Business Models in Software Outsourcing and Financial Feasibility Assessment
The transfer of the development and support of information systems to an outsourcing company has recently worried more and more companies. For the vast majority of IT, they are a non-core asset, so the opportunity to transfer their management to a professional external partner and free up resources for priority business areas looks very attractive. How can a company choose the most effective form of outsourcing and how to evaluate how much this approach is more profitable from a financial point of view than investing in the development of its own IT specialists?
As practice shows, IT outsourcing primarily suits two groups of customers. The first is medium and large companies operating in highly competitive market segments: banks, financial, insurance and investment companies, travel and air transportation industries, and all for which a quick reaction to changes in the external environment is critical. This can be achieved only with the stable operation of IT solutions that support the implementation of key business processes.
The second group – companies whose business is characterized by the low margin; for them, the most relevant is cost reduction when every cent is important to increase profitability. This situation is especially typical for organizations with a geographically distributed structure, for example, retail chains, telecommunications companies.
Three models of IT outsourcing are best known on the market today – project outsourcing models: fixed cost, time and materials, and a model in which outsourcing processes for developing or supporting systems are almost completely delegated and which implies the long-term nature of the partnership between the contractor and the customer, - Dedicated Development Center – DDC or Offshore Development Center – ODC or as this model is usually called among outsourcers – dedicated team.
The fixed cost model implies that before the start of the project, the amount of work that the service provider must perform, and the cost that the customer will have to pay are clearly defined. If during the project it becomes clear that it is necessary to perform many more tasks than originally planned, then the outsourcing company covers the difference in the cost of the project by themselves or agrees with the customer to change the budget of the project.
The peculiarity of the second model is the absence of a precisely defined project cost: the customer pays the actual amount of work performed by the outsourcer under the time spent on them and the hourly rates of the contractor’s specialists. Thus, both sides can be flexible with the regard to requirements, conditions, and priorities shifts, and are able to quickly reschedule the work.
The fundamental difference between the third model – a dedicated development center (DDC, ODC) - from the other two, lies in its long-term nature: partnerships between the customer and the contractor is established for a long time, may involve the implementation of not one, but a set of projects, or the whole business process delegation to the outsourcer (for example, maintenance of information systems).
Within the framework of the “dedicated team” model, the outsourcer, taking into account the needs of the client company, selects a team of IT specialists and creates the necessary infrastructure for its work based on one of its branches. The formed team focuses exclusively on the work for this customer. The set and scope of services provided by the center are chosen by the customer himself: this may include the development of new solutions, the development of the functionality of existing information systems, migration to other platforms, testing, software support, etc.
The criteria for choosing an outsourcing form that would be suitable for a particular company can be illustrated by two examples. Let's assume the company uses a small number of IT systems that do not have a strong impact on the success of its activities. At the same time, there are tasks associated with a minor refinement of their functionality or post-production support. In this case, it would be advisable to resort to the help of service providers offering IT outsourcing in the “time and materials” or “fixed cost” models. Project outsourcing is also optimal in the case of a one-time project (for example, creating a new business application).
Another situation is when a company uses a significant number of systems, including those developed on its own at different periods of the company's existence, and operating on various platforms. Often the documentation for these systems is outdated or completely absent, which further complicates the processes of maintenance and support. For the further development of the functionality, knowledge is required not only of technologies but also of the architecture and nuances of building these systems, as well as the presence of competencies specific to the customer’s business. In this case, an effective option is the model of a dedicated development center, whose specialists will study the customer’s systems, will be able to speak the same language, and accurately understand their tasks.
When choosing an outsourcing model, the financial factor is also important: the cost of using one or another form of the required services is estimated in combination with possible risks and compared to the option when the same amount of work is performed by the company's personnel and with resources available.
Financial pros and cons
At first glance, the most preferable option for the company is the fixed cost model: from the very beginning, it is determined how much resources are required for the project. And perhaps it will seem clear to you that you will not have to pay extra costs besides this amount. However, there are several pitfalls. All IT projects involve various risks: from the human factor to technological issues. It often happens that the tasks for the project and the requirements for it are determined very tentatively. Sometimes this happens due to the contractor’s lack of experience and knowledge in solving the customer’s problem (some companies act on the principle “the main thing is to sign a contract and think how we will complete the project afterward”), sometimes because of insufficient time and money allocated to the preliminary study of the project. Implementing a fixed cost-project, an outsourcing company tries to play it safe and includes an additional amount in the cost of its services to cover possible risks. The customer is at a disadvantage. If additional work within the project was not required, the client company overpays. If it was required to do something beyond the agreed scope of tasks, then the project becomes unprofitable for the contractor. Therefore, they will seek to agree with the customer on expanding the budget or on changing the scope and priorities of the project, reducing the quality requirements of the created product: only then will it be possible to reduce costs and keep within the original plans. But for the client company, this means allocating new costs for the completion of the project shortly in any way.
Thus, the use of the fixed cost model is effective only if both the customer and the contractor have a very accurate and detailed idea of what and how exactly needs to be done within the project. This can be achieved by increasing funding for the analytical phase of the project and allocating a sufficient amount of time for its implementation.
When working on the time & materials model, such risks are eliminated, since the project cost is calculated depending on the amount of work performed and the rates of the specialists involved. On the one hand, this ensures the customer against the contractor’s desire to save on everything, including the quality of services, on the other hand, there is a certain danger, which is that the contractor may have a desire to delay the project, “inflate” paid man-hours, which will lead to unlimited growth in the value of the developed product. To prevent such a situation, it is recommended to divide the project into separate stages that are small in volume and time, gradually creating the necessary system functionality and without losing control of the contractor.
In the first case, formally, the risks fall on the shoulders of the contractor, and in the second - on the shoulders of the customer. The dedicated development center model, or the dedicated team, implies equal responsibility. The customer company depends on the outsourcer since the outsourcer has been given the basic functions of developing and improving customer’s information systems. In turn, the outsourcer is linked with the customer, because in the event of a breakdown in relations, a well-formed team of specialists and the center’s infrastructure appears on outsourcer’s balance sheet, which hardly can be quickly appointed to another project. Mutual dependence opens up opportunities for creating a transparent and mutually beneficial partnership. Besides, in this case (with properly built interaction processes), there are practically no communication risks. This helps to avoid additional financial costs for the elimination of problems in the project that arise if the customer and the contractor are “new to each other” and have not yet found a common language. However, the establishment of a dedicated development center for the implementation of only one or two small projects does not make sense: this can lead to the fact that the center’s specialists will be unemployed between the projects and the customer will be obliged to pay for their services according to the contract.
Cost of services: own team or outsourcing specialists?
Sometimes, having decided to involve an outsourcer in the task (regardless of the chosen model), the company discovers that the cost of specialist services is at the same level or even higher than the cost of maintaining its own IT team. The main mistake that causes such a reaction lies in the fact that the customer compares the amount in which the outsourcing specialist will cost him with the salary of his employee. But this is an incorrect approach.
To determine whether the software development and support outsourcing are beneficial for a company financially, it is necessary to calculate the real cost of its own IT specialists. Here two groups of expenses should be taken into account - personal, related to the remuneration of a particular specialist (the amount of wages here is only one of the components), and organizational, caused by the need to provide certain working conditions for the employee.
Personal expenses include salary, together with personal income tax, insurance deposits and social benefits; bonuses (if the company practices this); and the cost of a social package (for example, medical or other insurance). Next, you need to add the cost of holiday allowances (about one month a year the specialist does not work but receives payments), sick leave (at least once a year everyone can get sick), and expenses for business trips. Often, company superiors have to experience the truth of a well-known rule: an employee costs their company about twice as much as their salary. But the calculation does not end there. It is necessary to take into account the share of the organizational costs of the company, which falls on each employee. These are primarily expenses such as organizing the workplaces, rent payment for the premises, utility bills, repair costs, etc. Next are the costs associated with supporting the activities of other non-profit company’s divisions: financial and personnel departments, marketing, and administrative structures. A separate item of expenditure, which all employees share as well - is IT costs: the cost of using licensed software and information systems, computer infrastructure, networks, and telecommunications, etc. Finally, when calculating, one should also take into account the resources that the company allocates into providing unified technologies and work methodologies, supporting the compliance of various internal processes with standards and rules.
Of course, each company will have its own set of components in this calculation. Some costs may apply to all personnel, and some only to certain groups, but in general the methodology remains the same: it is necessary to take into account all the items of expenditure related personally to the employee’s remuneration and the organization of their work as a whole. As a result, the final amount is three to four times higher than the number of wages - this is the real cost of an IT specialist for the company. It is this figure that needs to be compared with what the outsourcing companies offer and what they want in return: then it will be possible to understand how much IT outsourcing is more or less expensive compared to using your resources.
Productivity is an important factor when making a decision
There is another important point - the existing difference between the productivity of the company's specialists and employees of an external service provider, which directly affects the level of the company’s expenses for the IT compound. As an explanation, you can compare the work of a dedicated team with the work of the company's IT department (this comparison is most obvious since it allows you to compare two similar structures with the already existing infrastructure).
An IT service provider is especially careful in organizing the work of a dedicated team and allocates a significant amount of resources (time and financial) to create a structure that will help the teamwork as productively as possible. This is justified since the investments are directed to the development of the outsourcer's core business. On the contrary, companies from non-IT industries often finance the development of their own IT department on a residual basis, since for them IT is only one of the components that support the business. The difference in approaches determines the difference in the performance of the dedicated team and the non-IT company's unit.
The availability of financial and time resources allows the outsourcer to build a methodology for the functioning of the center, technology for managing the development, testing, maintenance of information systems in accordance with international standards (ISO, CMMI). To effectively manage projects and resources, specialized internal information systems are introduced and used - with their help, key points of the project are monitored (meeting deadlines and financial parameters, quality of work and issued solutions, etc.). This creates all the necessary conditions for efficient and high-performance work, quick determination of the most problematic issues in the project, and their elimination.
Only a few companies from outside the IT industry can boast of such infrastructure. This is understandable: for its creation, it is necessary to attract qualified and experienced IT managers and specialists, give them time to develop a methodology, build internal processes, and implement supporting information systems, select and train personnel. All this converts into serious capital costs, which also do not bring quick and measurable, from the point of view of the business, results. The presence of such an infrastructure provides higher productivity of specialists. But since the development centers have a well-built infrastructure, streamlined processes, a set of information systems to support development and project management, the productivity of specialists is higher than their colleagues from the internal IT department.
These are just a small number of questions that allow you to re-evaluate the financial feasibility of attracting an external service provider and choose the most effective IT outsourcing model for the company. Rational and balanced actions at the decision-making stage largely determine whether a company can achieve positive results from transferring the development and support of information systems to an external partner: quick launch of new products on the market and quick response to changes in market conditions, reliable and cost-effective support for all procedures and processes within the company, "enrichment" of the business through the application of best practices and experience that the service provider has. Such advantages explain the widespread outsourcing of the development and support of information systems.
Banking, investment, and insurance structures, software manufacturers, global corporations consider contacting an external partner as a way to control IT costs and ensure their predictability, get reliable support for their core business, and bring new ideas and technologies to their business. Their experience proves that cooperation with an outsourcer (especially when it comes to long-term partnerships) helps companies increase their efficiency and improve the quality of services for their end customers.