Service economies

Conventional wisdom suggests that the most forward-looking and successful organisations invest the most money in IT. But according to a survey carried out in March 2003 by return on investment consultancy Alinean, this simply isn’t true.

According to Alinean, the average company in Europe spends just over 7% of its revenue on IT, while the average US company spends less than 4%. Yet it is the US companies that are deriving the greatest profitability and cost savings as a result of those investments. Some of the top performing companies spend less than 1% of revenues on IT.

The secret? Alinean found that the companies that get the best return on their investments in IT are heavy users of ‘strategic sourcing’, frequently turning to outside services providers to carry out non-core functions so that they only focus on the activities that are central to their business. The UK and Belgium, Europe’s top performers in Alinean’s poll, are both keen outsourcers.


It’s not all about the money

One of the downfalls of many managed services contracts is that customers focus too heavily on the economic value they will bring – whether that is the cost savings or additional revenue. According to analysts at Giga Information Group, companies will get more out of these deals if they incentivise contractors to focus on the business value they provide, rather than the cost reduction they enable. To do this, they need to focus on two different forms of value provided by an outsourcer:

  • Direct value: If the outsourcer is responsible for all the people, processes and technologies required to perform a service, organisations can calculate the direct value they provide through the reduction in cost, say, to supply or repair PCs compared with how much it would cost to do it itself. This tends to be done by monitoring service level agreements (SLAs) and tracking the cost reductions the third-party service creates.
  • Indirect value: This is the incremental value, over and above what is stipulated in an SLA, that an outsourcer can provide. This could be the supplier making a recommendation or assisting with something beyond its direct control. For example, a services provider with specific vertical industry expertise, such as banking, could suggest new, more cost effective ways to deal with customers, such as real-time online credit checks.

Deal makers

The depressed state of the economy means that IT directors and line of business managers are being forced to do more with less in terms of technology investment, so justifying a multi-million, multi-year investment in IT services could prove difficult.

Yet research shows that outsourcing can make IT costs more predictable, give organisations access to skills they might not have in-house and even save money on IT spend in the long term.

One of the most well documented benefits of outsourcing non-core IT functions is that it enables organisations to focus on core business activities. As Marc Veelenturf, head of consultancy at UK IT services and telecommunications company BT points out: “Think about a board meeting. How much time is actually spent discussing IT instead of the real business issues?”

Keith Wilman, chief operating officer of IT services company Computer Sciences Corp (CSC) in the UK, echoes the point. “Most companies would rather focus on honing their supply chains or building relationships with customers. They want to buy IT as a utility,” he says.

Handing over to a managed services provider can also help smooth out peaks and troughs in demand for IT skills. UK high-street retailer British Home Stores, for example, recently suffered a major fault in the middle of the night with an Oracle application that was linked to its merchandising system. Because the merchandising system runs overnight so that BHS can schedule the right levels of product to be delivered to its stores each morning, the fault could have seriously disrupted BHS’ delivery schedules and stock levels for the next day.

BHS had outsourced the management of its Oracle applications to CSC, who were able to get an Australian team of administrators to fix the problem remotely, without anyone at BHS even knowing what had happened.

Another benefit of handing IT over to a third party is that, in many instances, that supplier can leverage its technology resources, skills and buying power across a number of customers to create economies of scale, ideally passing on those savings to customers.

BT, for example, is one of Cisco’s biggest customers worldwide, so it’s far more likely to get a better deal on communications infrastructure hardware than the average technology buyer or head of procurement.

Furthermore, many IT outsourcing contracts include a multitude of sub-contractors alongside the main services provider. By aggregating the purchase of skills from these contractors, an outsourcer can also lower IT management costs for the customer.

“Investing in IT is what we do,” says Wilman of CSC. In the case of BHS, for example, CSC, was able to get BHS’ problem fixed much more quickly and cheaply than BHS could have done.

Pass it on

The economies of scale enjoyed by large service providers are substantial, but how can organisations be sure they reap some of those savings and that they don’t just fatten the profit margin of the suppliers?

One increasingly popular approach is to share risk and reward. Typically, this might include a clause in the outsourcing contract that stipulates how any savings made will be shared, with X% going to the outsourcer, and Y% going to the customer. With a risk and reward contract, the outsourcer will generally agree to pay any additional costs incurred by delayed deployment or loss of business.

CSC, for example, agreed to roll out a single, centralised email system for a customer that had recently merged with a competitor. CSC took on the cost of deploying the new system, but guaranteed the customer that it would pay the same price for the deployment and maintenance of the new system as it had been paying to manage its existing 10 different systems. So in terms of investment, the organisation was not paying any more than it had been, but was able to reap the benefits of migrating to a single email system. CSC, meanwhile, banked the savings.

However, Duncan Aitchison, UK managing director of outsourcing consultancy TPI, warns that risk and reward sharing contracts such as these need to be carefully drawn up and closely monitored. “Realistically, no-one wants to share risk – they want to transfer it. Outsourcers and their customers are only really interested in sharing anything when there’s an upside, when money’s been made, which is often more difficult to measure,” he says.

Unlocking value

One of the most visible ways organisations can reap financial benefits from their outsourcing investments is simply by unlocking assets within their own business. By transferring staff over to a third-party, or in some cases entire premises, organisations are effectively removing those assets from their balance sheets, so they are able to demonstrate to investors they have cut costs.

Veelenturf at BT even has a name for it – ‘outsourcery’. “If an outsourcer transfers assets (people, hardware, software licences) from the customer site to its own then the customer can effectively claim this asset transfer as a sale on their profit and loss account,” he explains. “This way they make money on the deal immediately, rather than going back to shareholders and saying ‘we must spend £100 million to get such and such a saving over seven years’.”

When outsourcing deals have the potential to impact an organisation this deeply, then monitoring that investment is crucial, particularly as more and more deals focus on more subjective issues such as skills transfer or increased customer satisfaction.

“Total cost of ownership is a well-used concept, but it’s only aligned to cost,” says John Bardwell, a consultant at Alinean. “Now we’re not just looking at the price of things, but also at the value delivered. You increasingly find that investment needs to be backed up by some independent arbitration – whether that’s a benchmarking project by a consultancy, or an ongoing negotiation with the services provider.”

For this reason, many organisations call in third-party outsourcing consultancies, such as Morgan Chambers or TPI, who benchmark an outsourcer’s performance against extensive industry standards to ensure it is meeting up to the terms specified in the contract.

Ultimately, tracking ‘value’ rather than cost savings will be the key focus of every outsourcing investment, according to Dan Merriman, an analyst at Giga Information Group. But current economic pressures mean many organisations miss this crucial point.

Says Merriman: “The resources and skills of outsourcers are often some of the most valuable potential assets of many IT organisations – but most outsourcing relationships focus solely on reducing the cost of current services, resulting in an important missed opportunity for increasing the business impact of IT.”

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Ben Rossi

Ben was Vitesse Media's editorial director, leading content creation and editorial strategy across all Vitesse products, including its market-leading B2B and consumer magazines, websites, research and...

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