infrastructures and real-time delivery offerings that are positioned

as enablers of time enterprise Each vendor has developed its own vision for time infrastructure, delivery, enterprise, and template, and branded its vision as follows

real-in 2004: Agile Enterprise (EDS), Adaptive Enterprise (HP), and On Demand Busreal-iness(IBM) These brands reflect a focus on business value instead of technical value As ITinfrastructure services commoditize and mature, value shifts upward to the businessprocess level Real-time delivery offerings, whether end-to-end or point solutions,require major shifts in outsourcing contracting models, including financing, pricing,service levels, asset management, risk management, and standards

or the relative speed with which it is adopted by members of the social system The socialsystem consists of individuals, organizations, or agencies that share a common cultureand are potential adopters of the innovation Communication channels are the means bywhich information is transmitted to or within the social system (Ho, Ang, & Straub, 2003).Examining the adoption of IT outsourcing from the theoretical foundation of innovationdiffusion may shed some light on significant factors that affect the adoption decision andclarify misperceptions For example, a study by Hu, Saunders, and Gebelt (1997) examined

175 firms that outsourced their IT functions, and they tested three hypotheses of sources

of influences using four diffusion models: internal influence, external influence, and twomixed-influence models A mixed-influence model represents the combined effects ofexternal media, vendor pressure, and internal communications at the personal levelamong managers of companies that significantly influenced the decision to adopt ISoutsourcing Their findings suggest that the mixed influence is the dominant influencefactor in the diffusion of IT outsourcing, and that there was no evidence of the effects

IT Outsourcing 19

from early outsourcing cases (which has been labeled the Kodak effect) in the IT diffusionprocess This directly contradicts the conclusion of earlier studies, where the Kodakeffect argued that Kodak’s highly publicized decision to outsource its IT was the point

at which the internal influence model became dominant

Diffusion models have many underlying assumptions which may or may not be satisfiedunder the conditions of IT outsourcing Awareness of these limitations will certainlyassist in the interpreting of statistical results, as well as in generalizing the conclusions.For example, models permit only one adoption by an adopting unit, and no rescinding

of the adoption That is, once a company outsources it does not insource again.Furthermore, innovation models are typically based on a distinct and constant ceiling.That is, the potential number of adopters in a social system does not increase or decreaseduring the diffusion process

One of the things that are underappreciated is the amount of innovation that goes onthroughout organizations following the introduction of new technology Technologytypically makes a lot of information available to people at a very low cost Managementwants to encourage people to find new ways of using that information However,companies that are managed in a top-down, hierarchical manner will be disadvantaged.Employees will be discouraged from the very experiments that can lead to importantproductivity gains The way companies treat employees seems to have an importantimpact on their ability to get the most innovation out of IT investments (Financial Times,2004)

Outsourcing Definitions

If a firm does not want to use its internal resources to build or operate IS, it can hire anexternal organization that specializes in providing these services to do the work Theprocess of turning over an organization’s computer center operations, telecommunica-tions networks, and/or applications development to external vendors is called outsourcing(Laudon & Laudon, 2005)

Loh and Venkatraman (1992a) define IT outsourcing as the significant contribution by

external vendors in the physical and/or human resources associated with the entire or specific components of the IT infrastructure in the user organization Vendors may

contribute computer assets for the user from outside the organization Alternatively, theownership of certain computer assets of the user may be transferred to the vendor.Similarly, vendors may utilize their personnel to provide the required services, or thevendor may employ existing staff of the user In their research, they attempted to explainthe degree of IT outsourcing by using cost structures and economic performance Theyfound that the degree of IT outsourcing is positively related to both business and IT coststructures, and negatively related to IT performance IT outsourcing was framed as amake-versus-buy decision, where contractual modes differ in the domain of influencewithin the corporation (Loh & Venkatraman, 1992a, 1992b)

Lacity, Willcocks, and Feeny (1996) define outsourcing to dismantle internal IT

depart-ments by transferring IT employees, facilities, hardware leases, and software licenses

to third-party vendors Hirschheim and Lacity (2000) define information technology

outsourcing as the practice of transferring IT assets, leases, staff, and management

responsibility for delivery of services from internal IT function to third-party vendors.

Grover, Teng, and Cheon (1998) define outsourcing of IS functions as the organizational

decision to turn over part or all of an organization’s IS functions to external service provider(s) in order for an organization to be able to achieve its goals This decision-

making approach is interesting because it focuses on an early stage of a long process.Resource-based theory and resource-dependence theory from the field of strategicmanagement and transaction cost theory and agency theory from economics are used

in order to describe its implications for outsourcing research and practice The definitionincludes decisions about how to arrange external IT services Using several theoreticalperspectives of outsourcing, they presume that organizations attempt to make thesedecisions in their best interests Similarly, Grover, Cheon, and Teng (1996) define

outsourcing as involving a significant use of resources —either technological and/or

human resources—external to the organizational hierarchy in the management of information technology.

Hu, Saunders, and Gebelt (1997) define IS outsourcing as a business practice in which

a company contracts out all or part of its IS operations to one or more outside suppliers.

Here we find that outsourcing is a practical issue that also has a significant impact onbusiness organization Even though outsourcing is a business practice, for IS executivesacquiring outside services is an important strategic issue confronting their organiza-tions Thus, their theoretical perspective is strategic decision making In their research,they have identified sources of influence in the adoption decision One significantinfluence is the combined effects of external media, vendor pressure, and internalcommunications at the personal level among managers

Kern and Willcocks (2002) are more process oriented in their approach, focusing on thelong-term interaction They focus on the key elements of the exchange and the relation-ship between different stakeholder groups They recognize the influence of the environ-ment and the atmosphere in which the interaction takes place They define outsourcing

as a process whereby an organization decides to contract-out or sell the firm’s IT assets,

people, and/or activities to a third-party supplier, who in exchange provides and manages these assets and services for an agreed fee over an agreed time period In their

process-oriented approach, they are using Håkansson’s (1982) interaction model toexplain the client-vendor relationship of IT outsourcing Although Lacity and Willcocks(2000b) did not explicitly provide a definition of outsourcing, it seems that they are in linewith this process-oriented approach They introduced a relationship framework thatfocuses on relationship stakeholders, relationship types, and six phases (scooping,evaluation, negotiation, transition, middle, and mature phase) and activities related tothese phases In this perspective, IT outsourcing is viewed as a longitudinal processinvolving several stakeholder groups

Outsourcing can be defined as turning over all or part of an organizational activity to

an outside vendor (Barthélemy, 2003b) Here outsourcing is the purchasing, from outside

the organization, of IT services needed to perform business functions According to

Langfield-Smith and Smith (2003), outsourcing is the contracting of any service or

activity to a third party Both definitions are concerned with the interfirm relationship,

IT Outsourcing 21

Table 2.3 Outsourcing definitions in the research literature

Literature

Ang and Cummings (1997) Organizing for resources in

an open and networked form Institutional theory Nature of institutional pressures, perceived gain in

production economics, financial capacity to resist influences, and transaction cost considerations Ang and Straub (1998) Reliance on external service

providers for IS functions Economic theory, transaction cost theory Production costs, transaction costs, financial slack, firm

size Ang and Slaughter (2001) Use of contractors to

supplement permanent staff Social exchange theory Contracting of information services in light of corporate

downsizing and restructuring Bahli and Rivard (2003) Turning to external suppliers

in order to meet IT needs Agency theory Risks: lock-in, contractual amendments, unexpected

transition and management costs, and disputes and litigation

Barthélemy (2001) Entrust information

technology activities to a third party

Economic theory Hidden costs that undercut

anticipated benefits Barthélemy (2003a) Turning over all or part of an

organization’s IT to an outside vendor

Management theory Hard sides: preciseness,

completeness, balance Soft sides: relationships based on trust

Barthélemy (2003b) Turning over all or part of an

organizational activity to an outside vendor

Management theory Lacking management

expertise underlies most failed outsourcing efforts Beaumont and Costa (2002) Passing IT functions

previously performed house to outside contractors

in-Causal factors Access to skills, improved

service quality, focus on core business, defined service levels

Cross, Earl, and Sampler

(1997) Transformation of IT functions Management theory From monopoly supplier to mixed sourcing based on

functions that can add value versus activities where the main contribution is cost savings

Currie (2003) Procuring IT services from a

vendor in a long-term relationship

Knowledge management theory Risks at loosely coupled links between many different

vendors Earl (1996) Subcontract IT functions Economic theory Cost cutting

Elitzur and Wensley (1998) Transfer of assets and

services between company and vendor

Game theory Principal-agent games payoff

Grover, Cheon, and Teng

(1996) Turning over part or all of an organization’s IS functions to

external service provider(s)

Resource dependence theory, transaction cost theory

Service quality and partnership Grover, Teng, and Cheon

(1998) Turning over IS functions to external service provider(s) Strategic decision making, economic theory External services like applications development

and maintenance, systems operations, networks and telecom management Hindle, Willcocks, Feeny, and

Lacity (2003) Externalization of people, systems, and institutional

knowledge

Governance theory Vital intellectual capital often

leaves the organization when key processes are outsourced Hirschheim and Lacity (2000) Transferring IT assets,

leases, staff, and management responsibility to third-party vendors

Decision-making theory Companies most likely

outsource on a large scale when they are in poor financial conditions, have poor IT functions, or have IT functions with little status within the organization

Ho, Ang, and Straub (2003) Spin-off of IT functions Agency theory Persistent managerial

Ho, Ang, and Straub (2003) Spin-off of IT functions Agency theory Persistent managerial

expectations after outsourcing

Hu, Saunders, and Gebelt

(1997) Contract out all or part of its IS operations Decision-making theory Combined effects of external media, vendor pressure, and

internal communications at the personal level among managers

Kern and Willcocks (2002) Contract out or sell to a third-

party supplier Interaction theory The elements of the interaction approach

(services, information, financial, social), the parties involved, the environment, the atmosphere Kern, Willcocks, and Heck

(2002) Contract out or sell to a third-party supplier Winner’s curse theory Suppliers take a risk in hoping that they can recover

their costs Lacity and Willcocks (1998) Transformation of traditional

IT departments Management theory Indicators of success and failure Lacity and Willcocks (2000b) Transfer to suppliers Relational theory Relationship stakeholders,

relationship types, relationship phases and related activities Lacity, Willcocks, and Feeny

(1996) Dismantle internal IT departments by transferring

to third-party vendors

Economic theory Critical factors such as

degree of technological maturity and degree of technology integration Langfield-Smith and Smith

(2003) Contracting of any service or activity to a third party Transaction cost theory, agency theory Characteristics of the transaction, transaction

environment and parties Leiblein (2003) Organizational governance

form Transaction cost theory, resource-based theory, real

options theory

Resource heterogeneity, role

of uncertainty, direction for integration

Leiblein, Reuer, and Dalsace

(2002) Organizational governance form Transaction cost theory Technological performance Levina and Ross (2003) Transfer property and

decision rights to an external organization

Client–vendor relationship Vendor efficiency is based on

complementarities in organizational design, core competencies, and relationship management structures

Linder (2004) Partnering with another

company Organizational change Four varieties are rapid start-up, pathway to growth,

change catalyst, and radical renewal

Loh and Venkatraman

(1992a) Contribution by external vendors Neoclassical economics, procurement activities Business and IT cost structures, IT performance Lorence and Spink (2004) Vendors helping companies

integrate networks and solve information access

Decision-making theory Functions most likely to be

outsourced Sambamurthy and Zmud

(2000) Design of effective IT organizational architecture Theories of organizing logic Identify critical IT capabilities, design relational

architectures for capabilities, design integration architectures Steensma and Corley (2001) IT function outside firm

boundary Theories of firm boundaries Transaction cost, commercial failure, sustainable

advantage, organizational context

Willcocks and Lacity (1999) Management of IT

capabilities Decision-making theory Risk, creative contracting, and business advantage

Table 2.3 Outsourcing definitions in the research literature, cont.

Outsourcing is a phenomenon in which a user organization (client) transfers property

or decision rights over information technology infrastructure to an external (vendor) organization (Levina & Ross, 2003) By using this definition, Levina and Ross direct their

research at how vendors can deliver financial and managerial benefits to their clients thatoutweigh contracting costs and risks But instead of using traditional economic theories,they apply the concept of complementarity in organizational design as well as the corecompetency argument in outsourcing and theories of client–vendor relationships Theyexplain variability in outsourcing outcomes by using relationship factors as predictors

In Table 2.3, some of the definitions used in the research literature on IT outsourcing islisted We find that many of the researchers did not define outsourcing Among thosewho did, we have seen that definitions vary, both according to outsourcing perspectiveand according to theoretical perspective In Chapter IV we will go further in thediscussion of theoretical perspectives on IT outsourcing

The term “outsourcing” can be studied further by using the opposite term “insourcing.”Hirschheim and Lacity (2000) define insourcing as the practice of evaluating theoutsourcing option, but confirming the continued use of internal IT resources to achievethe same objectives of outsourcing They studied six decision factors: decision scope,decision sponsor, evaluation process, year of decision, size of the organization, anddecision outcome Lacity et al (1996) define total insourcing as the management andprovision of at least 80% of the IT budget internally after evaluating the IT service market.The common element of the two definitions seems to be that customers evaluate theexternal IT services market before a sourcing decision takes place

An outsourcing relationship consists of a vendor (supplier) and a client (customer) Thevendor is a firm that has the technology This firm is sometimes called the source firm(Steensma & Coorly, 2001) and sometimes called the outsourcer (Beamount & Costa,2002) The client is a firm that desires the technology This firm is sometimes called thesourcing firm and sometimes called the outsourcee For the purpose of clarity, Table 2.4lists some of the key terms used in this book

Figure 2.4 Definitions of some key terms for later use

Insourcing The practice of evaluating the outsourcing option, but confirming the continued use of internal IT

resources to achieve the same objectives of outsourcing

Offshoring The practice of migrating business process overseas to lower costs without significantly sacrificing

quality This practice is also called global outsourcing

Outsourcing A process whereby an organization decides to contract out or sell the firm’s IT assets, people,

and/or activities to a third-party supplier, who in exchange provides and manages these assets and services for an agreed fee over an agreed time period

Selective sourcing Selected IT functions are located with external providers while still providing between 20–80% of

IT budget

Source firm The firm that has the technology

The source firm is sometimes called vendor, supplier, or outsourcer

Sourcing firm The firm that desires the technology

The sourcing firm is sometimes called client, customer, or outsourcee

Transformational

outsourcing Partnering with another company to achieve a rapid, substantial, and sustainable improvement in enterprise-level performance

Business Example: Offshore Insurance

Business Process Outsourcing

Insurance companies have the value configuration of a value network They connectpeople who are afraid of risk to people who have been hit by a risk People who are afraid

of damage to their car, house, or health pay a premium to the insurance company Peoplewho have damage to their car, house, or health receive a payment from the insurancecompany The insurance company creates an arena for risk sharing by receiving andtransferring premium money to those who experience damage to their insured objects.There has been a rise of offshore BPO for mission-critical insurance operations, such aspolicy administration and claims processing From a theoretical perspective, offshoreBPO sounds promising Savings can be found from moving staffing and operations todeveloping regions, such as India, China, South Africa, or the Philippines These regionsmay provide the availability of human resources who may run insurance processing at

a lower cost than can be done internally or with onshore BPO providers However, dothe savings justify the risks involved with moving operations overseas, such as politicalbacklash, instability of the region, or loss of process control? Additionally, will the costsavings be a short-lived benefit as conditions improve in the region or as migration andprocess management costs rise?

Insurers, already burdened with legacy systems, large books of business that may bedwindling over time, and industry pressures to reduce operational costs, will find the costsavings attractive Two out of three primary activities in an insurance company seemattractive for outsourcing: customer services and operational infrastructure Insurersthat have past experience with IT outsourcing or third-party administrators may feelconfident about leveraging their sourcing experience to enter offshore BPO in areas such

as customer requests, claims, or policy administration processes, which all belong to theprimary activity of customer services

However, initiating and managing offshore BPO is a challenge for insurance companies.Fears regarding offshore BPO for insurance processes center around several issues:

• The inability to position offshore BPO providers in direct interaction with businessmanagers

• Concern over the loss of customer interaction for servicing activities, as insurersmust control and closely manage customer interaction

• Systems and data availability, because mission-critical processes and data cannothave downtime or periods in which systems are not available to users

• Lack of Web-enables systems that would enable external accessibility

• Compliance with privacy regulations and how to enforce privacy breaches outside

of the country of operations

• Inability to manage the process when one part of the complex process is doneexternally

IT Outsourcing 25

These challenges may deter insurers from engagement in large-scale BPO, except forisolated activities or diminishing processes, such as closed book-of-business process-ing (Gartner, 2004a)

Business Example: Ministry of

Children and Family Affairs

Statens barnevern og familievern (SBF, http://www.sbf.stat.no) is the Norwegian ernmental office for the welfare and protection of children and families Its main objective

gov-is to provide services of high and accurate quality to children, young people, and families

in need of assistance and support regardless of where in Norway they live The activities

of SBF encompass assistance to the municipalities in child welfare cases, the running ofinstitutions for children, foster home services, family-based measures, family carecenters, and initial handling of applications for adoption SBF is organized in five regionsunder a central leadership directly linked to the Ministry of Children and Family Affairs.SBF has taken over the activities that were previously handled by the County Councils

in Norway

SBF is a new department in the government, and needed to quickly get its IT infrastructure

up and running The IT functions’ role is mainly to facilitate accessibility and ality for their users in offices throughout Norway The solution is based on Microsoft

function-2003 software and Citrix technology in a centralized operations center The IT ture is designed and implemented by Ementor, which had the full responsibility ofbuilding and running the IT systems in a temporary phase of three months In addition

infrastruc-to the outsourcing business, Emeninfrastruc-tor helps SBF with consultancy service, IT strategy,organization, project management, acquisition, implementation, and testing Ementorhas also conducted many other projects such as IT security consultancy, organizationalrestructuring assistance, enterprise resource planning (ERP) implementation, and ITstrategy preparation

When selecting a partner for this vital project, SBF emphasized experience, proven ability

to execute projects of this size, and prepare for skills transfer and operations of thesolution Ementor was chosen on the basis of the totality in the offer Ementor is excited

to be a partner in building the ICT infrastructure for the new governmental office “Wehave thorough experience in comparable large solutions with strict security regulations,”says Vice President Steinar Sønsteby The operations solution at SBF consists of projectmanagement, test management, consultancy, service desk, firewall and LAN/WANmanagement, technical service, and on-site operations

Case Study: Total Outsourcing

Keeping a Strong In-House Group

Rolls-Royce is a global power systems company providing power for land, sea, and air,with leading positions in civil aerospace, defense, marine, and energy markets Rolls-Royce is also one of the most famous names in engineering throughout the world.The history of Rolls-Royce began in 1884, when Henry Royce and Charles Rolls started

to build, manufacture, and sell quality cars Success with the cars led to the formation

of the Rolls-Royce Company in March 1906 and the launch of the six-cylinder SilverGhost, which within a year, was hailed as “the best car in the world.” At the start of WorldWar I, Royce designed his first aero engine, used in the air war by the allies Demand forthe Merlin engine, which powered the Spitfire, during World War II transformed Rolls-Royce from a relatively small company into a major contender in aeropropulsion Rolls-Royce entered the civil aviation market in 1953, and the company has become a majorplayer in this market In the 1980s and 1990s, Rolls-Royce underwent a number of mergersand acquisitions to create the only company in Britain capable of delivering power foruse in air, at sea, and on land There are now some 54,000 Rolls-Royce gas turbines inservice and these generate a demand for high-value service throughout their operationallive Today, Rolls-Royce is a technology leader, employing 35,200 employees andoperating in 48 countries Group turnover in 2003 ended at £5,645 million (Rolls-Royce,2004a, 2004b)

Until 1996 Rolls-Royce had its own IT operation The company was growing rapidly inthe 1990s, and both IT costs and the number of IT employees were increasing dramati-cally In the IT business, there was a change between large mainframes and green screens

to graphic user interface (GUI) and clustered server environments The company reached

a point where it had to manage both environments The then CIO conducted a study ofthe capability of the IT function He had serious doubts about the in-house teams’ ability

to handle the change, in terms of both capability and scale In addition, Rolls-Royce wasfinancially strapped It considered outsourcing as one way, at least in the short term, tohelp the company deliver its results Rolls-Royce also needed a change agent So, thecompany began to look outside for a partner to deal with those aspects Today, Rolls-Royce has around 30,000 computers users, and many of the staff are using ERP systems.The first outsourcing deal was done in 1996, and was renewed in 2000 for 12 more years.Rolls-Royce outsourced the basic operation of the complete infrastructure—the man-agement of networks, data centers, servers, and so on And it outsourced the applicationsupport for most of its major applications and the application development function.What was kept was development of internal software at the control level, such as controlsystems for jet engines All major assets were transferred, such as computers, software,and people More than 1,200 people were transferred from Rolls-Royce to EDS Sincealmost 90% of the IT budget goes with the outsourcer, we may regard this as a totaloutsourcing Total outsourcing transfers IT assets, leases, staff, and managementresponsibility for delivery of IT services from internal IT function to a third-party vendor,and which represents at least 80% of the IT budget (Lacity et al., 1996) The intention was

to put a long-term agreement in place, and to build a close relationship

IT Outsourcing 27

In the early years, after the initial outsourcing, Rolls-Royce kept very little competencein-house But it realized that that was unhelpful, because keeping little competence in-house created nạveté on the company’s side and a degree of frustration on theoutsourcer’s side This was later corrected and now it has senior people with experience

of managing outsourcers The central staff doing IT cover the architecture, oversight ofprojects, and management of service levels

In 1999, when Rolls-Royce acquired Vickers (now Rolls-Royce Commercial Marine), thecompany obtained a strong in-house IT group with more than 70 professionals Thisgroup provided operational IT services for more 3,200 people at 50 locations worldwide

A memorandum of understanding was signed in 2000 between Rolls-Royce and EDS toevaluate outsourcing of this group The process was stopped, concluding thatoutsourcing was not profitable for Rolls-Royce The in-house IT group of Rolls-RoyceCommercial Marine is a self-efficient group with very significant geographic boundaries,located in Norway, and serving small business units primarily in Norway, Sweden, andFinland It has just over 10% of the overall IT budget IT is kept in-house of two reasons.First of all, it is not in the natural environment for an outsourcer And second, maintaining

a complete vertical capability in IT is healthy from the CIO’s perspective It is possible

to build on that group to bring services back in-house, and it provides Rolls-Royce withdirect cost comparison versus the outsourcer

by choosing from a list of 70 infrastructure services E-business has a double role here,

as an outsourced IT function more and more will be handled electronically This meansthat the transactions between vendor and client after outsourcing will be conducted aselectronic business Third, we present a vendor value proposition that explains why avendor may create value for the client because of its complementary competencies Then,

we look at IT function organization, outsourcing performance, and successful ships We conclude this chapter by discussing opportunities and threats in IT outsourcing

relation-Value Configurations

To comprehend the value that information technology provides to organizations, wemust first understand the way a particular organization conducts business and how ISaffect the performance of various component activities within the organization Under-standing how firms differ is a central challenge for both theory and practice of manage-ment, and such understanding is critical to ensure that the value of IT is recognized,exploited, and expanded in IT outsourcing

For a long time, Porter’s (1985) value chain was the only value configuration known tomanagers Stabell and Fjeldstad (1998) have identified two alternative value configura-

Some Fundamental Perspectives 29

tions A value shop schedules activities and applies resources in a fashion that isdimensioned and appropriate to the needs of the client’s problem, while a value chainperforms a fixed set of activities that enables it to produce a standard product in largenumbers Examples of value shops are professional service firms, as found in medicine,law, architecture, and engineering A value network links clients or customers who are

or wish to be interdependent Examples of value networks are telephone companies, retailbanks, and insurance companies

A value configuration describes how value is created in a company for its customers Avalue configuration shows how the most important business processes function tocreate value for customers A value configuration represents the way a particularorganization conducts business

Value Chain

The best-known value configuration is the value chain In the value chain, value iscreated through efficient production of goods and services based on a variety ofresources The company is perceived as a series or chain of activities Primary activities

in the value chain include inbound logistics, production, outbound logistics, marketingand sales, and service Support activities include infrastructure, human resources,technology development, and procurement Attention is on performing these activities

in the chain in efficient and effective ways In Figure 3.1, examples of IS/IT are assigned

to primary and support activities This figure can be used to describe the current IS/ITsituation in the organization as it illustrates the extent of coverage of IS/IT for eachactivity

To deliver low-cost or differentiated products, a firm must perform a series of activities.The different activities are called the firm’s value chain The typical assembler/manufacturer’s value chain can be illustrated using the example of a manufacturer ofcomputer hardware, such as a personal computer The inbound logistics stage involvesraw materials handling, such as computer central processing unit (CPU) chips, memorymodules, disk drives, fans, and so forth A manager would also have to worry about aninspection of the materials, selection of parts, and delivery issues The production stageinvolves the production of in-house components, assembly of the computer, testing andtuning, maintenance of equipment, and operation of the plant The outbound logisticsstage involves order processing and shipping The marketing and sales stage isconcerned with advertising, pricing, promotion, and management of the sales force.Finally, the service stage involves managing technical support and service representa-tives and replacement and repair of computers In performing the activities of its valuechain, a firm must interact with suppliers, customers, and firms in related industries Theother firms also have value chains of their own A system of value chains is called a valuechain system (Afuah & Tucci, 2003)

The value chain is more about efficiency than about new product development It is aboutprocess more than product And it is about low cost more than differentiation The valuechain describes the necessary activities once a product and its features have beenconceived, and it is not necessarily concerned with developing a continual stream ofinnovations However, marketing does have two roles in the value chain The first was