The Risks And Benefits Of It Outsourcing
In 1989, Eastman Kodak, a world-renowned imaging company, outsourced its entire data center, network and computer operations to the companies such as IBM, Digital Equipment and DEC. This 10-year, $250 million outsourcing contract became a Milestone in IT outsourcing development. Since then, the IT outsourcing industry has flourished and grown rapidly. Nowadays outsourcing has become a basic strategy in the field of information systems. However, the risks of IT outsourcing are gradually exposed, and many companies are beginning to return to the embrace of insourcing. This article aims to explore the risks and rewards of IT outsourcing to an organisation.
What is IT Outsourcing?
The IT outsourcing refers to a service model in which the enterprise strategically selects external professional technology and service resources and outsources all or part of the work to a professional company. Enterprises use their outstanding external professional resources to replace the internal departments and personnel to undertake the operation and maintenance of enterprise systems or business processes, thereby achieving the goals to reduce costs, improve efficiency, fully utilize the core competitiveness and enhance the resilience of the external environment.
According to the different businesses, IT outsourcing services are divided into IT Infrastructure Outsourcing (ITO), Application System Outsourcing (ASO) and Business Process Outsourcing (BPO). According to the location of the contracts, outsourcing services are divided into Domestic Outsourcing and Offshoring Outsourcing. According to different levels of outsourcing, IT outsourcing is divided into two forms, Integrated Outsourcing and Selective Outsourcing. The current outsourcing contract is very complicated, it is very difficult for companies to avoid risks even if they have a thorough and detailed contract. Researchers have identified many types and forms of outsourcing risks so far.
Clark (1995) believed that the most fundamental outsourcing risk is loss of control, including control over service quality, confidential information, cost and demand changes. Earl (1996) divided the risk of IT outsourcing into 11 categories, they are Possibility of Weak Management, Inexperienced Staff, Business Uncertainty, Outdated Technology Skills, Endemic Uncertainty, Hidden Costs, Lack of Organizational Learning, Loss of Innovative Capacity, Dangers of an Eternal Triangle, Technological Indivisibility and Fuzzy Focus. Clark and Zmud (1995) believed that outsourcing may not reduce the cost of information technology. The higher costs are usually due to unforeseen and unspecified changes. Cheon and Grover (1995) proposed Resource-Bases Theory (RBT), Resource-Dependency Theory (RDT), Transaction Cost Theory (TCT) and Agency Cost Theory (ACT). Hancox and Hackney (1999) proposed Core Competence Theory, Transaction Cost Economics Theory, Agency Theory and Partnership Theory. Aubert (1998) used transaction cost theory and agency theory to identify risks, analyzed the relationship between different risk factors and unintended consequences, and discussed the dynamics of risks. Bahli (2003) revised and supplemented Aubert's research model and proposed a more comprehensive and practical risk management framework. Gonzalez and Gasco (2005) identified 10 major IT outsourcing risks through a literature review and a questionnaire survey of 357 large companies, mainly over-reliance on suppliers, suppliers not complying with contracts, losing critical technology and hiding cost, etc.
Risks of IT Outsourcing
This section will analyze the risk mechanism of IT outsourcing based on the transaction cost theory and Bahli's theoretical framework. The risk sources of IT outsourcing can be divided into three categories: transactions, clients and suppliers. There are four main risk scenarios in IT outsourcing: lock-in, contract modification, unexpected transition and management costs, disputes and litigation.
In addition to the above risks, the risk of decline in client capacity must be considered. Rustagi (2004) found that client capabilities are significantly and positively related to the success of outsourcing. Client competence determines its position and future development in the market competition. In the classic outsourcing theory, the business and operations closely related to core competitiveness are not outsourced. However, due to the close integration of IT with strategy, management and operations, outsourcing inevitably affects client capabilities in a profound way, and both parties must pay attention to the risk it brings.
Lock-in is a state in which clients cannot get rid of the relationship between the two parties if they do not bear the loss or sacrifice some or even all of the assets to the suppliers. If the client chooses only a small number of suppliers or a single source of service, they are often at risk of being stuck. If the client has limited choices, they will be disadvantaged in contract negotiation and conversion of suppliers. Suppliers may also have more opportunistic behaviors, including bargaining during the entire contract period or when they are updated, because suppliers are now more aware of real costs than other bidders.
On the other hand, the correlation between business and operations increases the reliance on suppliers. The original supplier knows and adapts to the client's business, process, style and even culture more than the competitors. Suppliers may also use information asymmetry to exaggerate the impact of relevance. Clients are prone to path dependence, and their ability to acquire information, process data, and independently discover and solve problems becomes worse.
The modification of the contract was mainly due to the uncertainty of future events and the actions of the other party. For the various scenarios assumed, people cannot fully predict the probability of each possibility, the degree of harm, etc. Rapid changes in the environment or market and changes in demand (Pisano,1990; Pilling and Crosby,1994), technological changes or breakthroughs that make the technology in the original contract obsolete, and in the outsourcing process, the interests of both parties, the power comparison and the quality of the relationship are constantly changing. These uncertainties may force the parties to modify the contract. Putting a lot of energy into high costs.
Unexpected Transition and Management Costs
The greater the relevance of the outsourcing business, the more collaborative problems need to be resolved between the client and the supplier. Accordingly, the hidden costs incurred are higher. It should be noted that if multiple interrelated businesses are outsourced to multiple suppliers, it will increase the difficulty of managing suppliers and require more investment. Suppliers may also compare each other and ask for more compensation.
Aubert (1998) proved that the lack of business capability of clients can lead to hidden costs and thus to the loss of accidental and management costs. In particular, due to the inability to monitor and reject suppliers’ unreasonable demands, suppliers’ opportunistic motives are intensifying and costs are more likely to be out of control. If the supplier is unqualified, the client has to buy other products or services, re-invest in looking for other suppliers, or even pay liquidated damages for the termination of the contract.
Lack of outsourcing management capability leads to increased service costs, where clients experience more cost-transfer, over-repetition of personnel and equipment, re-arrangement of rents, and increased licensing software costs (Klepper and Jones,1998).
Disputes and Litigation
Because the contribution of external suppliers is difficult to measure, they are worried about disputes with clients about quality, service price/performance, pricing, etc. (Bahli and Rivard, 2003). The client cannot accept the supplier's measurement criteria and results, and vice versa. As the performance of the client's overall business is affected by the outsourcing, it will increase the number of complaints. If the relevant business is outsourced to multiple suppliers, the suppliers may evade some undefined work. When problems arise, they may also shirk responsibility, resulting in a more complex relationship between clients and suppliers.
Objectively speaking, the change of client's demand makes suppliers bear great pressure. If the supplier fails to respond to the rapid change of businesses, or fails to firmly grasp client’s goals, both parties will inevitably have a dispute on the service content and quality.
Decline in Client Capacity
Clark (1995) argued that the most fundamental outsourcing risk is loss of control, including control over quality of service, confidential information, cost and demand changes. In terms of innovation ability, Earl (1996) believed that service providers may be neglected to master new technologies, and the client as an organization is difficult to learn new knowledge and lack of innovation. On the other hand, outsourcing weakens the management of IT by clients, IT resources become fragmented and are no longer closely related to the core business, which ultimately reduces the client's competitiveness.
Rewards of IT Outsourcing
Klepper (1998) argued that IT outsourcing motivation mainly includes three aspects: organizational finance, strategic advantage and organizational change. Cheon (1995) believed that IT outsourcing can enhance corporate IT capabilities and focus on corporate core competitiveness. Scholars and entrepreneurs generally believe that the motivation of IT outsourcing mainly focuses on cost saving, core competitiveness, improving efficiency, and improving client's environmental adaptability. This paper analyzes the rewards of IT outsourcing from the perspectives of cost, competitiveness, management and organization.
IT outsourcing service providers can help clients reduce IT costs by leveraging their strengths in specialization and economies of scale. At the same time, when clients choose to outsource their IT business, the cost of IT is easier to predict and control, which is good for financial accounting. And because the company divests non-core business, it is more conducive to improving the financial structure of the company.
With the development of outsourcing services, more and more enterprises are weighing out from the strategic level whether to choose outsourcing services, and gradually focus on the core competitiveness of enterprises. By divesting non-core businesses, the company will focus more capital and energy on the core business of the company, thereby enhancing its core competitiveness.
More and more companies choose to outsource ordinary and regular IT business to service providers. On the one hand, by outsourcing the internal IT business, it can reduce the hierarchical structure of the IT department, improve the management efficiency and business performance and facilitate the management of the internal IT department; On the other hand, after outsourcing the internal IT business, Enterprises only retain the necessary members and power settings, which is more conducive to internal management. Companies can focus on managing core departments and operating core businesses.
Promote Organizational Change
Through the outsourcing of IT services, external standards are used as reference standards for internal IT departments, which enable enterprises to eliminate or transform inappropriate or ineffective IT departments to promote internal organizational changes. At the same time, because IT outsourcing service providers will not be affected by the internal pressures that hinder organizational change, they can reduce the resistance of internal change to a certain extent and promote organizational decentralization and reengineering.
Risks of IT Insourcing
Due to the risks of outsourcing, many companies have chosen to turn to insourcing. But building in-house IT operations is not an easy task, and companies still face many challenges. Listed below are the possible risks of IT insourcing：
- Some companies may generate switching costs when they move from outsourcing to insourcing, such as sunk investment costs, information transfer and setup costs, uncertainty costs of future IT operations. High switching costs may put economic pressure on the company. The company cannot achieve cost savings, but led to rising costs.
- The inherent structure and hierarchy of the company are complex and heavy, lacking the flexibility and adaptability to cope with the changing market environment and affecting the efficiency of IT operations.
- Due to the lack of IT talent and the lack of ability to integrate IT resources and knowledge, the company is unable to achieve the expected results of the project.
- Lack of experts and experience in insourcing organizations may lead to slow project progress and failure to achieve the desired results.
Rewards of IT Insourcing
Many companies have effectively integrated IT resources, or learned the management model and experience from outsourcing vendors, successfully established their own IT insourcing organization and formed efficient IT-enabled business processes. IT insourcing brings them good economic benefits and business performance. Listed below are several identified rewards of IT insourcing:
High Loyalty of Employees
External suppliers have high employee turnover rates and are not controlled by the client. Unlike internal employees who are proud of a company product or project that has been developed for a few years, external employees lack a company spirit. Once the previously trained external staff leaves, the client has to train new employees, which not only increases the cost but also delays the progress of the project. Similarly, If the problems of social culture and temporal distance emerge, such as poor communication, cultural differences and misunderstanding, it will be difficult to solve them effectively in a short period of time. Too much outsourcing of the business may cause dissatisfaction with internal employees, and the internal staff's motivation will be impaired because they feel that they are not taken seriously. Insourcing can avoid these problems because internal employees are relatively fixed, familiar with the company's environment and rules, and managed by the company in real time. They are more loyal to the company than the outsourcing team, and the internal team is more tacit and efficient in their collaboration.
The goal of outsourcing suppliers is to maximize profits. They tend to exaggerate their strength, it is difficult for clients to know the true level of suppliers, or to monitor suppliers in real time and continuously. Suppliers often fail to deliver projects on time or the quality of completion is less than expected. The cost of the client's communication and coordination with the supplier often exceeds their expectations, and with the supplier's speculative behavior, the actually total cost of the contract increases. Loss of control eventually leads to unsatisfactory service quality. Insourcing can enable the company to firmly grasp the control of the project. The company can monitor the progress and quality of the project at any time, can correct the underperforming areas and cut unnecessary expenses in time so that company will control the cost of the entire project more accurately.
Information Security and Intellectual Property
IT Outsourcing may pose a threat to the client's information security and intellectual property rights because the supplier does not comply with the security agreement in the contract. The outsourcing supplier's personnel flow frequently, lacking loyalty to the client side, and it is difficult to ensure that the confidentiality of the client's company is not leaked. Insourcing will greatly reduce this risk.
Core Competitiveness and Innovation Ability
Core competitiveness is related to the survival and development of the company. Once the business involving core competencies is outsourced, the client side is dependent on the capabilities of the supplier. In order to save costs, suppliers often do not employ the latest technology to ensure the quality of the client's project, resulting in the client losing many opportunities for innovation. Eventually, the client will lose its competitive advantages. Insourcing can protect the company's core competencies, motivate the company to strengthen its innovation capabilities and continuously upgrade its core business, which help enhance the company's ability to withstand risks and respond to market changes.
Executives are increasingly realizing that simple IT outsourcing is no longer a time-saving and cost-saving solution, and many companies are beginning to return to IT insourcing. But insourcing also has its own risks and challenges. How to weigh the pros and cons between the two channels is a problem that every company has to think about.