Apples to Apples

The only way to know if outsourcing will save you money, or cost you more money, is to compare rates of products and services on a like-to-like basis.

Most outsourcing studies don't do this. Instead, they either use high-level parameters to gauge overall spending levels, or compare "apples to oranges" when examining the cost of specific products and services. The inaccuracies in these approaches may lead you to believe that outsourcing will save money even when it won't.

This column explains why parametric approaches are misleading, where product/service-rate comparisons go wrong, and what it takes to do like-to-like comparisons of internal costs to outsourcing.

Parametric Approaches

The simplest, cheapest, and worst way to judge internal costs is a parametric model. This approach uses a few key attributes of the organization - such as corporate revenues, industry, and number of employees - to compare internal costs to other "similar" companies. These high-level averages don't take into account the unique configuration of technologies within your organization, or the unique needs of your business. For example, your company may be spending more on IT because it's using technology in innovative ways to gain strategic advantages, not because your IT department is less efficient. In such a case, a "bad" comparison is really a good thing!

Or you may be more expensive for reasons outside your control. For example, your company may be more geographically dispersed than others, or it may be headquartered in a high-cost locale. You may place your data center in a low-cost area, but your clients still need IT services where they work. These corporate decisions affect the cost of IT, and nobody could satisfy your company's unique requirements for the average funding level suggested by a parametric model.

You may be more expensive for reasons within your control, too. Your company may have made some decisions in the past that have led to higher costs now. This presents opportunities for cost reductions, typically requiring an up-front investment to save money in the future.

For example, you may save money if you consolidate infrastructure, move to different IT platforms, or replace myriad legacy systems with ERP. But you probably didn't need a cost study to reveal such opportunities, and outsourcing a mess isn't likely to fix that mess for free.

Even if parametric models could account for all these differences, comparing your costs to other similar companies is irrelevant because you can't buy from those other companies. They're not a realistic alternative. You may be somewhat more expensive than the average, but still less costly than outsourcing. Perhaps that discovery will cause you to work even harder on internal process improvements, but it doesn't mean you should pursue outsourcing.

The only relevant question when considering outsourcing is, "Can I buy equivalent products and services from vendors more cheaply than I can make them internally?"

Rate Comparisons

Perhaps this is obvious, but to evaluate outsourcing, you have to know the costs of your products and services. Calculating rates for internal products and services is often done badly, resulting in misleading comparisons. There are three challenges.

The first challenge is identifying comparable deliverables. For example, it would be unfair to compare the hourly rate of an internal applications developer - which comes complete with office space, office equipment such as a phone and PC, and management - with that of a contractor who must then be housed, equipped, and managed.

Similarly, it would be unfair to compare the cost of a PC - which comes complete with end-user computing tools, corporate applications, installation, and perhaps a network connection - with a mail-order PC of the same configuration but without any of the other services needed to make it useful.

Comparing products and services requires a precise definition of the deliverables that are included with each item and its level of quality (performance, response time, reliability, etc.). One prerequisite to meaningful comparisons is a well-defined product/service catalog.

The second challenge is sifting out unrelated products and services. Internal IT departments do things for the good of the enterprise which vendors don't have to do (and generally should not do). The cost of these corporate-good services must not be hidden within the costs of other products and services.

For example, IT may perform a "consumers report" function in which it evaluates the various PC products on the market and recommends a few standard configurations. This research must be done whether or not the provisioning of PCs is outsourced. It's a distinct service which must be costed separately, not amortized into the internal rate for PCs.

Other examples of corporate-good activities include coordinating enterprise policies and standards, facilitating committees that help the business manage its use of IT, managing "dotted line" decentralized IT staff, and unrelated activities such as community-action programs. All these services must carry their own rates, rather than treating them as overhead and burying their costs in the rates for products and services which clients buy.

Thus, the second prerequisite to meaningful comparisons is identifying corporate-good services and separating their costs.

The third challenge is properly amortizing indirect costs. Internal rates must bear their fair share of indirect costs such as facilities, management, client liaisons (sales), support services, etc., just as vendor rates do. Thus, all costs must be associated with products and services (both client and corporate-good services); no costs should be allocated and excluded from rates.

The Full-cost Maturity Model defines four layers of indirect costs that must be amortized into rates:

• The cost of staff's "unbillable" time for sustenance activities like their own training, new-product research, and client relations
• External-indirect expenses to train and equip staff and to support the infrastructure
• Internal-indirect expenses when one group within the organization "sells" its services to another group; for example, infrastructure engineers sell upgrades to the operations group, a cost which is spread over all the services sold by the operations group
• Overhead that's spread across the entire organization

Internal-indirect costs are the most difficult. IT consumes its own services, and there's a labyrinth of internal customer-supplier relationships within any IT department. This creates complex circularity in the calculations, when group A sells services to B, who in turn sells to C, who sells to A.

In real-life applications, simple iteration cannot resolve this circularity. The problem was solved in simplistic first-generation costing models (such as activity-based budgeting) by cascading indirect costs downward to external products and services, but never sideways or upward. While they produced credible rates, distortions turned out to be significant - often exceeding 50 percent - since some external products and services received more than their fair share of indirect costs.

New second-generation costing models represent the full web of internal customer-supplier relationships - down, sideways, and up the internal value chain - and include sophisticated tools to break circularity with a minimum in distortion. They offer many advantages, a significant one being accurate rates.

The third prerequisite to meaningful comparisons is a costing model that properly amortizes indirect costs.

Fair Comparisons

The best comparisons of internal costs to outsourcing juxtapose substitutable products and services, and calculate rates with all the appropriate indirect costs and none of the costs of unrelated corporate-good activities.

This requires a well-defined internal product and service catalog (as recommended by ITIL), both for products and services bought by clients and for internal products and services consumed within the IT department. Then, all costs (direct and indirect) must be amortized properly.

Thus, the first step in an outsourcing study is a business planning process that involves the leadership team in defining its product/service catalog, forecasting sales, and then calculating the IT budget and rates.
This planning process can be very revealing. It may uncover cost-savings opportunities through eliminating low-value indirect costs, better teamwork, internal consolidations, reductions in levels of service where "gold-plated" is not needed, etc.

The planning process has another benefit: it builds a customer-focused, entrepreneurial culture. As a result, internal entrepreneurs may volunteer to use outsourcing vendors whenever doing so improves their value proposition.

Accurate rates for internal products and services are the only meaningful basis for fair, like-to-like comparisons of internal and vendor costs. Before considering outsourcing, make sure you understand your own business by documenting your product/service catalog with rates.

Copyright 2008 N. Dean Meyer and Associates Inc. Used by permission.