The Reasons Why Organisations Outsource Information Technology Systems

P. R. Davis1, I. A. Knox 2 1 Curtin University of Technology Perth WA 2 Master Project Management graduate Curtin University of Technology, Perth WA Corresponding Author: Faculty of the Built Environment Art and Design (BEAD), Curtin University of Technology, GPO Box U1987 Perth WA 6845. Telephone +61 08 9266 7350 Facsimile: +61 08 9266 2711. Email: p.davis@curtin.edu.au

Summary The practice of outsourcing business is international with outsourcing of information technology (IT) systems leading the outsourcing phenomena. In Australia outsourcing is consistent with international trends. Detailed research concludes that organisations contemplate IT outsourcing for essentially thirteen reasons that fall within five categories. These categories represent financial, business, technical, political and environmental reasons. The research conducted concludes with key observations that include; outsourcing of IT systems is widespread, senior management are typically involved in outsourcing decision making processes. These managers have a good understanding of the concepts supporting outsourcing and are able to provide sound management practice towards planning for the introduction of outsourcing. It is found that functions that are repetitive, operational in nature or of less strategic importance, tend to be outsourced. Determination of the top six reasons to outsource validated this assessment. Finally it is noted that five of the top six reasons nominated by the respondents fall within the context of business and technical reasons. Keywords: Outsourcing, Information Technology (IT) Systems

Introduction The practice of outsourcing or subcontracting a piece of business outside the organisation has become prevalent internationally. In the United States for example companies spent more than US$300 billion on outsourcing in 2001. Major organisations use outsourcing to deliver functionality in IT. The trend in Australia is consistent with international illustrations. In Western Australia during recent years, the Water Corporation, BankWest, AlintaGas, the Ministry of Justice and the Health Department have initiated major outsourcing arrangements for IT Systems. Whilst there is a considerable body of knowledge on the subjects of Outsourcing and IT, there appears to be limited previous research conducted on the reasons why organisations outsource IT Systems.

Outsourcing Principles Outsourcing is underpinned by the basic premise as to whether an organisation should buy or make a service. The decision to buy enlists the two primary fundamentals of outsourcing that are transferring ownership of a business process to a third party, and enabling concentration on core competencies by the vendee (The Outsourcing Institute 2000, Lacity & Hirschheim 1993a). In terms of transfer of ownership outsourcing has a significant effect on an organisations transaction costs (Lacity & Hirschheim (1993a), cash flow, productivity, profitability and growth (Smith, Mitra & Narasimhan 1998, Corbett 1995). In a survey of 192 midsize and large companies in the United States, Sherter, Spencer & Burzawa (1995) found that a rising incidence of outsourcing suggested that it was proving an increasingly attractive strategy to organisations eager to lighten workloads, save time and trim costs. According to McFarlan & Nolan (1995), outsourcing can turn a largely fixed cost based business into one with variable costs. This is particularly important for businesses whose activities may widely vary in turnover from year to year or one facing significant pressures to reduce overhead costs. Core business competencies maintain a competitive edge, fostering growth and customer benefits (Edwards 1998). King (1994) describes core functions or business competencies as functions that evolves slowly through collective learning and information sharing. These competencies cannot be quickly enhanced with large investments but they should remain a focus of strategy and a resource target dominating corporate decisions (Johnson 1997; McFarlan & Nolan 1995). Determining what exactly a core competency is can contest conventional wisdom. Take, for example, The Continental Bank based in the United States. The bank was the first traditional trading bank to outsource all of its IT functions in the 1980s. The decision to outsource at Continental was made only after management realised that customer service and not IT was the bank's core competency (Huber, 1993). To qualify as a core competency, the business function should span more than one product or market, be strategic in nature and result in an increment to shareholder value (Skinner & Bond 1997). Outsourcing is a basic realignment/ restructuring of organisations around the concept of core competencies and long-term external relationships (The Outsourcing Institute, 2000; Corbett, 1998). Interestingly a contrary view is held by Tyler (1998) who indicates outsourcing to be an old fashioned supplier - buyer contract written with detailed levels of services to be met by the contractor with specified penalties for failure. For the purposes of this paper the wider view is supported, in as much as the fundamental principles of outsourcing are taken to involve the transfer of ownership allowing concentration on core competencies.

The reasons why organisations outsource IT Companies contemplate IT outsourcing for a variety of reasons. Whilst there is some consistency of reasoning between Green-Armytage & Hawkins (1998) and The Outsourcing Institute (2000), research by Smith, Mitra & Narasimhan (1998) indicates essentially four categories that describe why organisations outsource IT. These categories are financial, business, technical and political reasons. A fifth category, of environmental issues is introduced by McFarlan & Nolan (1995). 1. Financial reasons for outsourcing IT include operating costs reductions, improve cost

control, restructure IT budgets, and cash infusion. Each of these reasons is discussed below: Reduce Operating Costs There is a common belief that an external vendor can provide the same level of service at a lower cost than an internal IT Department (Zacharilla 1996). The Outsourcing Institute (2000)

supports this view and adds that companies that do not turn to outsourcing often incur high research, development and deployment expenses. Bolton (1996) extends the discussion and notes that cost reduction derived from the implementation of outsourced IT systems can provide more efficient and up-to-date technology. The often-cited rationale is that the vendor typically has better economies of scale, tighter control over fringe benefits, better access to lower-cost labour pools and more focused expertise in managing IT (Lacity, Willcocks & Feeny 1995). However, saving through IT outsourcing is controversial, especially because the vendor often maintains the identical infrastructure in terms of equipment and personnel in addition to having to make a profit from the outsourced arrangement Lacity & Hirschhe im (1993b). Nevertheless, Smith, Mitra & Narasimhan (1998) report case studies and anecdotal evidence suggesting that IT outsourcing is often perceived by managers to be a means to reduce IT costs. Improve Cost Control Outsource vendors operate much leaner overhead structures than many of their customers and this combined with a known baseline approach to fees payable encourages user organisations to improve their overall cost control (McFarlan & Nolan, 1995). Cost control can also be improved by leveraging the organisation and access to low-cost labour pools available from outsourcers for non-base services (McFarlan & Nolan, 1995). Restructure IT Budgets IT budgets become more predictable under an outsourced arrangement (Bolton 1996, Edwards 1998). This is due to costs effectively converted into fixed cost and variable cost components replacing the largely fixed cost overhead base associated with IT infrastructure. Budgets can be further restructured as outsourcing can replace technical capital intensive outlays with periodic overhead payments (Smith, Mitra & Narasimhan 1998). Cash Infusion Companies often outsource IT to liquidate assets (McFarlan & Nolan 1995; Hurst & Hanessian 1995). This is achieved through an agreement with the vendor who acquires the organisations IT infrastructure and subsequently hires it to the user as part of the baseline fee. This conversion of the IT asset into cash would be particularly attractive to companies with a short-term need for additional working capital (Smith, Mitra & Narasimhan, 1998). Outsourcing can also reduce the need to invest capital funds in non-core business functions making consequent capital funding available for core areas (The Outsourcing Institute (2000), Smith, Mitra & Narasimhan 1998). 2. Business reasons for outsourcing IT include a return to core competencies and sharing of

and management of risks. Each of these reasons is discussed below: Return to Core Competencies Companies may outsource their IT to simplify their business agenda, focus on the company’s core business interests and establish a leaner management structure concentrating on the outcomes of the retained business competencies (Cross, 1995; Lacity, Hirschheim & Willcocks, 1994 McFarlan & Nolan 1995). Outsourcing enables management to deploy resources to gain a competitive advantage in the core activities and retain strategic aspects of their business (Sherter, Spencer & Burzawa, 1995, Smith, Mitra & Narasimhan 1998, Jeffery 1997). Share and Manage Risks Outsourcing can spread business risk associated with non-core business activities (The Outsourcing Institute 2000). In an outsourcing relationship, the service provider is better able to weigh the alternatives and spread underlying risks across multiple clients (Corbett 1998; Johnson, 1997; Haavind 1991).

3. Technical reasons for outsourcing IT include an improvement to technical service, access talent, access new technologies and focus existing IT staff onto core activities. Each of these reasons is discussed below:

Improve Technical Service Improved technical quality of IT delivery is a motivating factor associated with outsourcing (Grover, Cheon & Teng, 1994). Due to rapid technological advances, a company’s IT functions may lack contemporary technical expertise and equipment. Outsourcing can be used to create or re-tool an IT infrastructure without substantial capital investment (McFarlan & Nolan, 1995). Outsourcing is also a means to reduce time to market new IT services (Saunders, Gebelt & Hu 1997). Delivering new business solutions requires dedicated resources. Outsourcing can assist this by either providing the new technology solutions or freeing up existing resources to focus on the services required. Access Technical Talent Recruiting and retaining IT staff with the skills necessary to maintain and develop current systems is a problem (Jeffery 1997). Outsourcing can provide access to resources not available internal to a company and can provide greater access to skilled personnel generally (The Outsourcing Institute 2000, Zacharilla 1996). Further, outsourcing can enable access to expertise and capabilities (Edwards, 1998). This can be particularly important when expanding operations and entering new market opportunities or segments (Corbett, 1998). Access New Technologies Equally important is the issue of new technologies. Outsourcing provides access to world class capabilities available from the vendor (The Outsourcing Institute 2000). Companies can become complacent with the use of leading-edge IT management practices and look to vendors of outsourcing services to supplement their in-house skills and capabilities with affordable new technologies and capabilities (McFarlan & Nolan, 1995; Smith, Mitra & Narasimhan 1998). Development of new technologies is often too expensive to duplicate within many organisations; outsourcing provides specialised, often global access to world-class technology and capabilities to meet customer needs (Corbett 1998; Sherter, Spencer & Burzawa 1995). Focus Internal IT Staff on Core Activities The consequence of companies outsourcing their IT is to focus internal IT staff on their core business (Cross, 1995). By outsourcing selective IT systems, an IT department can focus on creating technology solutions that meet immediate business needs (Bolton, 1996). Further, a ‘win-win’ opportunity exists to team with a vendor to ensure that activities undertaken in the internal IT environment provide the organisation immediate value whilst new IT systems are under development externally (Bolton, 1996). 4. Political reason for outsourcing IT. An organisation that is under intense cost or competitive pressure should outsource IT as a means to delegate time-consuming, complex IT issues. In this situation, outsourcing will optimise management’s time, energy and resources and elevate efficiency of its overall IT (McFarlan & Nolan, 1995). This approach can eliminate difficult to manage business segments whilst shifting the company focus and resources to dealing with customer related matters knowing that the IT infrastructure supporting the organisation is well managed by a vendor (The Outsourcing Institute, 2000). 5. Environmental reasons for outsourcing IT include industry and economic trends and

intense vendor pressure. Each of these reasons is discussed below:

Industry and Economic Trends Industry and economic trends often play a role in the decision to outsource (Hu, Saunders & Gebelt 1997, McFarlan & Nolan 1995). Whilst such factors may not be specific to the organisation concerned, they may be relevant to the organisation’s industry or be of economic significance at the time the outsourcing feasibility study is under consideration. The decision to outsource IT is also driven by management’s current business philosophy and mixture of external media coverage together with current vendor pressure (McFarlan & Nolan 1995). Further, the availability of qualified vendors willing to provide outsourced IT services and together with financial and contractual attractiveness of the arrangements are also factors that influence outsourcing decision (McFarlan & Nolan 1995). Intense Vendor Pressure Outsourcing trends attract a large number of computer vendors promoting a range of value-added services designed to reach customer in an environment of declining hardware margins and sales (Smith, Mitra & Narasimhan, 1998). Vendors operated with highly energetic sales teams actively promoted outsourcing to executive management providing them a range of compelling reasons to outsource (Hurst & Hanessian, 1995).

Method The literature review revealed that considerable valid information was available in the public domain regarding the nature of outsourcing, its application to Information Technology Systems (IT) and, most importantly, the reasons why organisations had pursued outsourcing of IT during recent times. A structured interview using a questionnaire was selected as the appropriate instrument to collect both qualitative and quantitative data (Patton 1990). A total of sixteen interviews were conducted. The first of these interviews was the pilot survey. The pilot survey was eventually included in the sample. The sample included major Western Australian based corporate enterprises including public listed entities and a range of large State Government Agencies and Departments. These organisations spent on average approximately $6,000,000 each year on outsourcing IT. The sample selected was based on a combination of ‘purposive’ and ‘snowball’ sampling.

Findings All sixteen people interviewed held senior management positions in their respective organisations. Each person was directly involved in current arrangement with outsourcing. All sixteen have current experience with outsourcing. Of these people, 69% had four or more years of direct outsourcing experience. The sixteen organisations involved included four public listed companies, two Statutory Authorities and ten State Government Agencies. The organisations ranged in size from small employers (35 full time staff) to very large employers (3,500+). Seven of the organisations (44%) had 501 or more staff. Within the organisations, outsourcing IT first commenced in 1985. Three of the organisations (19%) commenced outsourcing prior to the 1991 financial year, six organisations (38%) commenced during the period 1992 to 1996, whereas seven organisations (44%) commenced outsourcing IT within the past five years. Overall, there was depth of outsourcing within the organisations that took part. Estimated annual expenditure on outsourcing IT ranged from $300,000 to in excess of $50,000,000. Ten of the organisations (63%) expended more than $2,000,000 annually on outsourced IT. The total annual expenditure by the sixteen organisations

on outsourcing IT was in excess $96,350,000. Information provided by the respondents indicated that the industry supporting the outsourcing of IT in Western Australia was well established and participates in large annual expenditure contracts. Eleven of the organisations (69%) spent more than 40% of their annual Information Technology budget on outsourcing IT. Collectively, these organisations spent in excess of $88,000,000 annually on outsourcing IT. Ten organisations (64%) spent more than 3% of their annual operating budget (excluding capital works) on outsourcing IT. Of these, five organisations (50%) spent more than 10% of their annual operating budget on outsourcing IT. Outsourcing of Information Technology Systems in Western Australia is big business. When asked to consider the major attributes associated with outsourcing Information Technology Systems 69% of respondents noted business processes and the concentration on core competencies as the major attributes to the concept; and respondents also identified other attributes supporting the concept of outsourcing. These included process improvement and best practice (38%), engaging a higher level of expertise to reduce risks (25%), better efficiencies and economies of scale (38%), the value add of existing services by accessing new technology, etc (25%) and being able to define your service requirements and focus on the business outcomes (31%). “Commodity items” including Help Desks, Data Centres, Network Management, etc formed the nucleus of outsourcing Information Technology Systems and were considered as functions within the business were considered as potentially suited to outsourcing. The concept of a Virtual Joint Venture with the outsource provider was also evident for larger organisations. There was a focus on developing a collaborative, alliance approach to outsourcing IT. The greater the Information Technology function was considered strategic; the more reluctant are organisations to outsource these functions. This is consistent with the views expressed in the literature review by Smith, Mitra & Narasimhan (1998).

Financial reasons Reduce Operating Costs. There was strong disagreement by 62% of the respondents that outsourcing would reduce operating costs. A regular comment was “this is a fallacy – it doesn’t really happen”. Improve Cost Control. There was strong disagreement by 63% of the respondents that outsourcing would improve cost control. A regular comment was “costs of IT blow out regardless”. Restructure IT Budgets. Divided opinion indicated marginal support. Whilst Information Technology budgets may become more predictable and easily recorded for costing purposes, the overriding consideration was a need to diligently manage the outsourcer’s capacity to spend. The concept of receiving a cash infusion is seen to be a short-term gain in an environment of rapidly changing technology

Business Reasons Return to Core Competencies. This was found to be a major reason to outsource. Share and Manage Risks . The type of risk changes with outsourcing. Risk management of IT remained regardless control. It was recognized that business risks do not transfer to the outsource provider.

Technical Reasons Improve Technical Service. This was a very attractive component. It worked provided there was deployment of above average technical skills. Access Technical Talent. This was a very attractive reason providing the technical talent was available. Access New Technologies. This was also a very attractive reason and could be compelling provided it was delivered by the provider. Focus Internal IT Staff. This was accepted as a positive but caution was counselled to remember the aspects of IT systems being outsourced. It should be the non-strategic aspects.

Political Reasons Prove the Efficiency of IT. This provided a neutral response. Efficiency was influenced by many factors; quality of business processes, people skills and competencies and user service requirements for example.

Environmental Reasons Industry and Economic Trends . - A trend has emerged but you need to be aware of the industry hype surrounding Outsourcing Intense Vendor Pressure - The outsourcing industry appears to self perpetuate its own existence. Industry hype can outsmart business logic and rationale

Summary and Conclusions A high level of management awareness exists within the sample. IT Systems are a priority to Outsource. The concepts and principles are understood by management Repetitive, operational aspects of IT are outsourced but not the strategic components The decision to Outsource is generally supported by a business case. There is an expectation that a greater focus on vendor performance will achieve better results Transitiona l arrangements (“in and out”) remain a major issue. Outsource planning and implementation should follow traditional procurement guidelines.

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