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IT Outsourcing in the Small and Medium Businesses

There's a high rate of dissatisfaction among customers with IT outsourcing agreements, according to recent surveys by Deloitte & Touche, Coopers & Lybrand, and others. However, that  dissatisfaction appears to signal the industry's growing pains rather than its demise. The outsourcing market has continued to grow, enjoying a 15 percent to 20 percent annual growth rate for several years.

And the future continues to look bright. Giga Information Group projects that the growth rate will hold at roughly 15 percent through 1997.

Much of today's dissatisfaction is the direct result of earlier contracts that were awarded without adequate due diligence. Instead of abandoning outsourcing, organizations are now developing shrewder decision-making processes,  negotiation strategies, and agreements. Price remains a factor in outsourcing satisfaction, and customers are using approaches of varying sophistication to evaluate this critical element.

Some predict that as the industry matures, megadeals -- high-risk arrangements where one or more large service vendors manage the entire IT organization for many years -- will yield to shorter-term, selective outsourcing. While this development holds the potential for lowering prices, COMPASS believes it will only slightly reduce risk for the enterprise unless executives gain a better understanding of their internal IT costs.

The organizations that have come to COMPASS after outsourcing -- whether wholly or selectively -- are excellent examples of lost opportunities. Nearly all of them had initially approached outsourcing by providing the supplier with their costs. The supplier then simply undercut these existing costs to show the savings that an outsourcing agreement would provide. Subsequent COMPASS studies revealed these savings to be little more than a slight reduction in a premium the organization had grown accustomed to paying.

How can IT users ensure that they pay a fair price for the services they receive? By acquiring specific service levels from a competitive supply of vendors, so that the total cost to the enterprise is the best possible.

Now comes the sticking point. What is the best possible price?  COMPASS believes there are four likely reference points:

1) Price/bid: Comparing price with what other suppliers might charge you

2) Price/market: Comparing price with what other, similarly- sized organizations pay

3) Price/as-is cost: Comparing price with your own costs

4) Price/should cost: Comparing price with the costs of top-performing organizations

Price/bid comparisons are popular because competing bids give managers a ballpark estimate of outsourcing costs. When those bids obtained over time, they also can indicate market trends.

Those same reasons hold true for using price/market comparisons. However, each approach has its pros and cons. Price/market has the advantage of comparing negotiated prices paid by other organizations, rather than initial offers to your own organization. In effect, price/market weighs street price, whereas price/bid gauges list price.

Figure 1. Price/bid and price/market reference points.

Price/bid has the advantage in the ease of gathering information. The information is available without consulting assistance, although some organizations opt for help in preparing requests for proposals (RFPs). However, the downside of price/market is that actual negotiated prices are far more difficult to gather than competing bids. Most outsourcing contracts have strict confidentiality clauses. An external  onsultant usually is needed for insight regarding outsourcers' pricing policies.

Although as simple, unit-by-unit cost comparisons, the price/bid and price/market methods seem intuitively straightforward, this perception is deceptive for a variety of reasons.

• Outsourcing vendors normally roll into their fees some unique mix of tradeoffs. such as exclusivity clauses, staff policies, asset disposition, pass-through charges, and more.
• Some rates subsidize others and are used to influence behavior. For example, data center peak shift rates may be excessively high to discourage people from using computing resources during that time. These high rates then may be used to offset artificially low rates in areas more valued by the customer.
• Outsourcing contracts generally include client-specific arrangements. These can include non-IT asset transfers, exclusive supplier arrangements, transition of human resources, and the purchase of overvalued assets at book value.
• The markup is usually unknown. Among our outsourcing clients, COMPASS has identified vendor prices that vary from 7 percent to 300 percent over best-of-class reference group costs.

Despite the logic of their approach, this lack of commonality prevents price/bid and price/market comparisons from being of much use in determining the actual best cost of services provided.

Looking Beyond the Obvious

The price/as-is cost approach appeals to economy-minded managers as an obvious way to determine whether outsourcing will save money. Managers may quickly disclose their current cost to a potential outsourcer in order to expedite an acceptable bid. If the price is lower than current (or as-is) cost, outsourcing seems to make sense. However, that approach may not yield the best price.

Price/as-is cost gives the advantage to the vendor.  Once they learn the potential client's current cost, outsourcers know something the client does not: the negotiation range. The top end of the negotiation range is a rate some margin below the client's current cost -- say, 10%. The bottom end is a rate some margin above the vendor's cost of services sold. This usually leaves plenty of room for negotiation, because outsourcers, through their efficiency and know-how, tend to pay far less than non-outsourcers for exactly the same IT services. The bottom line is, with the price/as is approach, you can leave money on the table.

Price/should cost eliminates this knowledge disadvantage for the client. The price/should cost method compares vendor price with what the client cost should be -- that is, the lowest cost you could expect to incur if you were to provide the services yourself. For most organizations, this cost is very different from the actual cost.

Figure 2. Price/as-is cost and price/should cost reference points.

Should cost is more difficult to determine than as-is cost. It requires a baseline, low-level inventory of existing operations. It also requires a cost-and-quality analysis, using as a reference the levels achieved by highly efficient sites of similar size and platform. Because such information is complex and proprietary, third-party help is required to gather and interpret it for the organization's various decision-making levels. A third party also can provide the objective expertise needed to persuade vendors during negotiations.

While pricing is not the only factor in an outsourcing relationship, it remains an important element in customer satisfaction. By understanding the pricing approaches, you are in a better position to negotiate with a vendor.

Lessons from the Outsourcing Primer:

• Specify service levels in gathering competitive bids.
• Study the four approaches to pricing to determine which best suits your needs.
• Remember that by giving the vendor your current in-house costs, you are allowing the vendor to determine the negotiation range.
• Be aware that vendor mark-ups can range from as low as 7 percent to as high as 300 percent.

Alan Gonchar, president of COMPASS America, Inc., has 12 years of experience in IT sales, marketing and management. He joined COMPASS in 1993 as director of sales and, in 1996, began serving as vice president of operations of COMPASS North America. COMPASS is an international management consulting firm that has completed over 4,000 comparitive analysis studies for 600 clients in 25 countries.

Publish Date: October 1997

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Copyright © 1997 - Everest Partners, L.P.

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