Governing Outsourcing Relationships

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1 Governing Outsourcing Relationships Discussion Paper by Ron Babin, MBA, CMC This paper summarizes the key points presented at a recent Centre for Outsourcing Research and Education (CORE) seminar. CORE is based at the Rotman School of Business at the University of Toronto. Background Outsourcing of IT and business processes continues to grow at double digit rates, reflecting both supply of capable, competitive services and demand from corporations and governments to benefit from lower cost, efficient outsource services. Governance of IT and business processes that rely on IT continues to challenge many organizations because of the complexity and fast pace of change within IT. Because outsourcing relies so heavily on IT, governance has become the critically important key to success in an outsourcing relationship. This paper reviews issues related to governance and outsourcing and makes recommendations to benefit from improved governance of the outsourcing relationship. Situation The IT and business processes outsourcing market continues to grow. IT outsourcing in areas such as help desk, infrastructure operations and applications development and support relies on lower costs that come from economies of scale and delivery networks that deliver global labour arbitrage and high quality services. Business process outsourcing is growing even faster than IT outsourcing, in areas such as human resources, accounting and customer service. The ongoing investment in technology and skill upgrades required to remain competitive (i.e. low cost) in non-core areas such as backoffice administration are better accomplished by service providers who can leverage specialty skills and a global network of delivery centres. Outsourcing providers are experiencing strong growth. For example, Accenture reported an 18% annual increase in outsourcing for 2005, well ahead of their traditional consulting business growth of 11% (reference 1). Kennedy Information reports that business process outsourcing is growing at 12% globally, making it one of the fastest growing service areas. Kennedy also reports that the global market for IT outsourcing is about $260 billion, and for business process outsourcing it is about $130 billion (reference 2). Clearly outsourcing is a sizable and growing market. IT Governance is a complicated topic. Since the early 1990s, IT has been regarded as an area that requires a different management and governance approach. Even today, delivery of IT capabilities is not as reliable as business executives would prefer. The Standish Group delivers an annual report card of IT project success. In 2004 they reported that only 29% of projects are completed on time, within budget, according to Stevenson Kellogg Page: 1

2 specified requirements. Approximately18% of projects failed completely (cancelled or never used) while 53% of projects were challenged in terms of budget, schedule or deliverable (reference 3). IT s delivery record is not very good, although it is slowly improving. The lack of solid IT Governance is often cited as a contributor to this record of poor delivery. Recent research has identified the importance and value of good governance. The Center for Information Systems Research (CISR) at MIT reports that organizations with better IT governance also experience a better return on assets (reference 4). McKinsey and Co. have reported that well governed organizations have been shown to increase shareholder value (reference 5). Ongoing industry experience and research has begun to identify standards and acceptable industry practices in IT Governance, as documented by the IT Governance Institute (reference 6). However, many organizations continue to struggle with IT Governance. In our experience, the maturity of IT Governance varies widely between organizations, in areas such as vendor management, risk management, resource management and project prioritization and value realization. Some organizations continue to believe that IT Doesn t Matter (reference 7), and that a low cost commodity approach is best for IT services. IT Governance becomes a low priority item for business executives, subordinate to more pressing issues such as market growth, acquisitions and new products. Business executives: Become impatient with IT, since they frequently don t understand the value promised by IT, as Nicholas Carr has documented, Don t trust IT to deliver as promised as the Standish Group has shown, and Don t understand the complexity and jargon of IT. As a result, IT governance is poorly defined and poorly executed, resulting in a pervasive disappointment by business executives with their IT organizations. Complication The combination of poorly governed IT and outsourcing can be volatile. An outsourcing arrangement will be governed by detailed contracts and agreements that define payments and penalties for delivery of IT and business process services. Failure to live within the boundaries of the agreements will result in hard-dollar costs for the organization. An in-house service would experience similar costs, but the impact is within the same organization, with internal charges between budget centres. A significant IT governance gap, such as poorly managed priorities or lack of adequate resource allocation, can result in significant cash penalties, or payments without realization of value. Within many organizations today IT Governance is managed through good-will and common interests. When we have a common goal, such as increasing our brand value or Stevenson Kellogg Page: 2

3 share-price, and we work within a common culture with consistent promotion and recognition criteria, then IT Governance can be managed with less formal mechanisms. However, when the outsource provider is responsible for delivering resources and outcomes that are invisible to the customer, often located in a distant location, and governed by structured and complex legal arrangements, the good-will model breaks down. Typically the executives who negotiate and establish the outsource agreements have good intentions and a common view of what the deal should accomplish. However, at the 1/3 point in most outsource arrangements most of the negotiating executives have disappeared, moving on to other deals, other business units or other companies. The governance model for outsourcing cannot rely on good-will. A poorly established internal IT governance framework will jeopardize the outsourcing deal. Some organizations may see outsourcing as a way to move internal business or IT problems to a mature experienced provider who can fix the problems and deliver the service at a lower cost. The outsource provider should have almost infinite supply of resources compared to the client, with technical depth to meet the client business needs and lead innovative solutions. But lacking an established governance process to balance supply and demand, the client organization can become frustrated and disillusioned with the service provider. Growing demands may not be met in a timely fashion, or may be too costly. The working environment can become poisoned and the deal becomes difficult to manage. When the time comes to renew the relationship, the contract becomes open to other outsource providers. Recommendations How can improved IT governance help outsourcing relationships? We suggest five actions: 1. Recognize that well defined internal governance is required before outsourcing 2. Meld the outsource providers governance model to fit yours 3. Allocate appropriate resources to govern and manage the relationship 4. Use outside resources to provide best practices, benchmarks and objectivity 5. Continually monitor and evolve the governance of the outsourcing relationship First, recognize that a well defined internal governance process is needed before outsourcing. The governance process should clearly define the roles and responsibilities for IT and related business process decisions. Governance should define the mechanisms for establishing, monitoring and correcting direction. Governance should provide an unambiguous framework for creating, agreeing and delivering priority projects. If these attributes are lacking, an organization should take steps to improve IT governance before completing any outsourcing arrangement. Second, revise the established in-house governance model to integrate with the vendor s outsourcing arrangement. For example, the vendor will have a defined mechanism for managing growth and expansion. Use your internal model for defining and approving service expansion and meld the two together. Another example will be charge-back and how vendor charges are tabulated, reported and invoiced to the firm. Usage fees and Stevenson Kellogg Page: 3

4 controllable costs should be apparent to the responsible business unit, which is one mechanism for balancing supply and demand for services. Accenture (reference 8) suggests that the combined model should: Allocate the right responsibilities to the right governance body entities. Provide robust and well documented decision-making structures and processes. Provide appropriate change control processes. Provide guiding principles and proactive issue and dispute resolution processes. Third, allocate enough of the right resources to govern and manage the relationship. The IT Governance Institute suggests that estimates of resources needed to manage outsourced services effectively range from 1 to 7 percent of the contract costs (reference 9). As the Outsourcing Institute points out, suppliers and clients must pro-actively work together to achieve the holy IT outsourcing trinity of dramatic outsourcing savings, higher client service levels and a decent profit margin for the vendor (reference 10). The same attention that is required in an effective internal governance framework will be required to achieve value from the outsourced relationship. Fourth, use appropriate outside resources to provide best practices, benchmarks and objectivity. At the outset of the outsource relationship and when the relationship becomes tense, outsiders such as consultants and legal advisors can provide a fact-based point of view that should be fair and objective. Rather than relying on internal emotions and vendor claims, industry benchmarks can be used to illuminate how well the service levels and the overall deal are progressing. As the Outsourcing Institute suggests: Having a third party facilitate the performance assessment can reduce the tension that can otherwise arise between the company (client) and the service party (reference 11). Finally, expect that the governance model will evolve and grow. There is some evidence that organizations who mature in both governance and outsourcing are able to derive more value. Clients and vendors should recognize that both parties benefit from an ongoing improvement to governance of the outsourcing arrangement. Conclusion Outsourcing of IT and business processes has become a core foundation for success in most businesses and government organizations. Governance is increasing recognized as a prerequisite for effective organizational management and for deriving value from IT. The inverse is also true: poor governance will create ineffective management and make a challenge for deriving value from IT. So, although outsourcing may offer alluring efficiency and effectiveness benefits, those benefits will be elusive without a solid governance foundation. Governing the outsourcing relationship is easy to say, but is hard to deliver in practice. In our view, effective governance of the outsourcing relationship is the critically important key to success. Stevenson Kellogg Page: 4

5 About Stevenson Kellogg Stevenson Kellogg is a Toronto-based, independent management consultancy with specialty focus in IT Management, Process Innovation, Transformation Management, Strategic Management, Customer Value Management, and Operations Management. Founded in 1936 by Charles Stevenson and Paul Kellogg, the firm has provided excellent counsel to many organizations. Our web site is References 1. Accenture Ltd. Annual Report, SEC filing form 10K, August 31, Trends and Opportunities in the Canadian Management Consulting Market, Bradford Smith, Kennedy Information, October 5, Chaos 2004 Third Quarter Research Report, Standish Group International Inc. 4. IT Governance, Peter Weill and Jeanne Ross, Harvard Business School Press, Putting a Value on Corporate Governance, McKinsey Quarterly, Governance of Outsourcing, IT Governance Institute, IT Doesn t Matter, Nicholas G. Carr, Harvard Business Review, May Governance Sets the Stage for Outsourcing Success, Drew Blanchard, Accenture, March 22, Governance of Outsourcing, op. cit. 10. Outsourcing Essentials, Dr. Leslie P. Willcocks, Outsourcing Institute, Volume 3, Number 4, Winter Assessing Performance of an Outsourcing Arrangement, Mitchell H. Goldstein, Outsourcing Institute Stevenson Kellogg Page: 5

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