Costly Surprises

Outsourcing may save less money than you think. The hidden expenses include vendor evaluation, extra security, airline tickets and severance pay.

A headline may say that a company signed a $320 million IT outsourcing contract, but the actual costs will likely be much higher. Behind the scenes, the client spends big bucks on evaluating vendors, managing the contract, enhancing security, traveling to offshore sites and potentially paying severance packages for laid-off employees.

And that's only part of what can inflate the dollar figure quoted in a basic contract.

"Things change over time, and that inevitably leads to some form of cost-shifting," says John Hill, CIO at Praxair Inc., a Danbury, Conn.-based manufacturer of gases. He suggests that contracts be designed to accommodate some flexibility, such as changes in labor or computer and network hardware.

Other IT managers and outsourcing consultants point out that unexpected costs can arise during any phase of the project. Anyone considering outsourcing should take a close look at these potential costs or risk miscalculating the true benefits of outsourcing.

Vendor Selection

Many organizations overlook the costs associated with evaluating and selecting a contractor. The process typically can drag on for many months, depending on the project's complexity, and requires time commitments from senior executives in IT, human resources, finance, legal and other departments.

"It's a very complex [market], with many service providers that have changing terms and conditions," says Shawn McCray, a partner at TPI Inc., an outsourcing advisory firm in The Woodlands, Texas.

If the potential contractors are located offshore, organizations could incur extensive travel expenses for visits to evaluate services. "A lot of times, offshore service providers have very good sales and marketing abilities, but companies need to [scrutinize potential contractors] to see what their real capabilities are," McCray says.

In some cases, organizations will need to buy studies from independent research firms—at a cost of thousands of dollars—to evaluate outsourcing vendors, says Atul Vashistha, CEO of NeoIT.com Inc., an offshore outsourcing advisory firm in San Ramon, Calif.

Costly Surprises
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Credit: Monika Melnychuk
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IT and business leaders who haven't clearly defined the goals for the outsourcing project or communicated them to the managers negotiating the deal also slow down vendor selection and the contract-signing process. "The people negotiating the contract could be focusing on the wrong things," which will result in delays in getting the contract ironed out, McCray says.

All told, choosing the right vendor and writing the contract costs about 3% of the total outsourcing cost, according to a 2001 study of 50 IT outsourcing deals by French academic Jerome Barthelemy.

Transition Period

Unexpected costs can crop up during the early stages of the outsourcing relationship, when knowledge is transferred from people on staff to members of the outsourcing team. If the contractor is located offshore, that can mean extensive travel expenses and cultural or language training for employees who visit the contractor's site, possibly for months.

If the client and outsourcing vendor need to transfer data between their systems, that might require the deployment of additional network bandwidth and security technologies, says McCray. Companies using an offshore outsourcing service will also need to be aware of the communications and data encryption regulations and requirements in different countries in order to make the necessary network upgrades to comply with them. For example, compliance with U.S. regulations such as the Sarbanes-Oxley Act and the Health Insurance Portability and Accountability Act could lead to additional IT costs for some financial services and health care companies.

Organizations that are replacing employees with outsourced staffs through layoffs or attrition could face human resources costs for severance pay and employee benefits. Depending on how many people are involved, these expenses can run into hundreds of thousands of dollars. Vashistha notes that there may also be costs resulting from decreased productivity of workers who are slated to lose their jobs.

Some companies might have to pay retention bonuses to managers and staffers they want to keep on board during the transition and beyond, Vashistha says. "If the people you want to [retain do] leave, you're in trouble," he says, because the contractor often depends on the knowledge and experience of these people. "Companies have to use good HR practices to keep the people they need."

If the outsourcing arrangement involves moving U.S.-based people to overseas locations, Vashistha says, those costs could amount to $400,000 to $600,000 each year per employee, including travel, family relocation, taxes, training and other expenses.

For outsourcing projects that involve the transfer of IT and communications assets to the contractor, organizations could encounter unexpected costs if they haven't done a thorough, up-to-date accounting of assets. Textron Financial Corp. in Providence, R.I., learned this when it outsourced all of its telecommunications and data networking operations to AT&T Solutions in 1996. CIO David Raspallo says Textron underestimated the value of the assets, including servers and desktops, that it transferred to AT&T as part of its contract. The fact was discovered when the outsourcer did an audit, and Textron incurred unexpected accounting costs to fix the inconsistencies.

"If you don't have an asset management system that gives you an accurate and up-to-date accounting of all the assets in the organization, that's where the major surprise comes," Raspallo says. "You could have some serious miscounts."

Managing the Contract

After the contract is signed and the work begins, companies can expect to spend an average of $300,000 per year managing the IT outsourcing contractor, according to Barthelemy's study.

"People often underestimate the amount of effort and energy and the resources it takes to manage the relationship properly," including the transfer of in-house and outsourcing staffs, says Praxair's Hill. His company's South American facilities outsource some computer operations, and its U.S. sites outsource functions such as desktop support.

"There can be significant overhead costs in just managing the financial terms on an ongoing basis," Hill says. "If it's an offshore contract, there can be substantially more overhead just handling the coordination of work transfer between the offshore site and onshore analysts. I think that's often underestimated."

Another extra cost that may come up during the management phase is the hiring of an experienced contract manager. Companies may come to realize that no one on staff is capable of managing a complex project—or can devote sufficient time to it—and may instead turn to an outside expert for help.

Organizations that don't continuously manage and evaluate the contractor relationship could end up with additional costs or loss of benefits because they're not getting what they paid for. This is especially true for companies that have hired multiple outsourcing vendors for different functions.

McCray says it's wise to create an outsourcing management organization that oversees long-term service contracts and understands the objectives of each partnership. TPI recently helped a client with multiple outsourcing relationships save $200 million over the course of the contracts by developing such an organization.

"You can't abdicate management to the service provider, or you will pay the consequences," McCray says.

Nielsen Media Research Inc., which in 1995 began outsourcing select application development work to Cognizant Technology Solutions Corp., an outsourcer in India, created a U.S.-based employee "anchor team" responsible for project control and quality assurance. Nielsen has created similar teams for other outsourcing projects that typically include three or four Nielsen employees who devote all or most of their time to managing the outsourcing work, says Kim Ross, CIO at the New York-based company.

In addition, for each outsourced project, Nielsen relies on about three people from the outsourcing company to serve as U.S.-based liaisons and assist in project management. "This liaison team is more expensive per hour but is warranted to avoid extra time and effort losses due to project control and business knowledge issues," Ross says. In order to keep costs contained, it's important to have the correct number of people helping with contract management, he adds. Too many means higher-than-necessary fees; too few invites the risk of project failures.

With a strong U.S.-based anchor team and liaison group working with the offshore outsourcing staff, Ross says, "the quality and delivery time can match nonoutsourced development projects, so there is no hidden cost due to poor project quality or [late] delivery."

Unexpected costs are sure to arise in any outsourcing endeavor. But with thorough planning and close alignment between the outsourcing project and overall business goals, companies can minimize those costs.

"You need to think through the scenarios and the what-ifs long term as well as short term" to anticipate what costs might emerge and ensure that the outsourcing provider is delivering the expected services, says Hill. "At the end of the day, an outsourcing relationship is a task-based performance contract, not a partnership."

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Outsourcing Transfer Costs

Transition costs can add up to 5% to 15% of the annual base cost of the contract. Here’s an example of an outsourced data center (mainframe, Unix and NT), for which the total deal size is $25 million over five years, equaling $5 million per year.

Item Estimated Cost
Process (knowledge transfer) $50,000
People (employee severance plans) $100,000

  Technology

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Software license transfers

$100,000
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Moving acquired hardware
$150,000
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Parallel processing for critical apps
$50,000
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New network connections
$50,000
Subtotal $500,000
Other contingencies (10%) $50,000
Total $550,000
Annual Percentage of Deal 11%

Source: Gartner Inc., Stamford, Conn., 2003

Violino is a freelance writer in Massapequa Park, N.Y. He can be reached at bviolino@optonline.net.

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Copyright © 2004 IDG Communications, Inc.

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