Analysis: When Outsourcing Goes Bad

It's true that many companies benefit from turning over technology management, customer service, and back-office functions to third parties, and the outsourcing business is booming. But the stampede to outsource over the past few years has trampled more than one company. In the past six months alone, Sprint Nextel and Diebold have scrapped or renegotiated big outsourcing engagements. The growing list of deals that have backfired is raising fears in CIO offices and corporate boardrooms that outsourcing can be a high-risk, caveat emptor practice.

Outsourcing is like any other business initiative: It can be executed well or painfully botched. The secret is avoiding the pitfalls that can be seen in some of the more recent high-profile failures. Lack of awareness of IT's true costs is a big one--many companies underestimate what their in-house IT departments do and the flexibility they offer, until they send work to a third party that wants to charge every time it lifts a finger. Other common traps are failure to plan for management transitions, inability to manage a team of vendors, overly ambitious projects, lukewarm executive buy-in, and failure to acknowledge the complexity of offshoring.

Precisely half of companies rate their outsourcing efforts a success in InformationWeek Research's recent survey of 420 business IT pros. Yet, a third are neutral, and 17%--nearly one in six--call them disasters. That range should give pause to anyone looking to outsource IT or a business process for easy money. Companies also had better be prepared for the possibility of taking work back in-house, because it has become commonplace. Half of companies in our survey have done so, 23% on a major project.

For obvious reasons, most parties to a failed outsourcing engagement--if they're still employed--don't want to talk about the particulars. We tried with the companies that follow, and most turned us down. But in many cases, there's a paper trail as more and more bungled deals end up in court or as the subject of a company's Securities and Exchange Commission filings because they put such a dent in the bottom line.

Understand The Real Costs

In 2003, Sprint tapped IBM Global Services to handle a number of key software development and IT management tasks, such as developing a Web services environment that would let Sprint rapidly provision new services to businesses and consumers. There were high hopes for the engagement, valued at $400 million over five years. Sprint CIO Michael Stout heralded it as the best way for the telecom company to "focus on areas of growth and innovation." Sprint was counting on the deal as part of a plan to cut $2 billion in operating costs over two years.

Fast forward to 2006. Stout is no longer CIO, Sprint has merged with Nextel, and the company is accusing IBM in court of failing to achieve the promised productivity improvements and of concocting a scheme to "falsely bolster" its performance metrics.

Where did it go wrong? Sprint's internal accounting didn't properly value the work performed by the in-house IT staff, says a former Sprint IT worker who, along with about 1,000 of his colleagues, was "rebadged" to IBM as part of the deal. When those functions were turned over to a contractor, Sprint was hit with sticker shock and balked at the price for a number of projects meant to boost productivity and hit the goals in the contract. "No new projects were going through the pipeline," says the source, who spoke on condition of anonymity and no longer works for either company. Two hundred or more top engineers also left, he estimates, amid the confusion and lack of projects.

In its complaint, Sprint claims IBM failed to achieve contractually agreed upon productivity gains. The carrier wants IBM to provide an additional 119,000 hours of work free of charge and is seeking damages of not less than $6.4 million. Sprint CIO Richard LeFave, who replaced Stout after the merger with Nextel, declined to be interviewed.

At MeadWestvaco, CIO Jim McGrane sought a realistic appraisal of what his company was getting for its internal IT spending before trying to bid that work to outsourcers. MeadWest-vaco performed a thorough cost evaluation of all services performed by its tech staff. "We went through and defined our service catalog, and we defined the cost of delivering each service," McGrane says. To obtain objective measurements, the company benchmarked its results with those published by the Hackett Group consultants. "If you know what you have, you're in a much better position to achieve a contract that doesn't bite you," McGrane says. This year, his company handed a range of IT functions to Affiliated Computer Services.

With so much at stake, failed outsourcing deals can easily end up in court. Sears Holdings, the corporate parent of retailers Sears and Kmart, and Computer Sciences Corp. are still locked in a legal battle to settle the status of a 10-year, $1.6 billion IT services contract that Sears walked away from in early 2005, after just one year. Sears says it tore up the contract "for cause" but won't elaborate. CSC sued for damages, complaining that a corporate restructuring left Sears with a new management team that wanted nothing to do with outsourcing. According to Sears' most recent quarterly SEC filing, the two parties have agreed to "voluntarily mediate their disputes." At stake for Sears are millions of dollars in termination fees that it would have to pay CSC if a court rules it improperly ended the contract. CSC says it may not be able to recover investments made in Sears' infrastructure if it loses the case--an amount that could be as high as $100 million, according to Moors & Cabot analyst Cindy Shaw.

Deals Are Long-Lived

Outsourcing carries a long-term, big-ticket financial commitment, so major deals need board-level scrutiny. Just like building a new factory, they can outlast the executives who broke ground. Sears' contract with CSC was fashioned under CIO Gerald Kelly, who was out after last year's merger of Sears and Kmart. Kmart CIO Karen Austin got the top technology post at the combined company. It became her job to look for an exit from the CSC outsourcing deal.

Walking away from a deal early can cost a company dearly unless it can prove that the outsourcer was failing to live up to key terms in the contract. William Bierce, a New York attorney who specializes in outsourcing law, says he worked on a contract in which the penalty for early termination was $60 million. Typically, termination fees increase every year in the early years of a deal because, at that point, the vendor is investing heavily in PCs, servers, and software on behalf of the customer. But Bierce says filing a lawsuit should be a last resort because of the public scrutiny it brings to a company's operations. "Disputes with service providers are extremely sensitive because they highlight the dependency of the enterprise on the service provider," he says. "And anything that highlights a dependency is fair game for shareholders' attorneys and class-action lawsuits."

Sears has good reason to try to hammer out an amicable agreement with CSC, which continues to provide the retailer with IT services until the dispute is resolved. In its annual report, Sears suggests the imbroglio could create operational risk. "Given the number of individual transactions we have each year, it is critical that we maintain uninterrupted operation of our computer and communications hardware and software systems," the report says.

One company that handled a similar situation more adroitly is JP Morgan Chase. When it merged with Bank One in 2004, Chase execs decided to take advantage of the significant investments that Bank One already had made in its internal IT infrastructure and thus backed out of a $5 billion outsourcing contract with IBM.

Instead of mutual recrimination, however, the companies worked out a transition plan that saw Chase retake control of its outsourced operations and move 4,000 tech workers back in-house. IBM went so far as to issue a press release pledging to help the bank repatriate Chase's tech operations.

InformationWeek

Day-To-Day Impact

The aftermath of a failed outsourcing agreement isn't limited to the financial impact. It can seriously damage a company's day-to-day operations. U.K. grocer Sainsbury's found that out the hard way after a plan to outsource much of its supply chain systems to Accenture went awry. In April, the company said it had worked with Accenture to move all of the operations back in-house. Four hundred seventy IT employees who had transferred to Accenture as part of the original seven-year, $2.17 billion deal, signed in 2000, have moved back to Sainsbury's. The project was part of a wider initiative by the chain's former chairman Sir Peter Davis to modernize its operations. Sainsbury's took a charge against earnings of more than $118 million to cover the cost of the pullback. The damage already had been done, however. Sainsbury's last year publicly revealed that the relationship was in trouble after an effort to modernize its supply chain foundered, resulting in bare spots on shelves in some stores. Sainsbury's executives declined to be interviewed.

Companies aren't shy about taking back work from outsourcers if a project gets off track. One-quarter of 25 large companies Deloitte Consulting surveyed last year had brought functions back in-house after realizing they could do the work themselves more successfully and at lower costs. Forty-four percent said outsourcing didn't save any money. Nearly half identified hidden costs as the most common problem when managing outsourcing projects. In InformationWeek's survey, poor service and lack of flexibility are cited most often for failures, by 45%, and 39% point to hidden costs. The Deloitte study concludes that companies embrace outsourcing to cut costs, simplify projects, and tap expertise not found in-house. But many find outsourcing actually introduces unexpected com- plexity, adds cost and friction, and requires more senior management attention and deeper management skills than anticipated.

Diebold cited the need for speed and greater flexibility in its decision last month to pull back an ERP project, four years into a seven-year contract with Deloitte Consulting. The move will let the company get a payoff from its ERP system sooner and be more flexible in reacting to customer needs, Diebold CEO and president Thomas Swidarski said in a statement. The decision couldn't have been taken lightly: Canceling the contract will trim 7 cents per share from the company's second-quarter earnings.

Fed Foul-Ups

The federal government has lived through similar problems when it comes to outsourcing. The Department of Defense and EDS worked to create a state-of-the-art, highly secure intranet for the Navy and Marine Corps through a multibillion-dollar outsourcing agreement signed in 2000. In March, the Navy extended EDS's contract to maintain and further develop the system for three years beyond the original 2007 expiration, creating an additional $3 billion in revenue for EDS.

Work on the project now appears to be going smoothly. As of March, EDS was operating about 277,000 desktops on the intranet, about 96% of the number originally envisioned in the contract. But recent successes have come only after years of delays and cost overruns. Speaking publicly in 2004, Marine Corps Lt. Gen. Edward Hanlon Jr. called the project "rocky and problematic" and said EDS "was not prepared" to implement it. Twice in 2004 EDS had to delay the release of quarterly earnings reports because the project's finances were so muddled.

Communication was a big problem in the intranet's implementation. A number of people who worked on it cite a recurring problem of EDS teams not getting timely access to Navy bases. "They'd be told to come back the next day," says one person involved, adding "you don't argue with an admiral." The problem is one that can plague outsourcing deals in the private or public sector. Top executives--officers in the case of the Navy--running IT and business units must support an outsourcing initiative to ensure its success. "We had trouble in communicating who was responsible for what," says Mike Koehler, EDS's client executive for the project. Now, he says, "there will be no ambiguity about who does what and when."

Broad buy-in is vital but so is a single point of buck-stops-here accountability. The Navy and EDS made organizational changes to address that earlier this year, establishing a program executive office to keep things on track. "There were problems in the early days. I can assure you that doesn't happen now," says Col. Robert Baker, the Navy's technical director for the intranet project. The Navy also erred initially by treating the intranet solely as a services engagement, in spite of its huge hardware component. "This was not an acquisition program, but it required acquisition rigor," Baker says. "We've instilled that, and that's one reason why it's working better now."

More Vendors, More Complexity

Baker already is looking beyond the contract's expiration in 2010. He may follow a trend gaining steam in the commercial sector and opt for a team of vendors to manage once the contract expires. "I'm a proponent of dual vendor strategies," he says. "It instills competition."

The U.K. Ministry of Defense opted for that approach when it set about contracting for the construction of a secure intranet under its $4.3 billion Defense Information Infrastructure project. The ministry has tapped EDS and Fujitsu to act as prime contractors. "This is a lesson that MOD learned from us," Baker says.

Of course, divvying up a major outsourcing contract among a team of vendors isn't a guaranteed recipe for success. In its own version of the Navy-Marine Corps Intranet debacle, the U.K. government's attempt to modernize its flagging National Health Service is bogged down as numerous contractors attempt to install systems that, in some cases, use conflicting technology. Britain's Labor government now warns that the NHS's National Programme for IT will end up costing more than $55 billion--a whopping $26 billion over budget. Accenture has won $3.5 billion in contracts to implement the program in England's eastern and northeastern regions. CSC has a $1.6 billion deal for the northwest and West Midlands, and Fujitsu has a $1.7 billion contract for southern England. Several other vendors, including Agfa, Atos Origin, and Tata Consultancy Services, also have significant pieces of the work.

The project has been plagued by delays caused by everything from software incompatibilities to resistance from physicians. "I fear it will be the largest-ever systems integration disaster," says professor Ross Anderson, who heads the computer security group at Cambridge University. Anderson helped author a report on the project by the United Kingdom's National Audit Office, due out by month's end.

In many cases, systems installed by the various vendors working on the project aren't compatible, Anderson says. "It's different software, it's different standards, it's different everything," he says. "This isn't just a matter of wasting billions, it could cost lives."

The United Kingdom should have taken a more gradual approach to creating electronic health records, Anderson says. "It's too much change, too fast," he says. He notes that a number of countries, including the United States, are rolling out e-health systems incrementally. "There's not as much fanfare, but suddenly you find that you've got something that works."

NHS officials declined to be interviewed but provided a statement that the project isn't significantly over budget. The NHS argues that the government's latest cost estimate includes routine IT maintenance and training expenditures that aren't explicitly connected to the National Programme for IT. "The costs of the core contracts [of $11.65 billion] have not risen," the NHS says.

If there are cost overruns, it's hardly a boon to the vendors--they face big penalties and expenses if deadlines aren't met. In March, Accenture noted in an SEC filing that the setbacks have "significantly increased the risks and uncertainties associated with these [NHS] contracts." The company took a $450 million hit to second-quarter earnings as a result.

Offshoring À La Carte

Offshore deals carry their own set of challenges. (For more on attitudes about offshoring, see story, "Cost Cutting Is The Main Reason For Outsourcing--Survey".) But increasingly, offshoring is just one more variable to manage, since so many projects have some overseas component. Cost cutting is the overwhelming reason companies look offshore. Companies also need to moderate their expectations when it comes to offshoring, warns Worldspan CIO Sue Powers. "It's like a bell curve," she says. "Some projects will go well and others will be difficult. Most are somewhere in the middle." Worldspan outsources application development work to India's TCS and InterGlobe Technologies.

Companies concerned about offshoring their work need to make that part of the negotiations, since vendors often look to the cost savings of offshore labor to make deals profitable.

Faulty assumptions surrounding offshore outsourcing may have played a part in Sprint Nextel's fallout with IBM. IBM moved some functions to India, the former employee says, but Sprint refused to let a number of key functions leave the country. Understanding where work will be done and making sure all parties are comfortable with that, is key to success. Our survey finds three-quarters of spending on outsourcing is for domestic work, a quarter for offshore. But projects often will have elements of both, and buyers need to be prepared.

Outsourcing keeps growing, so companies must feel the benefits are worth the hassles. And IT and business services vendors keep expanding their staffs and capabilities, hoping to take on more work. The opportunities are there--as long as you know how to avoid the pitfalls.

Illustration by John Sledd