Cost Management in IT Outsourcing Contracts: The Path to Standardization


Cost Management in IT Outsourcing Contracts: The Path to Standardization
Cost Management in IT Outsourcing Contracts: The Path to Standardization

Date: 16.03.2018

IT Outsourcing contracts are a specific and complex set of IT services that require providers to give special attention to manage a long relationship at optimal cost. The challenge is to identify the best cost structure, cost methodology and  IT services variance, in order to manage a service with the highest level of standardization. Due to the specificity of this work, the research methodology chosen is case study research applied to seven contracts. This research shows that IT Outsourcing providers suffer from several sources of variance in services and increasing contract costs. However, due to economic downturn and competition, organizations are pursuing cost reductions, and providers should take this opportunity to trade-off customization (a characteristic of IT Outsourcing contracts) for standardization (a quality of cloud offering). The conclusions of the research show that providers need to have a well developed cost management system and mechanisms to control services variance in order to gain useful information about how their performance in a contract might affect a different one, because some contracts are silos, but others can use a common structure. Keywords: Cost management; IT Outsourcing; Cloud services; services standardization
Introduction Today organizations face hard challenges to keep their businesses above breakeven point. Markets are shrinking and managers are focused on optimization and cost reduction. In this context, new opportunities arise for Outsourcing providers (KPMG, 2012) as well as customer organizations that can (re)negotiate contracts to reflect changing market conditions or move operations to Outsourcing. Outsourcing as a management concept has been present for a long time (Quinn & Hilmer, 1994) (Dibbern & all, 2004) (Quinn & Hilmer, 1994; Dibbern et al., 2004; Brown & Wilson, 2005) as organizations gradually started to outsource non-core business processes to reduce operational costs, obtain higher efficiency standards and increase competitiveness. Outsourcing deals are based on the scope of the services to outsource ITO, BPO, among others (Brown & Wilson, 2005). Consequently, in order to respond to highly demanding customers, providers need to define a specific strategy for each contract (Cullen, Seddon & Willcocks, 2005; Cullen, 2009). In this paper, the researchers analyze how providers build and manage their cost structure, in order to respond to the specificity of an IT Outsourcing contract, given the actual market pressure for flexible demand and cost reduction. Generally, IT Outsourcing have two cost natures: capital expenditure (CAPEX), based on the underlying physical infrastructure necessary for the execution of the services, and operational expenditure (OPEX), based on continuous services during a predetermined period of time. During that time, providers need to accurately measure the cost to serve (Kaplan & Cooper, 1998). However, since IT services have a high level of variance, cost allocation and financial performance measurements are difficult tasks. Moreover, providers need to identify adequate metrics and cost drivers in order to make meaningful comparisons between different contracts. Cost data can be collected and analysed through costing systems, such as ABC (Kaplan & Cooper, 1998), and integrated into the overall accounting system for future extraction and analysis by the management and stakeholders. However, the primary emphasis of a costing system should be to provide relevant and reliable information for management decision making rather than focusing only on financial reporting requirements (Horngren, Foster, & Datar, 2000). Today, the existing literature on IT Outsourcing (Lacity & Hirschheim, 1993; Hanox & Hackney, 2000; Dibbern et al., 2004) offers a considerable body of knowledge. However, existing research on cost structure for IT Outsourcing contract is scarce. Consequently, the paper’s goal is to analyze how providers manage costs and variance of IT services by answering the following research questions: Research Question 1 (RQ1): What are the cost lines and cost methodologies used to manage an IT Outsourcing contract? Research Question 2 (RQ2): How the management of an IT Outsourcing contract copes with cost reduction in opposition to the need of revenue increase? The authors’ research work is based on a case study research (Yin, 2008) applied to seven contracts of an IT Outsourcing services provider. The remaining of this paper is structured as follows. In section 2, the authors discuss what IT Outsourcing and cost accounting are. In section 3, the authors present the research methodology; in section 4 the collected data.  Section 5  discusses the results,  section 6 provides the conclusion and  the last section  reviews future research. IT Outsourcing Contracts IT Outsourcing contracts are a specific way of delivering IT services. In the following paragraphs the authors present the literature review related to the research questions. In the following section, the focus is laid on the three main theories most referred to as to Outsourcing decision: Transaction Cost Theory (TCT), Power and Politics and Agency Theory, and their success factors and risks identified. Outsourcing Decision With the history of IT Outsourcing, from time to time, organizations face the strategic decision of making a contract with an IS/IT provider for part or totality of their information systems during a certain period of time. This action is called IT Outsourcing, according to Willcocks and Lacity (1998) “Handing over to third-party management of IT/IS assets, resources and/or activities for a required result”. As indicated by Hancox and Hackney (2000, p.217), “Precise definitions of information technology (IT) outsourcing differ in the literature, but there is general agreement that it is the carrying out of IT functions by third parties”. When organizations start the decision process to determine whether to outsource, they can base their decision on one or several theories, the most referenced in literature being: Transaction Cost Theory (TCT), Power and Politics and Agency Theory. TCT is attributed to Williamson’s (1979) but it has been applied extensively in discussing outsourcing relationships by Lacity & Hirschheim (1993); Willcocks & Lacity (1998); Poppo & Zenger (2002); Miranda & Kim (2006) Transaction costs or coordination costs are based on monitoring, controlling and managing transactions. Thus, managers must consider total costs (production costs plus transaction costs) when selecting between make-or-buy alternatives (Lacity & Hirschheim, 1993). Power and politics focus primarily on the power of the IS department, the vested interests of different stakeholder groups and the political tactics they may enact to sway decisions in their favour (Lacity & Hirschheim, 1993). Thus, this perspective would make a decision making situation in which the various elements in the decision process — even internal actors — tend primarily to their own welfare. The Agency Theory (Jensen & Meckling, 1976) is essentially concerned with the delegation of work by one party (the principal) to another (the agent) via a contract (Eisenhardt K. , 1989), whether or not they are both within the same organization. An agency relationship is defined as a contract under which one or more people (the principal(s)) engage another person (the agent) to perform some service on their behalf, which involves delegating some decision making authority to the agent. In this relationship, both parties want to maximize utility, which is a good reason to believe that the agent will not always act in the best interests of the principal, since both can have conflicting interests. The principal can limit divergences from their interest by establishing appropriate incentives for the agent and by incurring monitoring costs to supervise the agent (Hancox & Hackney, 2000). The history of IT Outsourcing goes back to the 1960s (Hirschheim, George, & Wong, 2004). Since then, the decision to use external entities to manage internal information systems and the people that operate them represent an option for many organizations to optimize costs and operations. During the decision process, managers can consider a wide set of factors that have been identified and studied in the past decades by academic researchers (Dibbern et al., 2004) in order to help managers in the decision process. Such factors are twofold; there are benefits as: capability and experience of service providers, cost reduction, increase of flexibility, focus on core competences, among others (Lacity, Shaji, & Willcocks, 2009, p. 134). However, there are also the associated risks, such as weak management, inexperienced staff, business uncertainty, outdated technology skills, hidden costs, lack of organizational learning, loss of innovative capacity, technology indivisibility and fuzzy focus (Lacity, Shaji & Willcocks, 2009; Earl, 1996). Beside knowing those factors, before IT Outsourcing can work ‘‘a company must be capable of managing the IT services first” (Earl, 1996, p. 27) and “Understand your strengths”, as concluded by Thomas, Zmud & Mcray (1995, p.15) In this sense, IT Outsourcing providers must guarantee to customers that they understand the business processes, since IT is part of the Organization business strategy (Ward & Griffits, 1996) and, consequently, a critical issue. During the decision process, organizations define the degree of outsourcing that best suits their needs. The degree of outsourcing is the amount of outsourcing as indicated by percentage of IT budget outsourced and/or the type and number of IS functions outsourced (Lacity, Shaji, & Willcocks, 2009, p. 136). If a company outsources 80% or more of the IT budget, then it is considered total/full outsourcing. According to the same study, high levels of outsourcing are related to lower levels of success. Therefore, organizations with less than 80% of IT budget outsourced have higher success rates. Outsourcing Configuration After the main decisions are made, such as the selection of the provider, the degree of outsourcing and contract duration, organizations need to deal with contract configuration. An IT outsourcing contract is a complex and long relationship that can be configured by seven attributes  (Scope Grouping, Supplier Grouping, Financial Scale, Pricing Framework, Duration, Resource Ownership and Commercial Relationship) with a set of options that allow organizations to design, implement and manage the IT Outsourcing services (Cullen, Seddon, & Willcocks, 2005). Likewise, a well-developed contract with specific Service Level Agreements (SLA),which represent the contractual means of helping organizations to manage the contract and a governance model (high values of coordination and consensus between client and provider), are also essential factors for IT Outsourcing configuration and success (Poppo & Zenger, 2002; Wullenweber, Beimborn, Weitzel & Konig, 2008; Goo, Kishore, Rao & Nam, 2009).

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