The Real Savings From IT Outsourcing

MITSloan Management Review

Magazine: Winter 2014 

December 19, 2013 

Kunsoo Han and Sunil Mithas

 

Recent research offers insights into how companies can use IT outsourcing to generate substantial savings — in non-IT areas of the business.

These days, it is rare for a business not to outsource some part of its information technology function. According to the IT research and advisory company Gartner, global spending for IT outsourcing was projected to reach $287 billion in 2013. What’s more, the growth of cloud computing may make IT outsourcing even more common.

For many companies, reducing operating costs is a key goal of IT outsourcing, but not all companies realize such savings. One reason managers may not realize the expected gains from IT outsourcing is that they narrowly focus on only their IT costs. However, our research suggests that outsourcing IT can also help to reduce other expenses such as sales and general and administrative costs, which are often four to five times IT costs. When managers think of IT outsourcing as a mere substitute for internal IT investments, this narrow focus hides many potential cost benefits.

In our study, based on data from approximately 300 U.S. companies over the 1999-2003 period, we found that a $96.14 million increase in IT outsourcing spending by a company was associated with, on average, a $121.14 million drop in operating costs in other, non-IT functions at the company. (Detailed findings from our study were published in the March 2013 issue of MIS Quarterly. See “Related Research.”)

We also found that IT outsourcing is not a substitute for internal IT investments, especially investments in personnel. Although outsourcing was associated with a significant reduction in non-IT operating costs, that reduction in non-IT operating costs was greater for companies that made higher levels of internal IT investments. We believe this is because IT outsourcing can increase the operational efficiencies of existing processes and free up resources, thereby allowing resource reallocation. Furthermore, companies’ complementary internal investments in IT can make business processes more information-intensive and facilitate coordination with vendors, thereby magnifying outsourcing’s cost-cutting effects.

An intriguing finding from our study is that among the various components of internal IT investments (hardware, software, employees, etc.), only investments in employees have a synergy with IT outsourcing in reducing non-IT costs. This is because IT employees play a critical role in managing and exploiting outsourcing: Not only do they ensure that the vendors keep making investments in the non-contractible aspects of the outsourcing relationship, but they also play the role of a trustworthy liaison between their internal customers (that is, business functions) and vendors.

While our research used data from 1999-2003, we expect these findings to remain relevant, as many companies are currently considering more intensive adoption of outsourcing, offshoring or cloud computing. Our findings can assist managers in formulating strategies and allocating budgets. First, managers need to take a balanced approach to their investments in internal systems and outsourcing to reap greater benefits in terms of cost savings: Merely substituting IT outsourcing for internal IT will not be very effective. Also, they should analyze the impact of outsourcing on non-IT costs and formulate strategies for maximizing the savings on these expenses to get the most out of their outsourcing spending.

More broadly, benchmarking with respect to competitors on IT budgets alone may be counterproductive. IT-enabled savings in areas such as marketing, sales and R&D may considerably outweigh increased IT spending. Too strong an emphasis on IT cost reduction may overlook this significant point. Managers should remember that it is ultimately the company’s overall costs, rather than just its IT costs, that affect its profitability.

Finally, managers need to be careful about the practice of transferring IT employees to the vendor company, which is common in IT outsourcing deals. Internal employees play a critical role in capturing value from outsourcing. To get the most out of IT outsourcing, companies should continue to make investments in their own IT professionals and help them improve their skills through continued education, training and accumulation of relevant industry experience.

About the Authors

Kunsoo Han is an associate professor of information systems at the Desautels Faculty of Management at McGill University in Montreal, Canada. Sunil Mithas is an associate professor at the Robert H. Smith School of Business at the University of Maryland in College Park, Maryland.