The hidden costs of IT outsourcing

Many outsourcing arrangements fail because customers do not factor in hidden costs. In 2009, I wrote a post on these hard-to-quantify transaction costs. The following short video (4 mins 45 secs) summarises the main points of that post in a (hopefully!) easy-to-understand way:

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Note: Here’s the full script, for those who prefer to read instead of watching…

One of the questions that organisations grapple with is whether or not to outsource IT work to external vendors. The work of Oliver Williamson  a Nobel Laureate in Economics – provides some insight into this issue.  This video is a brief look at how Williamson’s work on transaction cost economics can be applied to the question of outsourcing IT development or implementation.

A firm has two choices for any economic activity: it can either perform the activity in-house or go to market. In either case, the cost of the activity can be decomposed into production costs, which are direct and indirect costs of producing the good or service, and transaction costs, which are costs associated with making the economic exchange (more on this in a minute).

In the case of in-house IT work production costs include salaries, equipment costs etc whereas transaction costs include costs relating to building an IT team (with the right skills, attitude and knowledge).

In the case of outsourced IT work, production costs are similar to those in the in-house case – except that they are now incurred by the vendor and passed on to the client.  The point is, these costs are generally known upfront.

The transaction costs, however, are significantly different. They include things such as:

1. Search costs: cost of searching for a suitable vendor
2. Bargaining costs: effort incurred in agreeing on an acceptable price.
3. Enforcement costs: costs of ensuring compliance with the contract
4. Costs of coordinating work : this includes costs of managing the vendor.
5. Cost of uncertainty: cost associated with unforeseen changes (scope change is a common example)

Now, there are a couple of things to note about transaction costs for outsourcing arrangements:

Firstly, they are typically the client’s problem, not the vendors. Secondly, they can be very hard to figure out upfront. They are the therefore the hidden costs of outsourcing.

According to Williamson, the decision as to whether or not an economic activity should be outsourced depends critically on these hidden transaction costs. In his words, “The most efficient institutional arrangement for carrying out a particular economic activity would be the one that minimized transaction costs.”

The most efficient institutional arrangement for IT development work is often the market, but in-house arrangements are sometimes better.

The potentially million dollar question is: when are in-house arrangements better?

Williamson’s work provides an answer to this question. He argues that the cost of completing an economic transaction in an open market depends on two factors

1. Complexity of the transaction – for example, implementing an ERP system is more complex than implementing a new email system.
2. Asset specificity – this refers to the degree of customization of the service or product. Highly customized services or products are worth more to the two parties than to anyone else. For example, custom IT services, tailored to the requirements of a specific company have more value client and provider than to anyone else.

In essence, the transaction costs increase with complexity and degree of customization. From this we can conclude that in-house arrangements may be better for work that is complex or highly customized.  The reason for this is simple: it is difficult to specify such systems in detail upfront. Consequently, contracts for such work tend to be complex…and worse, they invariably leave out important details.

Such contracts will work only if interpreted in a farsighted manner, with disputes being settled directly between the vendor and client instead of resorting to litigation.  When this becomes too hard to do, it makes sense to carry out the activity in-house. Note that this does not mean that it has to be done by internal staff…one can still hire contractors, but it is important ensure that they remain under internal supervision.

If one chooses to outsource such work it is important to ensure that the contract is as unambiguous and transparent as possible.  Moreover, both the client and the vendor should expect omissions in contracts, and be flexible whenever there are disagreements over the interpretation of contract terms. In this end, this is possible only if there is a trust-based relationship between the client and vendor…and trust, of course, is impossible to contractualise.

To sum up: be wary of outsourcing work that is complex or highly customized…and if you must, be sure to go with a vendor you trust.