IT outsourcing: not a profitable business for service providers?
More than 50% of outsourcing deals make no economic sense for the providers.
According to Roland Berger, more than 50% of outsourcing deals make no economic sense for the providers. In his column, Partner Andreas Dietze spells out the reasons – and some possible remedies.
Recent years bear impressive testimony to the fact that, in Europe too, more and more big-name companies are opting to outsource their IT operations lock, stock and barrel. Yet cutting costs is by no means their only motivation for doing so. Most companies also want to farm out their IT to improve the quality of service they receive – thanks to "mass-produced" IT processes and innovative services, for example.
During the bidding process, external providers demonstrate how outsourcing will in future enable customers to purchase cost-efficient IT services. Outsourcing the operation of information technology, they argue, will leave customers free to concentrate on their core business and stay competitive in the marketplace. So much for the theory. In practice, things are much more complicated.
The firms that want to outsource have to set up a professional provider management unit. In many cases, co-determination issues too necessitate protracted negotiations. Yet they are not the only ones faced with new complexities.
Also IT outsourcing service providers have to overcome enormous challenges in order to win a contract. Especially in the case of high-profile deals, sales forces have to be prepared to make extensive concessions. The factory managers then work hard to see that the promises made by their colleagues in Sales are honored.
The process of establishing forward-looking target modes of operation (TMOs) indeed began years ago. This kind of model enables providers to achieve economies of scale across multiple customers by standardizing processes and consolidating their facilities. Automation and low-wage strategies are another way to significantly reduce personnel expenses.
Complex transitional processes
However, putting these strategies into practice remains fraught with problems. Migrating a customer from its current mode of operation (CMO) to the target mode of operation has proved to be especially challenging. Numerous technical interdependencies make this transformation process extremely complex.
To make matters worse, when operation changes hands, customers often hand over a variety of IT operating models that have usually grown organically over time within the company. Where responsibility for IT systems has been decentralized, for instance, all kinds of different modes of operation may have coexisted for years within one and the same company. However, since every CMO that is handed over requires its own transformation planning and implementation, this can be a powerful driver of complexity for the service provider.
Individual steps in the transformation process can also affect the people who use an IT service – when desktop systems are adapted, say, or when applications are migrated at the data center. This kind of change requires the prior consent of the customer. If the customer refuses its consent, however, this too can directly impact the transformation process.
The ever shorter runtimes agreed for outsourcing contracts are another factor that makes transformation more difficult. Whereas contract terms of seven to ten years used to be standard practice, five to seven years seems the best providers can hope for these days. As a result, the residual TMO phase that follows transformation is too short to justify the one-time expenses incurred to achieve transformation.
Even then, the provider's problems are not over though, because guaranteed retention periods for personnel exacerbate the difficulties. If these guaranteed periods extend beyond the transformation phase, providers will be unable to realize the benefits realized by transformation in time. By no means least, "the cloud" too is casting its shadow. Public debate about cloud services has now reached the stage where customers expect that providers will be able to flexibly adapt their production and cost structures in line with volume changes at the customer company.
IT outsourcing: not a profitable business for service providers?
In light of these factors, it is no wonder that more than every second IT outsourcing arrangement turns out to be a loss-maker for the provider concerned. Outsourcing service providers are gradually learning their lessons, however. Often headed by the factory boss, they are now taking a series of steps before any deal gets signed and sealed. Their aim is quite simply to minimize the risk of making a loss on the transaction. Three actions are needed:
If these important actions are to be set in motion before contracts are signed, IT outsourcing providers must do a number of things:
Recent years bear impressive testimony to the fact that, in Europe too, more and more big-name companies are opting to outsource their IT operations lock, stock and barrel. Yet cutting costs is by no means their only motivation for doing so. Most companies also want to farm out their IT to improve the quality of service they receive – thanks to "mass-produced" IT processes and innovative services, for example.
During the bidding process, external providers demonstrate how outsourcing will in future enable customers to purchase cost-efficient IT services. Outsourcing the operation of information technology, they argue, will leave customers free to concentrate on their core business and stay competitive in the marketplace. So much for the theory. In practice, things are much more complicated.
The firms that want to outsource have to set up a professional provider management unit. In many cases, co-determination issues too necessitate protracted negotiations. Yet they are not the only ones faced with new complexities.
Also IT outsourcing service providers have to overcome enormous challenges in order to win a contract. Especially in the case of high-profile deals, sales forces have to be prepared to make extensive concessions. The factory managers then work hard to see that the promises made by their colleagues in Sales are honored.
The process of establishing forward-looking target modes of operation (TMOs) indeed began years ago. This kind of model enables providers to achieve economies of scale across multiple customers by standardizing processes and consolidating their facilities. Automation and low-wage strategies are another way to significantly reduce personnel expenses.
Complex transitional processes
However, putting these strategies into practice remains fraught with problems. Migrating a customer from its current mode of operation (CMO) to the target mode of operation has proved to be especially challenging. Numerous technical interdependencies make this transformation process extremely complex.
To make matters worse, when operation changes hands, customers often hand over a variety of IT operating models that have usually grown organically over time within the company. Where responsibility for IT systems has been decentralized, for instance, all kinds of different modes of operation may have coexisted for years within one and the same company. However, since every CMO that is handed over requires its own transformation planning and implementation, this can be a powerful driver of complexity for the service provider.
Individual steps in the transformation process can also affect the people who use an IT service – when desktop systems are adapted, say, or when applications are migrated at the data center. This kind of change requires the prior consent of the customer. If the customer refuses its consent, however, this too can directly impact the transformation process.
The ever shorter runtimes agreed for outsourcing contracts are another factor that makes transformation more difficult. Whereas contract terms of seven to ten years used to be standard practice, five to seven years seems the best providers can hope for these days. As a result, the residual TMO phase that follows transformation is too short to justify the one-time expenses incurred to achieve transformation.
Even then, the provider's problems are not over though, because guaranteed retention periods for personnel exacerbate the difficulties. If these guaranteed periods extend beyond the transformation phase, providers will be unable to realize the benefits realized by transformation in time. By no means least, "the cloud" too is casting its shadow. Public debate about cloud services has now reached the stage where customers expect that providers will be able to flexibly adapt their production and cost structures in line with volume changes at the customer company.
IT outsourcing: not a profitable business for service providers?
In light of these factors, it is no wonder that more than every second IT outsourcing arrangement turns out to be a loss-maker for the provider concerned. Outsourcing service providers are gradually learning their lessons, however. Often headed by the factory boss, they are now taking a series of steps before any deal gets signed and sealed. Their aim is quite simply to minimize the risk of making a loss on the transaction. Three actions are needed:
- Perform a technical due diligence test
On top of the usual commercial due diligence investigation, outsourcing providers should also perform a comprehensive technical due diligence test in order to fully grasp both the technical and commercial specifics of different CMOs. Accordingly, the delivery processes – including the level of automation, the delivery locations and the delivery systems – must be analyzed for each and every service. - Define the target mode of operation for each service
Having performed a technical due diligence test, the provider must then determine the degree to which the target mode of operation is to be realized during the contractual term for each service. Key factors that influence the scope for improvement include the level of heterogeneity to begin with, the existing level of professionalism, technical interdependencies and lifecycle considerations (with regard to hardware investments, for example), the length of the contractual term and the commercial conditions set for the transaction. - Produce a carefully coordinated transition and transformation roadmap
Defining the transition and transformation roadmap and anchoring the details in a contract gives provider and customer alike a reliable set of planning parameters. Providers understandably attach particular importance to a precise description of the customers obligations during the transition and transformation phase – and of possible implications if contractually agreed services and materials are not provided.
- Define the rules governing compensation for operational transformation
Migrating multiple current modes of operation to a single, forward-looking target model adds value for the customer above and beyond the end of the contractual term. On the other hand, realizing this transformation causes substantial one-time costs for the provider. In the past, most outsourcing contracts included no provisions that explicitly governed compensation for this expenditure.
Customers argued that outsourcing providers themselves reap the benefits of transformation over an extended period. As contractual terms continue to shrink, however, providers are now well advised to agree on explicit rules specifying how they are to be compensated for the value they add for customers. - Define a coherent volume/price matrix
To accommodate customers' desire for flexible, volume-linked cost structures in the age of cloud computing, volume/price matrices are a useful option. These matrices define volume ranges within which the unit price for a given service can be kept constant. If a volume range is undershot, however, the customer is obliged to pay either a higher unit price or one-time compensation.
If these important actions are to be set in motion before contracts are signed, IT outsourcing providers must do a number of things:
- They must know exactly what customer-specific deviations from the standard target mode of operation are acceptable. To know this, they need answers to the following questions: How do deviations affect the provider's ability to realize economies of scale across multiple customers? And what impact does the level of automation have on delivery processes?
- They must plot a standard transformation roadmap based on the typical sequence of transformation steps. This then serves as the blueprint for each customer and reflects the technical interdependencies between all the various services.
- To optimize capacity management across multiple customers, factories should define delivery and sourcing strategies that can cope with capacity fluctuations of ±20% relative to the existing customer base. Only then is it possible to model volume and price matrices in realistic terms.
CIO Expert column
More news
Germany 2012 - Restructuring...
German businesses have come out of the financial and economic crisis in good shape: 63% expect to... >>
How OEM importers will win the...
As the eurozone hits a mild recession this year, the passenger car market is expected to shrink... >>
New restructuring study from...
German businesses have come out of the financial and economic crisis in good shape: 63% expect to... >>
Roland Berger Strategy...
As new Partner and Competence Center head, Martin Erharter has been working on pharma &... >>
IN DIALOG - Prof. Dr. h.c....
In an interview with Germany's "Top Career Guide Automotive", Roland Berger, Founder... >>
Have we whined enough? (Die...
In an interview with the German daily newspaper Die Welt, Burkhard Schwenker, Supervisory Board... >>
