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Eye on ROI:
To Outsource or Not: The ROI Question, Part 1

online columnist The Gantry Group     Column published in DMReview.com
September 23, 2004
  By The Gantry Group

This month's column is the first of two on the topic of enterprise technology solution outsourcing. In this issue we will address the determination of total costs (TCO) and next month the focus will be on capturing net benefits.

Initially fuelled by the desire for competitive pricing by manufacturing companies in the U.S. in the post-2001 era, technology outsourcing is increasingly viewed as a fundamental strategy for staying in business. In 2004, outsourcing has become more than just a means for remaining competitive by taking advantage of cheaper overseas labor. Indeed, outsourcing is now well aligned with enterprises' imperatives for continual operational cost reduction, efficiency and quality improvement, and process streamlining and automation. Outsourcing is no longer only about securing offshore partnerships (e.g., India, China, Korea) to access low-cost labor; rather it represents a whole new entrant into the technology solution landscape for the U.S. as well as abroad. As a solution category, process outsourcing providers are a fast-growing segment in the market and one to be reckoned with by competing traditional enterprise software solution providers.

Over the past two years technology outsourcing has undergone inflationary expansion, moving from hosted application service providers (i.e., shared services providers - see "Eye on ROI," August 2004), to third-party processing of discrete repetitive transactions (e.g., check processing, employee payroll), to the complete outsourcing of entire business processes (e.g., employee benefits) and even to whole functional departments. Outsourcing clearly is a complicated, multifaceted solution category. This month's column will focus on business process outsourcing.

Following the broader deployment of enterprise-wide ERP systems, companies became painfully aware of the real costs and problems associated with the on-premise application suite. Deployment difficulties driven by complex data integration challenges, needs for extensive customization and requirements for actionable analytics all have one component in common: money. Not only are such applications costly to design and implement, the ongoing support and maintenance can amount to a significant annual cash drain.

As enterprises of all sizes evaluate their IT strategy within a cost constrained economic environment, the consideration of third-party process outsourcing has gained serious attention. Whether you are an enterprise with in-house applications or one just considering process automation for the first time, the best practice for arriving at a decision is to conduct a thoughtful, carefully executed ROI assessment for both scenarios. Comparing the ROI of the in-house versus outsourced solution should be a key decision tools and a strong influence on your IT decision process.

TCO = Total Cost of Outsourcing

The traditional ROI equation is based on the subtraction of net costs from net benefits. In the case of weighing an in-house versus an off-premises hosted solution, one of the areas most difficult to assess is the total cost of ownership (TCO) - or "outsourcing" in this case.

When comparing the costs associated with the purchase, design, implementation and ongoing maintenance of an enterprise application, there are some major differences between the costs of an in-house solution and a hosted, off-premise solution. Of course, the cost line items differ widely depending upon the particular application and its configuration across the enterprise. There are some however, that are common to most situations.

In-House TCO

Most enterprises are, by now, somewhat familiar with estimating the TCO of in in-house, on-premise, licensed application. The main categories of upfront capital investment, annual maintenance, feature/maintenance upgrades, and data source integration are well understood. The following is a checklist of the costs to consider for an in-house application:

  • License fees - Either one lump sum payable upfront or as an annual subscription fee based on number of seats, concurrent users, size of enterprise, etc.
  • Annual maintenance fee - Typically 15 - 20 percent of the total contract price, including some feature and maintenance upgrades as well as some level of phone technical support/help desk.
  • Premium support - Generally designed as contracts with various levels of service offered.
  • Major upgrades, not included in maintenance fee - Definition of which differs with vendors.
  • Data integration - Most enterprise applications require data from a wide set of disparate sources. The costs of integrating the data for cleansing and loading into a database or data warehouse are not to be underestimated.
  • Customization - Typically applications must be customized to the individual enterprise environment. This will incur added cost whether it is done by the application vendor or a third party integrator.
  • IT infrastructure - Hardware and networking infrastructure required to support the application brings capital cost plus annual maintenance. As with software, IT hardware components have bounded life cycles, eventually requiring replacement.
  • IT support and consulting - Whether it is your in-house IT team or a team from a third party, in-house applications require more or less constant attention from an IT expert. An internal help desk is often staffed by IT personnel and their time should be added into the cost of ownership.
  • Training - In order to extract value from your in-house solution, the intended user community must be continually trained to access the capabilities within the solution.
  • Network costs - In these days of mobility, it is possible that your application will have a wireless component. This will not only include the installation and maintenance of the wireless network but also the airtime costs from the wireless carrier.
  • License management compliance - Enterprise software solutions have risen to the status of being considered a corporate asset which must be managed. License management for a highly distributed enterprise workforce has become a time-consuming and costly task for most enterprises. Keeping track of software revision levels for each user's system and ensuring contract compliance with the solution vendor is on most IT organizations' pain point list.
  • Migration - When a new application is purchased there is typically a need to migrate from the existing processes, which is true even if these processes were manual. The cost of migration is often not included in the implementation estimate and should be included in the TCO calculation.

Outsourced TCO

Capturing all the hidden costs of outsourcing a transactional or business process can be tricky - particularly if you have not outsourced technology before. Often, unsuspecting enterprises think the decision to outsource technology is a "no-brainer" since costs will "automatically" be lower. As a result, many enterprises transitioning to a hosted off-premise provider get a big surprise when they look at their annual billings. Our recommendation is that you not take automatic savings for granted and spend the time and resources to really understand the costs.

Here are the various categories to consider:

  • Recurring expense - This is the annual services fee, often paid on a quarterly basis. This expense is typically based on transaction volumes. Many such arrangements have a cap on the volume, such that if the number of transactions exceeds a certain number, the customer is charged an additional fee that might be at a different rate. If the provider does require a volume cap, make sure there is a floor as well. This way if your volume is less than a certain amount, you won't be over-paying. Ensure that your recurring services payments are clear and model them in your TCO exercise.
  • Customization - One of the ways in which outsourced processes can be offered so inexpensively is that there is limited customization. A one-size-fits-all technology is provided to be shared among many customers. With an outsourced service such as benefits enrollment, companies often want a certain look and feel or the company logo to appear on screens for employee access. Customization can run the full gamut - from a simple positioning of the customer's name and logo to specifically formatted screens and online forms. The former is often provided free of charge, but fees rise sharply for additional customization. Many customers don't realize they are paying for this additional customization since they are quoted a per employee charge (in the example of outsourced benefits administration). If you are specifying additional customization, make sure you find out what it costs and include that in your TCO analysis.
  • Reporting requests - Often transaction reports are required that go beyond the standard report formats included in the package. While some services providers are willing to take in one or two custom report requests infrequently without an additional charge, regular special requests can be cost prohibitive. As part of your due diligence with the vendor's offering, review all their standard reports and decide whether you will need to augment these with customized reporting. Find out the costs before you buy.
  • Data interfaces - The costs of developing and deploying data interfaces between the service provider's systems and your own are not to be underestimated. Many outsourcers make claims of expertise and knowledge that they, in fact, do not have. Make certain that you clearly establish what the fixed cost will be for data feed development and any other data flow interfaces. If possible, speak with a reference customer who has a system like yours who can speak to the provider's skill in this area. If the provider lacks the necessary skills, you may end up spending more should you need to bring your own IT staff into the picture.
  • Relationship management - The idea behind outsourcing transactional processes is to off load the department that previously owned these processes from administrative tasks, enabling them to focus on the more strategic aspects of their jobs. However, this will only come true if the relationship management is smooth and seamless. Typically, a relationship manager on the provider's side is the point person for the customer. The strength of this relationship is vital to the success of the project and ultimately to the predictability of the cost. To improve your chances of getting a good relationship manager, request that that person be present prior to the sale during the sales process. This way you will meet and work with them prior to signing the contract which can save you the cost of lost productivity in the future.
  • Contract management - If your outsource vendor is offshore, there is an additional category of costs you will have. These include travel costs, foreign regulatory fees and the cost of a person(s) to oversee the contract. If the country is non-English speaking, the contract overseer is typically an ex-pat who can speak the language, but comes with U.S.-based salary requirements.
  • Performance-based pricing - One of the drivers of the appeal of third-party process outsourcing is the concept that paying a small annual fee will, in the long run, cost less than putting down a large upfront capital investment accompanied by annual maintenance fees. To ensure that this will be true for your organization, it is wise to negotiate performance guaranties into the pricing. These guaranties are essentially performance metrics that monitor the quality of the delivered service. If the performance metrics are missed by a threshold amount, then your next set of payments is discounted by a pre-set amount. These arrangements are also called fees at risk, and without them you may be paying lower fees but getting diminished quality which ultimately will cost money to fix.
  • Implementation - Implementation can often make or break the economic success of an outsourcing decision because the costs can quickly ramp out of control without proper planning. To fully model the TCO of an outsourcing strategy, you need to spend time with the provider's conversion team. A good outsource provider will develop a customized implementation plan complete with milestones and progress checkpoints. Make sure the cost of the implementation is fixed according to specific milestones and not open ended. The full implementation cost is a key driver to your TCO assessment.
  • Migration - Similar to, but separate from implementation, is the cost of migration - also called transition or conversion cost. In the case of an outsourced solution, business processes are likely going to change dramatically. This change has a cost associated with it that should be captured for the TCO analysis.
  • Offshore vendor - If you are considering an offshore vendor, a whole other category of possible costs is introduced into the TCO equation. The role of the contract overseer becomes even more important and often more costly. Depending upon what process is being outsourced, quality can be especially costly. Errors that ultimately need to be fixed can erase any savings you may reap from cheaper overseas labor.

A careful analysis of the costs of outsourcing as compared with the costs of an in-house solution will help shape your IT strategy. If the TCO is nearly the same and you are confident of your analysis methodology, be wary of making a snap decision. If implemented correctly, process outsourcing is generally less costly than an in-house application. A word of caution is in order however: as the processes being outsourced become more and more strategic (as opposed to transaction-based) the risks and need for risk mitigation are dramatically greater.

In next month's column, we will detail the high level net benefits that technology process outsourcing can, in theory, bring. While every solution type has its own associated benefits, there are some that are shared in common by all outsourced technology solutions. We'll highlight these to complete the ROI of outsourcing picture.


For more information on related topics visit the following related portals...

Dawna Paton and Dale Troppito are managing partners of the Gantry Group. Paton has helped guide the Gantry Group's rigorous ROI best practice models based on a 25-year career as chief executive officer, CFO, sales and marketing executive, and venture capitalist in high technology companies. You can reach her at dpaton@gantrygroup.com. Dale Troppito, company cofounder, believes that the technology leaders of the future will be those that understand the crucial role that a market-validated, value delivery strategy and compelling ROI play in shaping corporate competitiveness and customer satisfaction. You can reach her at dtroppito@gantrygroup.com.

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