Outsourcing IT: Miracle cure or emetic?

by Paul A. Strassmann
Excerpted from The Squandered Computer
Published in Across The Board, May 1998

Perhaps the most crucial contemporary issue of information management is whether to outsource all or some of the information technologies to specialized-services firms. The issue is not a transient phenomenon; the shift from company-management computing to outsourcing is accelerating. The decision when, how, and where to outsource is likely to be one of the few information-management issues that will be coming up for review at board meetings. So far, there is only one good explanation that fits almost every case of outsourcing information technologies: The outsourcing corporations are trying to return to profitability by cutting employment. That is not, however, the rationale one finds in press releases announcing the transfer of most information-processing assets to an outsourcer. One hears assertions about computers no longer being a core competency. "Partnership for innovation" is another oft-quoted phrase. The plain fact is that top executives have become disenchanted with their capacity to digest information technologies. Massive divestment of a corporation's IT resources appears to be more like an emetic than a miracle cure. The Puzzle I didn't start out thinking this way. What I read in trade magazines about letting professional firms manage the modernization of information technologies was entirely plausible. Nevertheless, I was apprehensive about the benefits of outsourcing. I also knew a great deal about two huge outsourcing contracts that crippled their firms' information management for years and made them unable to respond to competitive encroachments. It seems that whenever corporate management discovers it must write off a large portion of existing systems assets and enter into another round of modernization, the first reaction is to replace their computer chiefs. To avoid any confrontations with accumulations of neglectful practices, the new CIO then launches a program of modernization calling for brand-new applications. Old programs thus become useless junk and the software branded euphemistically as "legacy software." The act of writing off the accumulated knowledge of prior years, whether in people or software, opens the door to outsourcing contractors. Unencumbered by maintenance or operating problems, there's a hope that these experienced mercenaries are more likely to get the job accomplished. Meanwhile, the talent that previously guarded the information assets of the organization gets the unglamorous custodial task of keeping daily operations going while waiting for the newcomers to collect all the prizes. No wonder this creates conditions ripe for a disaster. When computer people recommend modernization, they usually concentrate on the desirability of replacing equipment and software. What they miss are the problems of organization, motivation, and conflict that take place when previously essential talent learn that they are about to become a disposable rear guard. Announcements of the dismissal or transfer of computer personnel featured imaginative stories telling why a function with the reputation of being one of the corporation's critical success factors should now be transferred into the hands of complete outsiders. Some corporations claimed that their information technologies were not an essential part of their business anymore but, rather, like electric power or the water supply. For others, the divestment of routine processing was expected to make it possible to concentrate on strategic systems. One also heard that outsourcing was preferable because the contractors offered technical expertise that the firm could not muster by other means. It's impossible to list all the reasons for outsourcing. It has become the computer business' fastest-expanding segment. In 1995, worldwide outsourcing revenue was $76 billion, with the United States making up 48 percent of that total. Most of the outsourcing (64 percent) was for processing standard transactions such as claims, billing, and credit cards. Only 33 percent was for IT services. Maintenance and support of centralized computing facilities accounted for about half of these services. Only a small fraction of that (less than 10 percent) was for systems planning, integration, and implementation. Should top management view massive outsourcing of IT as a new and imaginative way to obtain such services, or as an excuse for getting rid of responsibilities that they have been unable to manage all along? The Search One would expect outsourcing to be a widely spread occurrence throughout the Fortune 1,000 if it does indeed improve strategic fit, realizes lower costs, takes advantage of vendor's skills, and overcomes the dearth of technical expertise. Outsourcing should be an equally good solution for anyone. It would work well for all corporations, without regard to size, industry, assets, profitability, or growth, as each finds that one or more of the many claimed benefits satisfy their needs. Applying such reasoning, outsourcing would show up as a random phenomenon, modestly biased in favor of growth corporations seeking added resources to enhance their capabilities. Statistical analysis would then reveal whether outsourcing is a random, evenly spread phenomenon or clustered around some causal connection. To examine the randomness hypothesis, I asked a librarian to assemble a list of commercial companies that most frequently appeared in the trade press as corporations that have taken outsourcing actions. With this list I searched my productivity database, which includes data about operating performance of U.S. corporations, as well as their IT budgets. With that, I set out to determine if there were any discernible characteristics among corporations that chose to outsource more than half of their IT resources. I ran many statistical tests, which revealed that the occurrence of outsourcing was not random. The analysis showed a connection between outsourcing and a firm's economic value-added. Those corporations that outsourced more than 60% of their IT budget were economic losers when they began outsourcing. They were probably shedding IT resources along with other corporate functions because they were in financial trouble. I could not find any corporation with a consistently large economic value-added and rising employment that outsourced most of its information technologies, despite claims of synergy or the advantages of getting rid of commodity work. The losers were casting off IT because they were shrinking their firms anyway. Anorexia Outsourcing is, in reality, only one aspect of a currently popular downsizing trend among troubled corporations. It takes place under a more palatable label, just as reengineering is, in most cases, a euphemism for cutbacks. The IT community has consistently ranked, in a wide range of surveys, as one of the least admired corporate functions and therefore becomes an attractive target when there is a new quota regarding how many bodies must leave. Cutting staff, divesting business, and getting rid of hundreds of person-years of accumulated skill seems to be a prevailing compulsion among large firms that are seeking to improve profitability by shrinking their size. Although the number of papers that deal with outsourcing is considerable, only a 1993 work by MIT researchers Erik Brynjolfsson and Loren Hitt has studied the relationship between outsourcing and profitability. They noted that, "[C]ompanies that try to jump on the outsourcing bandwagon may be chasing a parked car. We found no association between outsourcing and success. If anything, companies that outsourced more of their information systems work tend to have lower productivity and profitability. The only performance measure heavy outsourcers did well on was stock-market returns. In the short term, the market reacts favorably to outsourcing. Whether the market will continue to react favorably, especially if productivity doesn't improve, remains to be seen." One could say that outsourcing has many of the attributes of anorexia nervosa. People with anorexia have a distorted self-image that makes them feel fat even when emaciated; preoccupation with food, low self-esteem, and emphatic denial of the problem characterize most anorexics. Similarly, executives in companies with poor financial performance seem to concentrate on downsizing as the preferred method for restoring competitiveness. Unfortunately, shareholders and investors don't have a clue about the losses to the firm whenever knowledgeable workers leave in droves. There is no such thing as a balance-sheet write-off for human capital. When machinery or buildings become scrap, the auditors reflect that cost with a great deal of precision. The government even allows taking decisions to scrap as a tax deduction. Because outsourcing always takes computers off the list of financial assets, the accountants see that reduction in costs while neglecting the loss of the employees' know-how and commitment to serve the enterprise. There's always a test to see if a corporation did or did not abandon its essential information capabilities, and it's a simple one: Does the firm retain the choice to repatriate, or move its systems to another vendor without excessive expense, no matter what has been outsourced? If that exit option from outsourcing has an executable plan, then the essential managerial competence of the firm remains intact. I am in favor of outsourcing for any of the good reasons that would take advantage of somebody else's capacity to accumulate knowledge faster than when it remains homegrown. It should not be a substitute for the corporate version of an emetic. I shall find encouragement about the prospects for outsourcing when I see a large list of prosperous and growing organizations that use this option to enhance their mastery of information management.   The Brains of the Company The medical profession has learned how to do heart transplants, simulate the functions of kidneys, and implant synthetic knee, hip, elbow, and wrist joints. So far, it is inconceivable to do a brain transplant. The brain is individual-specific, whereas other parts of a body have only generic characteristics. The brain stores a person's knowledge patterns and experiences, which make individuals what they are, whereas body parts are equivalent to interchangeable mechanical components. The brain is also where a person retains a sense of individuality and privacy. Therefore, one of the critical issues in outsourcing is the safeguarding of uniquely confidential information. The outsourcing contract between Swiss Bank Corp. and Perot Systems solved this problem admirably. The bank retained all of the input and output processing within the bank, while Perot Systems handled only encrypted data, without ever having access to the encryption keys. Swiss Bank gave up nothing of importance, because it had reserved to itself all options and privileges. It had not yielded any of its essential managerial functions. My studies show that more than 85 percent of corporations now spend more on information management than on financial capital. Therefore, I consider it unwise for management to let someone else manage all of their information systems processes. Information management and information systems (whether computerized or not) are indeed the core competence of almost every business in the information age. With the increasing embodiment of information management into software, the control over information systems remains one of the essential managerial functions that an organization should not fully abdicate.   Outsourcing? Try Out-Tasking There are good and sufficient reasons for selectively outsourcing. I call that out-tasking, and it applies if any of the following conditions prevail: The organization is incapable of attracting or retaining talent for specialized technologies, especially for innovative uses. It is increasingly true in the public sector. The budgeting and capital-investment process is spasmodic, short-term-oriented, and subject to reversals in top management's goals, objectives, and preferences. Increasingly, this characterizes much of the industry, as well as most of the public sector. The learning curve for a new or risky technology is especially steep. Therefore, it pays to have an experienced firm introduce the technology at a much lower cost. If the new service becomes attractive, one can always reconsider the outsourcing decision. I have used this strategy over the years with considerable success by negotiating a favorable licensing and technology-transfer agreement as a clause in the initial agreement. The organization is internally in turmoil and cannot manage IT because its managerial energies are concentrating on the survival of the firm. The organization is very profitable but does not wish to devote scarce managerial resources to managing IT. This calls for inventing new forms of relationships that may not be arm's-length commercial contracts.

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