How to Manage an IT Outsourcing Alliance

Long-term sustained management of a strategic alliance is turning out to be the dominant challenge of effective IT outsourcing. From a relatively unusual entrepreneurial activity, IT outsourcing has recently exploded across the global corporate landscape.1 Xerox, Delta Airlines, AMP Insurance (Australia), British Aerospace, and the Inland Revenue Service are the latest of these mega-alliances. Several years ago, Shell Oil out-sourced its Brazilian IT activities. Like marriage, however, these arrangements are much easier to enter than to sustain or dissolve. The special economic technology issues surrounding outsourcing agreements necessarily make them more complex and fluid than an ordinary contract. Both parties need to make special efforts for outsourcing to be successful. In addition to clear successes, we have identified troublesome relationships and several that had to be terminated.

Our purpose in this article is to provide a concrete framework to help senior managers think about IT out-sourcing and focus on how to manage the alliance to ensure its success.

Why Outsourcing Alliances Are Difficult

Outsourcing contracts are structured for very long periods of time in a world of fast-moving technical and business change. Ten years is the normal length of a contract in an environment in which computer chip performance is shifting by 20 percent to 30 percent per year. (This standard contract length has emerged to deal with switching cost issues and to make the economics work for the outsourcer.) Consequently, a rigid deal that made sense at the beginning may make less economic sense three years later and require adjustments to function effectively.

Exacerbating the situation is the timing of benefits. For the customer, the first-year benefits are clear; usually the customer receives a one-time capital payment. Next, the customer feels relieved to shift its problems and issues to another organization. Finally, the tangible payments in the first year occur in an environment in which the outputs most closely resemble those anticipated in the contract. In each subsequent year, the contract payment stream becomes less and less tied to the initial set of planned outputs (as the world changes) and, thus, more subject to negotiation and misunderstanding.

The situation from the outsourcer’s perspective is just the reverse. During the first year, there is a heavy capital payment followed by the extraordinary costs for switching responsibility and executing the appropriate cost-reduction initiatives. All this is done in anticipation of a back-loaded profit flow.

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References

1. R.L. Huber, “How Continental Bank Outsourced Its ‘Crown Jewels,’ ” Harvard Business Review, January–February 1993, pp. 121–129.

For a critical discussion of the outsourcing phenomenon, see:

R.A. Bettis, S.P. Bradley, and G. Hamel, “Outsourcing and Industrial Decline,” Academy of Management Executive, February 1992, pp. 7–22.

A library search on “outsourcing information technology” articles for the past year and a half identified over 700 articles, almost all describing IT outsourcing as reported in the various industry trade journals.

2. For a discussion of the impact of outsourcing, see:

L. Loh and N. Venkatraman, “Diffusion of Information Technology Outsourcing: Influence Sources and the Kodak Effect,” Information Systems Research 4 (1992): 334–358.

3. See “Kodak’s Outsourcing Deal Brings Risks — And Not Just for Kodak,” The Business Week Newsletter for Information Executives, August 1989; and

D. Norton, H. Pfendt, G. Biddle, and R. Connor, “A Panel Discussion on Outsourcing,” Stage by Stage, 25 January 1990, pp. 13–16.

4. “General Dynamics and Computer Sciences Corporation: Outsourcing the IS Function” (A), (B), (C), (D) (Boston: Harvard Business School, Publishing Division, 1993).

5. The theory of what transactions are best conducted within the firm and outside the firm has been comprehensively covered. See:

O.E. Williamson, Markets and Hierarchies (New York: Free Press, 1975).

For further contributions on the inefficiencies of hierarchies, see:

H. Leibenstein, Inside the Firm: Inefficiencies of Hierarchy (Cambridge, Massachusetts: Harvard University Press, 1987).

For the notion of a new form of relationship evolving among firms, see:

R. Johnson and P.R. Lawrence, “Beyond Vertical Integration: The Rise of the Value-Adding Partnership,” Harvard Business Review, July–August, 1988, pp. 94–104.

For further discussion of the nature of the evolving firm, see:

J.L. Badaracco, Jr., The Knowledge Link: How Firms Compete Through Strategic Alliances (Boston: Harvard Business School Press, 1991).

For a discussion of the process of managing strategic alliances, see:

M.Y. Yoshino, Managing Strategic Alliance (Boston: Harvard Business School Press, 1994).

Finally, for a discussion of competitive strategy and the role of strategic alliances, see:

M.E. Porter, Competitive Advantage (New York, Free Press, 1985).

6. Porter (1985).

7. See R.L. Nolan, “Managing the DP Crisis,” Harvard Business Review, March–April 1979, pp. 115–126; and

R.L. Nolan, D.C. Croson, and K. Seger, “Note on Stages Theory Today” (Boston: Harvard Business School, Publishing Division, 1993).

8. See S.P. Bradley, J.A. Hausman, and R.L. Nolan, eds., Globalization, Technology & Competition (Boston: Harvard Business School Press, 1993).

9. See L. Loh, “Determinants of Information Technology Outsourcing: A Cross-Selectional Analysis,” Journal of Management Information Systems 9 (1992): 7–24.

10. See K.P. Arnett and M.C. Jones, “Firms That Choose Outsourcing: A Profile,” Information Management 26 (1994): 179–188.

11. For a discussion of the strategic grid, see:

F.W. McFarlan, J.I. Cash, and J.L. McKenney, Corporate Information Systems Management (Homewood, Illinois: Richard D. Irwin, 1992). McFarlan developed the framework in 1982. See:

F.W. McFarlan, J.L. McKenney, and P. Pyburn, “The Information Archipelago — Plotting a Course,” Harvard Business Review, January–February 1983, pp. 145–160.

We have generalized the two dimensions of strategic importance. The operations dimension has been generalized from dependence of the company on the computer for processing transactions to overall dependence of the company on sustained real-time processing of overall business processes. We term this dimension “information intensity.” See:

M.E. Porter and V.E. Millar, “How Information Gives You Competitive Advantage, Harvard Business Review, July–August 1985, pp. 149–160.

The second dimension of the strategic grid that we generalized was the importance of new applications development. Here we generalize applications development to the importance of innovative information resource management. Indeed, in-house applications development is one aspect of this dimension, but modern development initiatives commonly involve a number of outside partners as well.

12. See McFarlan et al. (1992).

13. For additional issues in outsourcing development, see:

“The Managing of Partnering Development in IS Outsourcing,” Proceedings of the Twenty-Sixth Annual Hawaii International Conference on Systems Sciences 4 (1992): 518–527.

14. See M. Hammer and J. Champy, Reengineering the Corporation (New York: Harper Collins, 1993); and

T. Davenport, Process Innovation (Boston: Harvard Business School Press, 1993).

15. For a discussion of issues involved in an outsourcing contract, see: W.B. Richmond and A. Seidmann, “Software Development Outsourcing Contract: Structure and Business Value,” Journal of Management Information Systems 10 (1993): 57–72.