Two Vendor Claims on Cost Savings that Deserve Scrutiny

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By Dean Meyer

Service providers offering outsourcing services have promised dramatic cost savings, along with enhanced flexibility and the vision that line executives will have more time to focus on their core businesses.

While, on the surface, vendors' claims may seem plausible, under scrutiny, most do not hold up well. To become a judicious buyer of outsourcing services, decision makers must cut through the hype and focus on the fundamental economics and business trade-offs.

That's exactly what we'll do in this series. We begin by examining the claims that outsourcing can lower costs or increase financial flexibility. Future columns will share common vendor claims and the reality and show you new ways to evaluate common management claims for outsourcing. Then I'll show you new ways to get more value from your internal IT organization and manage service providers without becoming dependent on them.

-->Cost Claim #1: Outsourcing can reduce costs.

Claim: Economies of scale will reduce costs.

Reality: While there may be some economies of scale, outsourcing vendors also introduce some new costs.

The outsourcing vendor must earn a profit at the customer's expense, typically at least 10% to 20%. That, of course, is after their sales and marketing costs, which are far higher than those of internal service providers, perhaps another 10% to 20%. In all, their price has to be at least 20% over their operating costs.

In addition, the firm incurs its own costs managing the service provider, which adds another 5% to 10%. These costs must be covered by a price that is commensurately lower than the cost of the internal provider for outsourcing to be worthwhile.

In summary, if the economies of scale don't add up to at least 25% -- which is rare -- the outsourcing deal will probably cost more, not less.

Meanwhile, many of the cost savings promised by outsourcing vendors can be obtained by decisive internal managers. In IT, for example, one area of savings from outsourcing frequently comes from data center consolidation. Once a firm has consolidated its data centers on its own, outsourcing is typically more expensive.

A service provider must do more than consolidate the pieces of a function within a firm. To gain economies of scale beyond what the company could do on its own, the vendor must combine your firm's operations with those of other companies. That is, it must serve a number of organizations with shared operations. This is not always possible or desirable.

Real cost/benefit: Outsourcing is less expensive if -- and only if -- there are significant economies of scale, or synergies, that cross corporate boundaries. Size may or may not lead to economies. And even when it does, inter-corporate sharing is not always possible. If economies of scale don’t cross corporate boundaries, the outsourcing vendor isn’t producing any savings you couldn’t produce for yourself through intra-corporate consolidation.

A cautionary note: A vendor may appear less expensive by delaying costs until later in the contract (or even until the follow-on contract). This is sometimes called "buying the business," where the vendor underbids and takes an initial loss in order to secure the deal. Then, once the firm becomes dependent on the vendor, the vendor raises its prices and recovers those lost profits. In the long run, you won’t really save money.

The way to avoid this trap is to look past aggressive sales tactics and analyze the fundamentals to ensure that true economies are available to the vendor (and unavailable to internal staff).

-->Cost Claim #2: You can make fixed costs variable.

Claim: Outsourcing converts fixed costs (or relatively fixed costs such as people) into variable costs, giving the firm greater financial flexibility. This should be advantageous as the company grows or shrinks, as technologies and standards change, and as business strategies evolve.

Reality: Most outsourcing vendors aren't going to make an investment in working with you only to find the contract disappearing (or shrinking) before it pays off. They require long-term contracts for basic services that provide them with stable revenues over time. This amounts to a fixed expense, not the hoped-for variable cost.

True, anything over and above the basic contract, such as new projects and services, is negotiated separately, at a variable cost. (Note that this variable cost is no different than asking an internal service provider to take on additional work by funding them to hire contractors, not in itself a benefit of outsourcing.)

Of course, the unanticipated can't be anticipated. The price of these future add-ons is difficult to negotiate at the time the outsourcing contract is agreed to. Once the deal is signed, your negotiating leverage is drastically reduced. Thus, no matter how good the basic deal is, add-on projects can be quite expensive. This is the price you pay for flexibility.

Real cost/benefit: If freedom from fixed costs is the goal, the contract must be carefully negotiated to allow variability in demand and in the nature of the services. Generally, this freedom comes at a relatively high price.

In my next column, we'll cover issues of accountability, business flexibility, and competence.

© 2005 NDMA Inc.

Useful Links:

How To Transform IT without Outsourcing: An Interview with N. Dean Meyer
http://www.sourcingmag.com/home/home.aspx?i=02_6/27/2005_cn_513_5_00_00

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