Hidden costs
Costs are difficult to measure and quantify for a particular exercise in a typical organization. As outsourcing leads to a redefinition of organizational boundaries and, by implication, structural adjustments involving human resources, these changes often result in social as well as financial costs. Although these costs are not permanent and are mitigated through retraining and redeployment of people resources within the organization, their transfer to the supplier organization can result in considerable redundancy payouts. The costs of outsourcing are not uniformly distributed among the stakeholders of the organization and the effects of contracting out on overall employment levels in the economy are not well researched or understood.
The costs of outsourcing are composed of the costs of carrying out the transaction and, in addition, hidden costs due to co-ordination difficulties and contractual risks. These hidden costs have often not been accounted for in the outsourcing exercise.
This is as a result of the relative inexperience of buyers seeking to use outsourcing services. Unlike suppliers, buyers do not have the benefit of past experience. The savings gained as a result of economies of scale are then theoretically translated as direct savings for the tasks outsourced by the buyer. Sometimes other costs that are incurred as a result of implementing the outsourcing framework offset these savings. For example, the costs of becoming dependent on outside suppliers for services can destroy all the benefits of outsourcing. When control is lost over a critical function like IT and faced with the prospect of managing relationships that go wrong and lowering the morale of permanent employees, the move towards outsourcing becomes a significant hidden cost to outsourcing. This eventuality forms the biggest risk to the buyer, and is seen to outweigh many of the other benefits. It is an element of risk, i.e. an event that is 54
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driven by a low probability and that therefore may not happen.
Outsourcing can also generate other new risks for the buyer, such as the loss of critical skills or developing the wrong skills, the loss of cross-functional skills, and the loss of control over suppliers. These risks are especially pertinent when the supplier’s priorities do not match buyer needs.
For the organization that buys outsourcing services, outsourcing activity provides it with the ability to adjust the scale and scope of its production capability upwards or downwards, at a lower cost, to meet changing demand conditions. In addition, outsourcing decreases the product/process design cycle time.
With the use of multiple best-in-class suppliers, who work simultaneously on individual components of the system, each supplier contributes greater depth and sophisticated knowledge in specialized areas and thus offers higher-quality inputs than can any individual supplier or client. The cost margins that previously existed when the IT function was performed in-house no longer exist as the services from the supplier would either cost the same or less than when the IT function was performed internally.
Buyers often have no basis or ability to budget for costs of contracting for services involving searching for a suitable supplier, negotiating a fair price, writing the contract, monitoring performance and enforcing the contract. Other costs include co-ordination among the different organizations, bridging cultural gaps among participants, and risks inherent in contractual relations. Contractual risks pose probably the largest transaction cost in procuring IT services. These benefits appear to be greater than the costs of monitoring that arise from supervision and legal arrangements.
Transferring fixed costs into variable costs by selling assets to an outsourcing supplier is also considered an advantage for many organizations. An organization receives a cash payment and transfers fixed costs into variable overheads. These overheads are adjusted in line with increases and decreases in business.
This is beneficial in the majority of businesses.
With outsourcing there is a balance between the costs of running a larger, less specialized organization and the costs that arise from search issues and imperfect contracting. An organization that decides to outsource its IT components must search for a suitable partner, and then try to provide this partner with incentives to produce service inputs to its specifications and to the timeliness of the information it demands. Searching is costly and does not always end in success. When an organization 55
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decides to maintain its IT function (along with others), however, it faces higher costs of producing components and services, because of the many divisions left to manage, and because it cannot benefit from the learning and expertise that is acquired with specialization in a single activity.
Financial accounting methods of product costing, aimed mainly at profit calculation for the whole organization, do not usually provide complete and relevant information of this sort. Hidden costs come simply from choosing the relevant time period for comparing own and supplier costs/prices, and choosing the scope of own and supplier costs/prices for comparison. In addition, the most important decision variables are usually not quantified (e.g. safeguarding own know-how, maintaining hi-tech image).
2.6
Information technology
outsourcing risk
Risk is a common feature with any business endeavour. As ITO is like any other business activity, risks are an integral part of the ITO exercise. Unlike most business environments, however, ITO
involves a very long term relationship with a supplier of outsourcing services. This also means that there is a wide range of risks for ITO that need to reflect the dynamics of the arrangement, the fast-paced IT industry and changes in people including leadership, workers and customers. The risks (previously identified as pure risks) occurring in an ITO exercise are unique and relate specifically to (1) the IT function itself (comprising operations and development of components), and (2) the ITO deal.
ITO arrangements represent promises between a buyer and supplier of IT services over an agreed period. Along with this are the associated contract risks over the same period. A contractual agreement that benefits both the buyer and supplier of ITO services, therefore, naturally also contributes to a successful outsourcing relationship. An essential component of this outsourcing relationship is the governance of the ITO exercise. Inherent in the governance activities are changes that need to be agreed and subsequently made in the contract or agreement between the parties. As result of inevitable influences from the dynamic business and operating environment, changes need to be reflected in the contracts. This governance process will ensure that both parties continue to share maximum benefits and also an equitable portion of the risks that manifest in the ITO exercise.
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In addition to a consideration of risks of contract amendments and disputes leading to litigation, an increased understanding of the different types of risks encountered by each of the contracting parties would allow for more effective governance of contracts, which mitigates the risks and balances difficulties between the parties.
Before the risks in an ITO are discussed in detail, it is necessary to establish a common understanding of several key concepts in an ITO exercise. The most common of the concepts misunder-stood is the ‘core competency’ argument and the risk elements that are carried along with the use of this notion.
The IT function has a unique role in any organization, especially in the current economy. It is different from any other function within the organization. When it is outsourced special consideration needs to be given to it.
Many managers, IT practitioners and researchers in this area warn of risks when embarking on the outsourcing of the organization’s IT function. Part of the reason for this is because there are very few data available on the organizations’ risk tolerance (or ability to absorb the effects of risk) when embarking on an ITO exercise. The innate inability to understand and subsequently manage the risks involved is a factor that contributes significantly to this hesitance. There is scant knowledge on the effects of actions to mitigate risk exposure in an ITO exercise. Little wonder, then, why many organizations remain reluctant to outsource the IT function. It is often decided not to outsource the IT
function at all, or to take only partial measures, in which case the benefits of outsourcing the IT function are often not fully realized.
We know from the work done in the area of outsourcing that one of the benefits accruing is the ability to move some of the operational risks encountered in the IT function from the buyer to the supplier organization. This ability to shift the risks to an organization that is more capable of managing the risks is valuable to the buyer organization. It allows the buyer organization to focus on other tasks and frees resources that would otherwise have to be allocated to managing the IT operations and associated risks.
The dominant sources of risk derive from information asymmetry (between buyer and supplier), the inherent inability to monitor the partner’s actions, and exogenous changes that allow one party to behave opportunistically during the period of the partnership. It is, hence, a gargantuan task to understand the 57